Financial Markets (Bilingual Teaching)
Chapter 9 Financial Futures Markets
1. Futures are a derivative security 1) Derivatives
? Securities whose value is derived from the value of some underlying asset or financial instrument 2) Standardized agreement
? Standardized agreement to deliver or take delivery of a financial instrument at a specified price and date 3) organized exchanges
? Trading on organized exchanges provides liquidity and guaranteed settlement
? Only members or those leasing privileges can transact business on the floor of the exchange: ? Commission brokers or Floor traders 2. Steps Involved in Trading Futures 1) Establish account and initial margin 2) Maintenance margin and margin call 3) Order to trading floor 4) Open outcry trading 5) Clearinghouse function
6) Daily market-to-market of contracts
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Financial Markets (Bilingual Teaching)
3. Purpose of Trading Financial Futures 1) To Speculate
? Take a position with the goal of profiting from expected changes in the contract’s price ? No position in underlying asset 2) To Hedge
? Minimize or manage risks
? Have position in spot market with the goal to offset risk 4. Valuation of Financial Futures
1) Futures contract price related to the price of the underlying
asset
2) Futures contract price reflects the expected price of the
underlying asset or index as of the settlement date 3) Anything that affects the price of the underlying asset
affects the futures price
5. Speculating with Interest Rate Futures 1) Long position; purchase futures contracts
? Strategy to use if speculator anticipates interest rates will decrease and bond prices will increase
? Buy a futures contract and if rates drop the contract’s price rises above what it cost to purchase and exchange adds gain with daily settlement to investor’s account
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Financial Markets (Bilingual Teaching)
? If interest rates rise instead of fall, futures contract price drops and investor’s account is reduced by daily loss 2) Short position; sell futures contracts
? Strategy to use if speculator anticipates interest rates will rise and contract prices drop
? Sell (short) a futures contract and close the position by buying a contract to offset short
? If rates rise, the price to buy the contract and close the position is less than the price received for the initial sale of the contract; Speculator loses money if rates drop 3) Closing out the Futures Position
? Most buyers and sellers of futures contracts do not actually make or take delivery of the underlying asset
? Can close position any time before contract expiration date ? Trade the same contract and maturity month to open and close the position
6. Hedging with Interest Rate Futures 1) The short hedge
? Sell futures contracts with characteristics similar to the securities being hedged
? If rates increase, hedger closes out the position at a profit in the futures market to offset spot market position
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Financial Markets (Bilingual Teaching)
opportunity loss (reduced interest margin)
? If rates decrease, hedger’s spot market gains (wider interest margin) offset by losses on the futures position 2) The long hedge: opposite to short hedge 7. Stock Index Futures
1) Value of futures contract highly correlated with the value of
the underlying index
2) Contract’s price is the index times the dollar value given in
the contract’s specifications
3) Under some circumstances, arbitrage profits are possible ? Institutional investors capitalize on differences between price of index futures and stock prices
? Simultaneous buy/sell program trading when there is a profitable difference between index futures and stocks represented in the underlying index 4) Speculating with stock index futures
? Capitalize on expectations without having sufficient cash to buy the actual stocks in index
? Expect an increase in stock prices, buy index futures; gain/losses leveraged with small investment 5) