FINS1612 SUMMARIES

Week 10
Futures Contracts and Forward Rate
Agreements
Note: These are both derivatives because they derive their price
from an underlying physical or financial market product.

1/7 Hedging Using Futures Contracts:

The purpose of derivative contracts is to enable investors and borrowers to

protect assets and liabilities against the risk of changes in interest rates,
exchange rates and share prices via hedging.
o Hedging is the transferring of risk of unanticipated changes in prices,
interest or exchange rates to another party.

The change in the market price of a commodity or security is

offset by a profit or loss on the futures contract.

Two main types of derivative product:

o Commodity (Gold, wheat, cattle etc)
o Financial (shares, CGB, money market instruments etc)

A futures contract is an agreement to buy or sell a specified asset at a

specified time in the future.
o Buy futures (LONG POSITION) = agreement to buy an asset in the
future.
o Sell Futures (SHORT POSITION) = agreement to sell an asset in the
future

Decision rule for futures:

o What you want to do with the asset in the future do in the futures
market now
>>>What position you have in the asset now, take the opposite
position in the futures

A farmer concerned with wheat prices and wanting to SELL in

the future should do that in the futures market now; SELL =
Short position.

2/7 Main Features of Futures Transactions:

These are generally standardised but variation exists between countries.

o This is due to the underlying securities being traded being different
(Sydney futures exchange is different to CBOT, Chicago board of
trade)
o Also, there is differences in the quotation convention:
>>>Clean price bond quotation in US and EUR (PV minus accrued
interest)
>>>YTM bond quotation in AUS markets.

Special note: Clean price is more stable than dirty price as

clean price only changes for economic reasons such as interest
rate change or issuer credit rating. Dirty prices change each
day depending on time to coupon payments AS WELL as the
economic reasons.

Orders and agreement to trade (standardised part);

o Whether it is buy/sell order
o Type of contract (varies between exchanges)
o Delivery month / expiration
o Price restrictions (such as a limit order)
o Time limits on the order

Margin requirements:
o The buyer (long position) and the seller (short position) both pay an
initial margin, held by the clearing house, rather than the full
price of the contract.

This is imposed to ensure traders are able to pay for any

losses they incur owing to unfavourable price movements in the
contract.

o A contract is marked-to-market on a daily basis by the clearing

house
>>>repricing the contract daily to reflect current market valuations.
o Margin calls may be made, requiring the contract holder to pay a
maintenance margin to top up the initial margin to cover adverse
price movements.
Closing out of a contract:
o Entering into an opposite position

If company A initially entered into a sell one security X with

company B, then company A would close out the position by
entering into a buy one security X for delivery on the same
date with a third party, company C.

The second contract closes out/reverses the first contract and

company A would no longer have an open position in the
futures market.

Contract delivery:
o Most parties want to manage risk/speculate and never actually
deliver or receive the underlying commodity/instrument and close
out the contract prior to the delivery date.
o Sydney Futures Exchange (SFE) requires financial futures in
existence at the close of trading in the contract month to be
settled with the clearing house either;

Standard delivery delivery of the actual underlying financial

security.

Cash settlement

o Settlement details (calculation of cash settlement amounts etc) for

each contract traded on the SFE are available on the website;

www.sfe.com.au

3/7 Futures Market Instruments:

Futures markets can be established for any commodity or instrument that:
o

Is freely traded

Experiences large price fluctuations at times

Can be graded on a universally accepted scale in terms of quality

Is in plentiful supply (or cash settlement is possible)

EXAMPLES:
o

Commodities:

Mineral (au, ag, cu, zn etc)

Agricultural (wool, coffee, butter, wheat, cattle) amongst others

Financial:

Currencies (pound, sterling, euro etc)

Interest rates (short term instruments such as 90-day us

treasury bills, 3-month Eurodollar deposits, AUS 90-day bankaccepted bills and longer term instruments such as US 10-year
T-notes and AUS three/ten year Commonwealth treasury
bonds). Also share price indices (all ords) amongst others

4/7 Futures Market Participants:

The four categories of participants provide depth and liquidity to the futures
market, improving its efficiency.
1) Hedgers:
o Attempt to reduce the price risk from exposure to changes in interest
rates, exchange rates and share prices
o Take the opposite position to the underling, exposed,
transaction

If an exporter has USD receivable in 90 days. To protect against

falls in USD over the next three months, the exporter enters
into a futures contract to sell USD.

