FIN 4329 Derivatives Part 1: Futures Markets and Contracts.
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Transcript of FIN 4329 Derivatives Part 1: Futures Markets and Contracts.
FIN 4329
Derivatives Part 1:
Futures Markets and Contracts
Copyright 2004, Dr. Jeffrey M. Mercer 2
Introduction
A forward contract is an agreement between two parties in which the buyer agrees to buy from the seller an underlying asset at a future date (called the expiration date) at a price established at the start of the contract (called the forward price).
Both parties have commitments. The buyer is called the long - said to have taken the
long position. The seller is called the short - said to have taken the
short position. Note that no money changes hands until expiration.
Copyright 2004, Dr. Jeffrey M. Mercer 3
Delivery and Settlement For a deliverable contract, at expiration the short delivers the u.a. and
the long pays for it. This is called delivery settlement.
For a cash-settlement contract, at expiration the two parties settle up based on the net cash value of the contract. Cash-settlement is used when delivery of the u.a. is impractical
(e.g., the S&P 500 Index).
Copyright 2004, Dr. Jeffrey M. Mercer 4
Default Risk
Forward contracts are subject to default, in that one party might be unable/unwilling to carry through with their commitment.
Only the party who has a “loss” can technically default (i.e., you would not walk away if you had a gain).
How much is at risk? Only the “gain” coming to one party, not the forward price.
Copyright 2004, Dr. Jeffrey M. Mercer 5
Termination by “Offsetting”
One can effectively terminate a forward position by later taking a second, offsetting position. An initial long can be offset with a subsequent short, and vice versa.
This can be done with the same party or with a different party.
Copyright 2004, Dr. Jeffrey M. Mercer 6
Structure of Forward Markets
Not a centralized market. Dealers (mostly big BHC’s and
securities/investment firms) make a market and specialize. CSFB, Goldman Sachs, etc.
Dealers transact with end users (those who wish to lay off risk) or other dealers so that they do not have large exposures.
Copyright 2004, Dr. Jeffrey M. Mercer 7
Futures
Like a forward contract, a futures contract is an agreement between two parties in which the buyer agrees to buy from the seller an underlying asset at a future date (called the expiration date) at a price established at the start of the contract (called the futures price).
Key differences: Futures contracts are initiated (“opened”) on an
organized futures exchange. Futures contract specifications are “standardized.” Futures contracts trade on an organized exchange (a
secondary market); “pit trading.”
Copyright 2004, Dr. Jeffrey M. Mercer 8
Public Standardized Transactions
Forward contract transactions are private transactions.
Futures contract transactions are recorded and reported – but not the direct identity of the parties.
What are the “terms” of a forward or futures contract? Price –only term established by the two parties. All other terms (next slide) are established by the
exchange – they are “standardized.”
Copyright 2004, Dr. Jeffrey M. Mercer 9
Terms of a Futures Contract
Specifications and grades of underlying asset. Expiration dates
Months and days How far in the future
Contract size (e.g., 5000 bushels) Price quotation unit Settlement specifics Delivery location Standardization creates liquidity. Traders can easily
offset (buy if previously sold; sell if previously bought).
Copyright 2004, Dr. Jeffrey M. Mercer 10
Daily Settlement
Each futures exchange has a clearinghouse. Capitalized by clearing members. Guarantees all trades.
Buyer to every seller. Seller to every buyer.
Requires margin. Settles gains/losses every day. Called marking to market.
Copyright 2004, Dr. Jeffrey M. Mercer 11
Margin and Marking to Market
Margin Initial margin requirement
Set by the clearinghouse. Based on risk exposure. Usually small. Creates leverage.
Maintenance margin Lower than initial requirement Minimum end-of-day balance allowable (based on
settlement price) before margin call Margin call; must bring balance back to initial level.
Amount necessary is variation margin.
Copyright 2004, Dr. Jeffrey M. Mercer 12
Delivery and Settlement
Most futures contracts are offset before expiration. What happens if a contract is not terminated through
offset? It depends on whether the contract calls for cash
settlement or delivery. For a deliverable contract, at expiration the short
delivers the u.a. and the long pays for it. This is called delivery settlement.
