Version 1/9/2001

FINANCIAL ENGINEERING: DERIVATIVES AND RISK MANAGEMENT (J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

LECTURE Futures Contracts

Copyright K.Cuthbertson and D.Nitzsche 1

Topics
Basic

Concepts

Speculation

Arbitrage

Hedging

Marking

to Market (Margin Account)

Copyright K.Cuthbertson and D.Nitzsche 2

Topics

Basic Concepts

Copyright K.Cuthbertson and D.Nitzsche

Spot and Futures Markets

Futures contract is an agreement to buy or sell something in the future at a price agreed today. There is a spot/cash asset underlying the futures contract (eg. can have a futures written on live hogs/oil/stocks) Let S = Spot/Cash price S = price for delivery today(in cattle market) Futures prices F are continuously quoted and change from second to second (and moves almost one-for-one with movements in S) But it is the futures contract you are buying and selling not the underlying asset itself (e.g. they are traded on different exchanges - e.g. NYSE and CBOT)

Copyright K.Cuthbertson and D.Nitzsche

FUTURES CONTRACT

Futures Price F0 =$100 on live hogs, quoted today (1st Jan) with Delivery Month in say September Buy = Long Futures - Agreed a (legal) contract to buy the underlying (eg, 1-live hog) the delivery month at F0 = $100 (IF the contract is held to maturity)

in

Sell = Short Futures - Agree to sell the underlying (1-live hog) in the delivery month at , F0 =100 ( IF the short contract is held to maturity)

(You will be notified by the exchange a few days before the maturity date of the contract, that on your particular contract delivery is going to take place - in order that you can have your hogs ready and looking good.

Copyright K.Cuthbertson and D.Nitzsche

FUTURES CONTRACT

No payment made today ( only a deposit to guarantee you will not quit on the deal - this is know as a margin payment AND IS NOT THE FUTURES PRICE - see later).

This means that futures provide LEVERAGE, in that a speculator can enter into a futures contract whose value changes with that of the underlying stocks, but she does not have to spend any of her own money at t=0 !
The clearing house/futures exchange acts as an intermediary between buyers and sellers (and keeps a record of all transactions) Analytically: Care must be taken to state whether your analysis involves holding the futures to maturity or buying then selling prior to maturity

Copyright K.Cuthbertson and D.Nitzsche

Why does F change between 1st Jan and 1st Feb ?

As we see later arbitrageurs ensure that F changes as the price of hogs changes in the spot market S.
If S increases (falls) then F will increase (fall) - almost $1 for $1 over short horizons (e.g. 1 - 3 months)

Copyright K.Cuthbertson and D.Nitzsche

Table 2 : Forward and Futures Contracts

FORWARDS

FUTURES

Private (non-marketable) contract between two parties

Delivery or cash settlement at expiry

Traded on an exchange
Contract is usually closed out prior to maturity

Range of delivery dates

Usually one delivery date No cash paid until expiry Negotiable choice of delivery dates, size of contract

Cash payments into (out of) margin account, daily Standardised Contract

Copyright K.Cuthbertson and D.Nitzsche

FINANCIAL FUTURES MARKETS LIFFE CBOT(IMM) CME N.Y. Futures Exch. Phil. Exch. Singapore Int Exch. Hong Kong Tokyo\Osaka Pacific St. Ex. (San F.)

Money market instruments: 3-mth Euro$ Deposits 90-day US T-bills 3-mth Sterling, DM, deposits Bonds US T-bond, UK Gilt, German Bund. Stock Indexes S&P 500, FTSE100 Currencies DM, Sterling, Yen, Mortgage pools (GNMA)

Sydney Fut. Exch.

Copyright K.Cuthbertson and D.Nitzsche

FUTURES CONTRACT
Most contracts are closed out prior to the maturity/delivery date ( -see also hedging, later) Note that if on 1st Jan you bought a Sept-futures contract at F0 then you can get out of this contract before maturity simply by selling this Sept-futures contract on say 1st Feb at whatever price F1 is being quoted for the Sept-contract on 1st Feb. Then nobody delivers anything at maturity.

Copyright K.Cuthbertson and D.Nitzsche

Who Uses Futures ?

Speculation with futures Buy low, sell high - risky ( naked/open position)

Hedging with futures eg.In Jan, farmer wants to lock in sale price of his hogs which will be fat by Sept - In Jan he sells hog futures at F0=$100 with maturity date of Sept - if he holds contract to maturity he delivers his hog in Sept and receives the $100 (for certain) - ie. even if hogs in (spot) cattle market are selling for $10 .
Arbitrage Spot and futures prices are linked by the actions of arbitrageurs and S and F move almost one-for-one - latter is useful for hedgers (see later)

Copyright K.Cuthbertson and D.Nitzsche

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Table 2.4: Futures: Price Quotes CORN (CBT) 5,000 bu (cents per bu.)

