Lecture 7 - Futures Markets

FuturesMarkets

FNCE30007DerivativeSecurities/Lecture7

Schedule

2

IntroductiontoOptions

PropertiesofStockOptions

TheBinomialModel

TheBlackScholes MertonModel

DividendsandOptionsonOther

InstrumentsTheGreeksFuturesMarkets

HedgingwithFuturesandForwards

ForwardandFuturesPrices FuturesOptions Swaps

Outlineandreadings

3

Outline Futuresandforwardcontracts Futurescontractspecifications Clearinghouse Openingandclosingafuturesposition Relationshipbetweenfuturespriceandspotprice Marginsandmarkingtomarket Openinterest FXquotes

Readings Hull,7th/8th ed.,chapter2

FuturesandForwardContracts

4

Futuresandforwardcontracts

5

Futuresandforwardcontractsareagreementstobuyorsellassetsatacertaintimeinthefutureforapricethatisfixedtoday.

Futurescontractsaresubjecttoadailysettlementofgainsandlossesandguaranteedagainsttheriskthateitherpartymightdefault.

Futurescontractsaredistinguishedfromforwardcontractsbecausefuturesaretradedonorganizedexchanges. Forwardcontractsareprivatecontractsnegotiatedbetweeninvestors.

Futuresandforwardcontracts

6

Thereisnodailysettlement(unlessacollateralizationagreementrequiresit)forforwardcontracts.Attheendofthelifeofthecontractonepartybuystheassetfortheagreedpricefromtheotherparty.

Futurescontractsvs.forwardcontracts

Futures Forwards

7

Tradedonanexchange

Standardized Rangeofdeliverydates..

Settleddaily Usuallyclosedoutpriortomaturity

Virtuallynocreditrisk

Privatecontractbetweentwoparties

Notstandardized Usuallyonespecifieddeliverydate

Settledatendofcontract Deliveryorfinalsettlementusual

Somecreditrisk

WhyTradeFuturesContracts?

8

Thereareusuallythreemotivationsfortradingfuturescontracts: Atradermaybeseekingtospeculateonthepriceoftheunderlyingasset effectivelybettingthatthepricewillgoupordown.

Atradermaybeseekingtohedgeorreducetheriskhefacesfromfuturemovementsinthepriceoftheunderlyingasset.Suchtraderscanusefuturestofixthefuturepriceorsalespriceoftheunderlyingasset.

Thereisamathematicalrelationshipbetweenthepriceofafuturescontractandthepriceoftheunderlyingasset.Tradersknownasarbitrageursseektoprofitfromdiscrepanciesinthepriceoffuturescontractinordertolockinaguaranteedprofit.

FuturesContractSpecifications

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Contractspecifications

10

Thespecificationsoffuturescontractstradedonanyfuturesexchangearestandardized,inthesensethattheyarethesameacrossallfuturestransactions.

Allelementsoffuturescontracts theunderlyingasset,thequantityandthequalityoftheunderlyingasset,deliveryarrangements,deliverydate,pricelimits,positionlimits,andthewayinwhichfuturespricesarequoted areallsetbytheexchange. However,thepricesatwhichfuturescontractstradearedeterminedbytheforcesofsupplyanddemandforfuturescontracts.


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Underlyingasset:TheSFEhascontractslistedonmanydifferentunderlyingassets.Thesearemainly:interestratefutures,stockindexfutures,commodityfutures,cattlefutures,andelectricityfutures.

Contractsize:Thesizeofafuturescontractistheunitsoftheunderlyingassetonwhichthecontractisbased.

Settlementordeliveryarrangements: Notallcontractsrequiretheassetunderlyingthefuturescontracttobephysicallyboughtorsold.Somefuturescontractsarecashsettled.


12

Settlementordeliverydate: Afuturescontractistypicallyidentifiedbyitssettlementordeliverymonth.Thesettlementmonthisthedateonwhichtheassetunderlyingthecommoditycanbedelivered(inthecaseofcashsettledfutures,thedateonwhichtheprofit/lossonthecontractiscalculatedandpaid/incurredbythebuyerorseller).

Pricelimits: Formostcontractsdailypricemovementlimitsarelimitedbytheexchange.Tradingishaltedforthedayifthecontractislimituporlimitdown.


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Positionlimits: Positionlimitsarethemaximumnumberofcontractsthataspeculatormayhold.

PriceQuotations: Thewayinwhichthepriceofafuturescontractisquotedvariesconsiderably.Thequoteiseffectivelyusedtodeterminethepricethatmustbepaidforthetransactionintheunderlyingassetonthedeliverydate.Itisalsousedtocalculatethevalueofacontractthroughtime,andtheprofitorlossontheposition.


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90DayBABFutures

10YearBondFutures 3YearBondFutures SFESPI200IndexFutures

Code IR XT YT AP

ContractSize $1million $100,000 $100,000 $25xIndex

Quotations 100 yield 100 yield 100 yield Indexpoints

MinimumTick 0.01% 0.005% 0.01% 1point/$25

ContractValue Pricex$25

SettlementMonths MJSD MJSD MJSD MJSD

SettlementDay 12pm2nd Fri Thebusinessdayfollowingthelastpermitteddayoftrading.