2) Speculators:
o Expose themselves to risk to make profit
o Enter into the market with the expectation that the market price will
move in a direction favourable for them

Speculators who expect the price of the underlying asset to rise

will go long (BUY) and those who expect the price to fall will
go short (SELL).

3) Traders:
o These are a type of speculator
o They trade on very short-term changes in the price of futures
contracts (intra-day changes)
o They provide liquidity to the market.
4) Arbitragers:
o Simultaneously buy and sell to take advantage of price differentials
between markets.
o Attempt to make profit without taking any risk

For example, differentials between the futures contract price

and the physical spot price of the underlying commodity.

5/7 Hedging: Risk Management using Futures

Futures contracts may be used to manage identified financial risk

exposures. For example:

6/7 Risks in using Futures markets for Hedging:

Standard contact size:
o The physical market exposure may not exactly match the futures
market exposure, making a perfect hedge impossible.

Margin Payments:
o Initial margin required when entering into a futures contract.
o Further cash is required if prices move adversely (margin calls)
o Opportunity costs associated with margin requirements.
Basis Risk: Perfect hedge has zero initial AND final basis risk
o Initial basis:
>>Difference between the price in the physical market and the
futures market at commencement of a hedging strategy.
o Final basis:
>> Difference between the price in the physical market and the
futures market at the completion of a hedging strategy.
Cross-commodity hedging:
o Using a commodity or financial instrument to hedge a risk associated
with another commodity or financial instrument.
o Selection of futures contract with price movements highly correlated
with the price of the commodity or instrument to be hedged.

7/7 Forward Rate Agreements (FRAs):

What is it?
FRA is an over-the-counter product enabling the management of an interest
rate risk exposure.
o An agreement between two parties on an interest rate level that will
apply at a specified future date.
o Allows the lender and borrower to lock in interest rates
o Unlike a loan, no exchange of principal occurs

Payment between the two parties involves the difference

between the agreed interest rate and the actual interest rate at
settlement.

Advantages:
o Tailor-made, OTC contract with good flexibility with respect to period
and amount of each contract.
o Unlike futures contract FRA does NOT HAVE MARGIN PAYMENTS
Disadvantages:
o Credit risk (risk of non-settlement)
o No formal market exists
Specifications?
o FRA agreed date, fixed at start of FRA
o Notional principal amount of the interest cover
o FRA settlement date when compensation paid
o Contract period on which the FRA interest rate cover is based (end
date)
o Reference rate to be applied at the settlement date

 Settlement Mathematics and numbers?

The settlement amount

o
= FRA settlement rate FRA agreed rate:
o

o Where:

is = reference rate at the FRA settlement date, expressed as a

decimal

ic = the fixed FRA agreed rate, expressed as a decimal

D = the number of days in the contract period

P = the FRA notional principal amount

Example:
On 19 September this year a company wishes to lock in the interest rate on
a prospective borrowing of $5 000 000 for a six-month period from 19 April
next year to 19 October of the same year. An FRA dealer quotes 7Mv13M
(19) 13.25 to 20. On 19 April the BBSW on 190-day money is 13.95% per
annum.
o is =

0.1395 (on 19 April)

o ic =

0.1395 (on 19 September)

o D = 183 days (from 19 April to 19 October)

P=

o
000 000

$5

 Due to interest rates rising over the period the settlement amount is paid
by the FRA dealer to the company.