For a cash-settlement contract, at expiration the two parties settle up based on the net cash value of the contract. Cash-settlement is used when delivery of the u.a.
is impractical (e.g., the S&P 500 Index).
Copyright 2004, Dr. Jeffrey M. Mercer 13
Short-Term Interest Rate Futures
Primary short-term interest rate futures are Eurodollar futures (IMM of CME) Federal Funds futures (CBOT)
Copyright 2004, Dr. Jeffrey M. Mercer 14
Eurodollar Futures Contracts
The contract is based on the LIBOR rate on a 90-day Eurodollar deposit with $1,000,000 par (maturity) value.
The futures contract is quoted as 100 minus the LIBOR rate (in percent) that is priced into the contract.
100 minus the Rate is called the IMM Index, so traders reference the IMM Index when quoting the futures “price.”
Copyright 2004, Dr. Jeffrey M. Mercer 15
Eurodollar Futures Contracts
Say we see the IMM Index at 97.75. This implies that the discount rate on LIBOR being priced into the contract is 2.25%.
The actual futures price would then be
375,994$360
900225.01000,000,1$Price
x
Copyright 2004, Dr. Jeffrey M. Mercer 16
Eurodollar Futures Contracts
So we can speak to the “price” of the futures contract in three separate ways:
1. The LIBOR rate itself (2.25%)
2. The IMM Index (97.75)
3. The actual contract price ($994,375)
Copyright 2004, Dr. Jeffrey M. Mercer 17
Eurodollar Futures Contracts
Note that as LIBOR declines, the IMM Index and the futures price increase.
So eurodollar futures prices are inversely related to interest rates.
For every one basis point move in LIBOR (say from 2.25% to 2.26%, or IMM Index from 97.75 to 97.74), the contract price changes by $25.
The minimum tick size is one basis point, or $25.00 in price.
Copyright 2004, Dr. Jeffrey M. Mercer 18
Eurodollar Futures Contracts
The available expirations are the next two months plus March, June, September, and December out ten years.
So at any point in time you can “lock in” floating rate payments tied to 3-month LIBOR.
We can therefore observe the market’s expectation of 3-month LIBOR (i.e., LIBOR forward rates) from the futures market.
Copyright 2004, Dr. Jeffrey M. Mercer 19
Federal Funds Futures Contracts
The contract is based on the average daily fed funds overnight rate for the delivery month.
The contract size is $5,000,000. The price is quoted as 100 minus the average
daily fed funds overnight rate for the delivery month (e.g., a 2.25 percent rate is quoted as 97.75).
Copyright 2004, Dr. Jeffrey M. Mercer 20
Federal Funds Futures Contracts
The contract price, at a rate of 2.25%, would be
The minimum tick size is one-half basis point, or $20.835 in price, calculated as (0.01)x(0.01)x(0.5)x(30/360)x($5,000,000).
625,990,4$360
300225.01000,000,5$Price
x
Copyright 2004, Dr. Jeffrey M. Mercer 21
Federal Funds Futures Contracts
The available expirations are the next 24 months.
Open interest in the nearby contract is almost 200,000 contracts.
Cash settlement.
Copyright 2004, Dr. Jeffrey M. Mercer 22
Intermediate- and Long-Term Interest Rate Futures Contracts The two most popular are T-note and T-bond
Futures. T-notes have original maturities from 2 to 10
years. T-bonds have original maturities greater than
10 years. This is the only significant difference. The futures contracts are basically the same. We’ll focus on the T-bond contract.
Copyright 2004, Dr. Jeffrey M. Mercer 23
T-Bond Futures Contracts
The contract is based on the delivery of a U.S. T-bond with any coupon rate but with a remaining maturity of at least 15 years, and $100,000 par value.
At any time, there are many different issues, with very large outstanding principal balances, that will satisfy this condition.
That is, many different bonds are “deliverable.” The short, then, will want to deliver the “cheapest”
bond he can find.