Thefirstbusinessdayafterexpiry.

SettlementPrice Meanyieldof10dealerquotesat9:45,10:30and11:15ontheexpirydayexcludingtwohighestandlowestones.

S&P/ASX200Index

TradingHours 8:28am 4:30pmand5:08pm 7:00am(USdaylightsavingtime)8:28am 4:30pmand5:08pm 7:30am(USnondaylightsavingtime)

9:50am 4:30pmand5:10pm 7:00am(USdaylightsavingtime)

Settlement Physical Cash Cash Cash

OptionsonFutures Yes Yes Yes Yes

Example:SPI200IndexFutures

15

TheSFESPI200contracttracksthepricefluctuationsoftheASX200index.

Supposethataninvestorthinksthatthestockmarketwillgoupoverthecomingweeks.

Assumethatthecontractcurrentlytradesat5,500.Eachpointmoveinthefuturescontractisworth$25,sofrom5,500to5,501representsaprofitof$25forsomeonewhobuysacontract.Amovefrom5,500to5,499representsalossof$25percontractforsomeonewhobuysacontract.

Example:SPI200IndexFutures

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Imaginethatafterafewweeks,thestockmarketdoesgoupandtheSFESPI200contractnowtradesat5,550.

Theinvestordecidestosellthecontractandtaketheprofit.Ifhesellsat5,550,hewillhavemade50pointsprofitwhichisequalto$1,250(50x$25).

Ifthestockmarketgoesdownandthecontracttradesat5,480,thenthelossoftheinvestoris$500(20x$25).

Clearinghouse

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Clearinghouse

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Aclearinghouseisanadjunctoftheexchangeandactsasanintermediaryinallfuturestransactions.

Tradesareexecutedinanexchangewherethebuyerandsellermeetthroughbrokers.

Afteratradeiscleared,theclearinghousebecomesasellertothebuyerandabuyertotheseller.

Theclearinghouseguaranteestheperformanceofthepartiestoeachtransaction.

Theclearinghousekeepstrackofallthetransactionsthattakeplaceduringadaysothatitcancalculatethenetpositionofeachofitsmembers.

Howtoopen/closeaposition

19

Tradingonthefuturesexchange

20

Toopenafuturesposition,youonlyneedtocallyourbrokertoinstructhim/hertobuyaparticularcontract.

Contractsarereferredbytheirdeliverymonths. Therefore,youwouldprobablyspecifythecontractasMayoilfutures.

Alargemajorityoffuturescontractsdontleadtodelivery. Deliverymightbeinconvenientforsomeinvestors(i.e.,speculators).

Deliverycanbequiteexpensiveinsomecases(i.e.,storagecosts).


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Tocloseaposition,aninvestorentersintoanoppositetradetotheoriginalonethatopenedtheposition. Aninvestorwhobuys fiveOctobercornfuturescontractsonJune15cancloseoutthepositiononSeptember20bysellingfiveOctobercornfuturescontracts.

Aninvestorwhosells fiveOctobercornfuturescontractsonJune15cancloseoutthepositiononSeptember20bybuyingfiveOctobercornfuturescontracts.


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Ifafuturescontractisnotclosedoutbeforematurity,itisusuallysettledbydeliveringtheassetsunderlyingthecontract.Whentherearealternativesaboutwhatisdelivered,whereitisdelivered,andwhenitisdelivered,thepartywiththeshortpositionchooses.


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TraderA TraderBExchangeTraderAsellsat$92.50

TraderBbuysat$92.50


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TraderA TraderBExchange

TraderC

TraderApreviouslysoldat$92.50

TraderBpreviouslyboughtat$92.50

TraderAbuysat$93

TraderCsellsat$93


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TraderBExchange

TraderC

TraderAfirstsellsat$92.50

TraderBpreviouslyboughtat$92.50

TraderAthenbuysat$93

TraderCsellsat$93

Loss:$0.50

TraderAslossisBsgain.

ConvergenceofPrices

26

Convergenceoffuturespricetospotprice

27

Asthedeliverymonthofafuturescontractapproaches,thefuturespriceconvergestothespotpriceoftheunderlyingasset.

Otherwise,therewillbeanarbitrageopportunity. Letsassumethatthefuturespriceisabovethespotpriceduringthedeliveryperiod(FT >ST). Theprincipleistoselltheovervaluedsecurityandbuytheundervaluedone.

Inthiscase,investorssell(short)afuturescontract,buytheasset,andmakethedelivery.

Asinvestorsdothis,futurespricewillcomedownandtheunderlyingassetpricewillgoup,untilthepricesareveryclosetoeachother.

Convergenceoffuturespricetospotprice

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SPI200December2008Futuresvs.S&P/ASX200

SPI200Futures S&P/ASX200

Margins

29

Margins

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Thereisatleastoneriskwhentwoinvestorsenterinatradewithoutanexchange:defaultrisk.

Oneofthekeyrolesoftheexchangesistoorganizetradingsothatdefaultriskisavoided.

Whenatradertakesapositioninafuturescontract,heisrequiredtodepositasumofmoneywithhisbrokerknownasmargin.

Inturn,thebrokerdepositsallorpartofthismoneywiththeclearinghouseoftheexchange.

Margins

31

TheSFEsclearinghousepaysinterestonmarginsdepositedwithitroughlyequivalenttothecashrate. However,theclearinghousekeepsaround0.50percentofit.

Thebalanceinthemarginaccountisadjustedtoreflectdailysettlement(markingtomarket).

Brokersalsohaveamarginingsysteminplacewhichdiffersslightlyfromtheexchanges. Theymayindeeddemandlargermarginsfromtheirclientsthantheminimumrequiredbytheexchange.

Themarginislikeasecuritydeposit.Itprotectsthebuyer(seller)fromlosses,incasetheseller(buyer)defaultsonhisobligationsunderafuturescontract.

Markingtomarket

32

Everymarketparticipantisinspectedattheendofeachtradingday.

Thesettlementpriceofatradingdayisbenchmarkedagainstthatofthepreviousday.

Pendingonthetwopricesandthepositionitself,eitheragainoralossisincurred.

Fundsarethendepositedintoortakenoutofthemarginaccountcorrespondingly.

Example:Markingtomarket

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Aninvestortakesalongpositionin15OctobercornfuturescontractsonJune15. Contractsizeis100bushels. Futurespriceis$2.00bushel. Marginrequirementis$200/contract($3,000intotal). Maintenancemarginis$180/contract($2,700intotal).

Example:Markingtomarket

34

Day FuturesPrice

DailyGain(Loss)

CumulativeGain(Loss)

MarginAccountBalance

MarginCall

NewMarginAccountBalance

15Jun $2.00 $3,000

15Jun $2.15 $225 $225 $3,225

16Jun $2.05 $150 $75 $3,075

17Jun $1.95 $150 $75 $2,925

18Jun $1.65 $450 $525 $2,475 $525 =$3,000

19Jun $1.42 $345 $870 $2,655 $345 =$3,000

20Jun $1.82 $600 $270 $3,600

OpenInterest

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Readingpriceinformation

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Open:Pricerecordedwhenafuturescontractstartstrading High:Thehighestpricerecordedduringtheday Low:Thelowestpricerecordedduringtheday Last:Thelasttradedpriceduringtheday Settlement:Thedailysettlementpricedeclaredbytheexchangeatwhichall

contractsinthatcontractaremarkedtomarket.Thisusuallydeterminedasthemidpointoftheclosingbidandofferinthemarketandmaybedifferentfromthelasttradedprice.

Expiry Open High Low Last Sett SettChg OpenInt

OpenInt Chg

Volume

Jun2008 3,380.0 3,394.0 3,380.0 3,388.0 3,389.0 19.0 154,892 672 10,479

Sep2008 3,395.0 3,395.0 3,395.0 3,395.0 3,397.0 19.0 3,639 1

Dec2008 3,405.0 3,420.0 3,405.0 3,411.0 3,412.0 19.0 2,509 72 286

OpenInterest

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SettlementChange:Thesettlementchangeisthedifferencebetweenyesterdaysandtodayssettlementprice.

OpenInterest:Thetotalnumberoffuturescontractsenteredintoaparticulardeliverymonthorfuturesmarketwhichhavenotbeenliquidatedbyanoffsettingtransactionorbyactualphysicaldelivery.

OpenInterestChange:Thenumberofnetnewpositionsinthemarket.

Volume:Thenumberofpurchasesandsalesoffuturescontractsduringaspecifiedperiod.

OpenInterest

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Questionstoconsider: Whenanewtradeiscompletedwhatarethepossibleeffectsontheopeninterest?

Canthevolumeoftradinginadaybegreaterthantheopeninterest?

Example:OpenInterest

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Trader1 Trader2 Trader3 Trader4 Trader5 OpenInterest

Long Short

Long Short

Long Short

Long Short

Short Long

ForeignExchangeQuotes

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Foreignexchangequotes

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Directquotation: Ifquotesaregivenusingacountryshomecurrencyasthepricecurrency(fromthecountrysperspective). 0.574744=$1intheUK

Indirectquotation: Ifquotesaregivenusingcountryshomecurrencyastheunitcurrency. $1.73990=1intheUK.


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FuturesexchangeratesarequotedasthenumberofUSDperunitofforeigncurrency 0.9050USDperCAD indirectquotation 0.9315USDperAUD indirectquotation


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Forwardexchangeratesarequotedinthesamewayasspotexchangerates. ThismeansthatGBP,EUR,AUD,andNZDareUSDperunitofforeigncurrency 0.9315USDperAUD indirectquotation

Othercurrencies(e.g.,CADandJPY)arequotedasunitsoftheforeigncurrencyperUSD.

1.1049CADperUSD directquotation

Lecture 7 - Futures Markets

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Transcript of Lecture 7 - Futures Markets