(1)

(2)

(3) Low
1 1

(4)

(5)

Lifetime High
2 265 1

Open Interest 132,493 176,843 37,875

Open High Sept Dec

1 1 1 1

Settle Change 1802 1924 2044

1 1 1

Low
4 178 1

182 2 183 4 179 4 194 2 195

2

- 24 - 2 1/2 - 24
1

191 4

279 190 279 202

Mar 01 206

206 203

Source : Wall Street Journal Thursday 27th July 2000.

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Speculation With Futures

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Speculation With Futures

Purchase at F0 = 100 Hope to sell at higher price later F1 = 110 Close-out position before delivery date. Obtain Leverage (ie. initial margin is low)

Example:Leeson: Feb 95, Long 61,000 Nikkei-225 index futures (underlying value = $7bn). Nikkei fell and he lost money (lots of it) - he was supposed to be doing riskless index arbitrage not speculating

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Figure 2.3 : Speculation with futures

Profit/Loss per contract

Long future $10
F2 = 90

F1 = 100

F2 = 110

Futures price

-$10

Short future

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Payoffs: Direction Vectors

F increase then profit increases F increase then profit decrease

Profit/Loss

Profit/Loss

+1
Underlying,S

-1 -1 Short Futures or, Short Spot

+1 Long Futures or, Long Spot

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ARBITRAGE with FUTURES

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ARBITRAGE AT MATURITY
At expiry (T) we must have FT = ST

otherwise riskless arbitrage profits could be made EG. Suppose 1-day before maturity FT = 100 > ST =98

Then buy low at S=98 in cattle market , and at same time sell one future contract at F = 100. One day later deliver the hog in the futures contract and collect F=$100 (at maturity). This is (virtually) riskless.
Copyright K.Cuthbertson and D.Nitzsche

Figure 2.7 : Backwardation and Contango

Forward price in contango : F > S

0
T

Stock price, St
At T, ST = FT

Forward price in backwardation : F < S

For simplicity we assume that the spot price remains constant. In practise, S and hence F will fluctuate as you approach T but with Ft > St if the market is in contang and Ft < St if the market is in backwardation.
Copyright K.Cuthbertson and D.Nitzsche 19

ARBITRAGE(at t<T): Pricing Futures Cash and Carry Arbitrage

Stock price, S = $100 Safe rate r = 4% p.a. (for delivery in 3m )

Quoted Futures Price F = $102

Strategy Today Sell futures contract at $102 (receive nothing today)

Borrow $100, buy stock ( = synthetic future)

Use no own funds

3-Months Time ( T = 1/4 ) Loan Outstanding = $100( 1 + 0.04 / 4) = $101 Deliver stock and receipt from f.c. Riskless profit = $102 = $1
20

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ARBITRAGE: Pricing a Futures Contract

Borrow and purchase stock today is equivalent to having the stock in 3-mnths = SYNTHETIC FUTURE

( Note: No own funds used to create the synthetic ) Cost of synthetic future, SF = S ( 1 + r.T ) = $101

Arbitrage ensures F =

quoted futures price equals SF S ( 1 + r .T ) = $101

Futures Price = Spot price + cost of carry Cost of Carry = S rT = $1

Copyright K.Cuthbertson and D.Nitzsche 21

Hedging with Futures

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Hedging with Futures

Arbitrageurs ensure F and S are nearly perfectly positively correlated and move $1 for $1.

F = S ( 1 + r .T ) = S (1.01)
so approx: (F1 - F0) = (S1 - S0) ie. dollar for dollar

Copyright K.Cuthbertson and D.Nitzsche

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Hedging with Futures

F and S are positively correlated Create a negative correlation

If you are long spot( ie. own 1-share) then short the futures contract ( on the share) to offset the risk in spot/cash market

1) Hope that the loss in the cash/spot market is (partly) offset by gain on the futures (dollar for dollar)
or, 2) Final Value = Cash Market Value + gain on futures, locks in a known price

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Hedge = Long Underlying + Short Futures

+1 +1

Long Underlying Stock +

Short Futures

-1

-1
0 0 =

Hedge

Copyright K.Cuthbertson and D.Nitzsche

Simple Hedging
Own (long) 1-share Spot price S0= $100 Fear price fall over next 3-mths 3-month futures contract has current price, F0 = $101 AIMS: 1) To offset some of the loss in S by profit on F or,

2) To lock in a final value of F0 = $101

Assume: F and S are perfectly (positively) correlated Strategy: Long share + short one futures contract

Copyright K.Cuthbertson and D.Nitzsche

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Simple Hedging (S0 = $100, F0 = $101) 1) Loss in spot market offset by gain on the futures
3 MONTHS LATER(Spot Price has fallen) Spot Price S1 = $90 Futures Price F1 = $90

Note that we have assumed the contract is closed out just before maturity so that S1 = F1
Gain on Futures = (101 - 90) = ( F0 - F1) Loss on the spot = (100 - 90) = (S0 - S1 ) = $11 = $10

Net Profit = ( F0 - F1 ) - ( S0 - S1 ) = 11 - 10 = $1 Note that you cannot guarantee that the hedge will give a net profit of zero, only that the net profit in the hedge will be less uncertain than simply holding the stocks (ie. here a loss of $10).
Copyright K.Cuthbertson and D.Nitzsche 27

Simple Hedging (S0 = $100, F0 = $101)

2) Can we lock in a price of F0 = 101 ? 3 MONTHS LATER(Spot Price has fallen) Spot Price S1 = $90 Futures Price F1 = $90

Spot asset is worth S1 = 90 and we close out futures position

Profit on Futures = (101 - 90) = F0 - F1 = $11

Final Value = Final Value of stocks + profit from futures

= 90 + 11 = (S1) + F0 - F1 = $101 Hence we have locked in a final value of F0 = 101
Copyright K.Cuthbertson and D.Nitzsche 28

Simple Hedging (S0 = $100,

Some Algebra: Final Value

F0 = $101)

= S1 + (F0 - F1 ) = $101

= (S1 - F1 ) + F0
= b1 + F0 where Final basis = b1 = S1 - F1 Note: At maturity of the futures contract the basis is zero (since S1 = F1 . In general, when the contract is closed out prior to maturity b1 = S1 - F1 may not be zero. This is called BASIS RISK. However b1 will usually be small in relation to F0. Source of basis risk is changes in r : F = S (1+r.T)
Copyright K.Cuthbertson and D.Nitzsche 29

Why does the hedger close out before maturity ?

Even though you close out the contract, you still lock in a price which is close to the initial futures (delivery) price of F0 = 101. But why not just take delivery at F0 = 101 ? Easiest to see if you are a farmer in New Orleans who wants to sell his live hogs in 3-months time when they have been fattened up.

If he delivers them in the futures contract he will have to send the hogs to Chicago (the delivery point). This is expensive, so instead he sells them in the local cattle market in New Orleans for S1 =90 But he also makes $11 cash profit on the futures, giving an effective price of $101, which EQUALS the F-price had he taken delivery
Copyright K.Cuthbertson and D.Nitzsche 30

MARKING TO MARKET

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MARKING TO MARKET:CONTRACT SPECIFICATION

One contract is for z = $100,000 of the underlying asset (eg. US TBond Future). F= price per $100 nominal Let 1-tick = change in F of 1 unit (eg. 98.0 to 99.0 ) Tick Value (set by the CBOT) = $1000 (= 1.0 /100) x $100,000

Initial Margin = $5000

Maintenance Margin=$4,000

If balance in margin account falls below $4,000 at market close, then it must be made up to $5,000 by the next morning. Buy one contract at F0 = 98 (noon, day-1) [ Value = $98,000] Close out contract at F3 = 98.5 (after 3-days)
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Table 2.3 : Marking to Market

Day Settlement (Price) Mark to Margin Balance Market Payment

1. 2. 3.

94,000(94.0) -4000 93,500(93.5) -500 98,500(98.5) +5000

5000 4000

$1000 $4500 $9500

Tick value (=1unit) = $1,000 Initial margin = $5000, (Maintenance margin = $4000) Buy at F0 = 98 (noon, day-1) TEXT BOOK: Total Profit = (F3 - F0) 1,000 = (98.5 - 98) $1,000 = +$500
Copyright K.Cuthbertson and D.Nitzsche

Marking to Market

Buy at F0 = 98 (noon, day-1)

End of Day-1, contract is worth F1 = 94.0 Change on the day = - 4 x $1000 = -$4000 New balance = $5,000 - $4,000 = $1000

Balance is below maintenance margin, hence must pay in 4,000 to make opening balance on day-2 = 5,000 (ie. the initial margin)

End of Day-2, contract is worth F2 = 93.5 (ie. Lost 500) Closing balance = 5,000 - 500 = 4,500 (above, maintenance margin)

End of Day-3, contract is worth F2 = 98.5 (ie. +5 ticks)

Closing balance = 4,000+5000 = $9,500 (send cheque)

Total Profit using Margin Account Final balance received = $9,500

less what you paid in $5,000+$4000 = $9,000 So final profit = + $500

Copyright K.Cuthbertson and D.Nitzsche

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MARKING TO MARKET

Futures contract is like a forward contract that is closed out every day and your daily cash gains/losses are noted by the Clearing House (CH). Then you enter a new forward contract at the beginning of the next day at the new futures price. Any cash gain/loss alters the balance in your margin account, daily.

The initial margin of $5000 is equivalent to 5 ticks. If the market falls less than 5 ticks in a day, the long (and the Clearing House) can always honour the contract. Trading halts are sometimes used to prevent a fall of more than 5 ticks in one day, so that margin payments can take place before the next days trading.

This is why futures contract involve no credit(default) risk

Copyright K.Cuthbertson and D.Nitzsche 35

SLIDES END HERE

Copyright K.Cuthbertson and D.Nitzsche

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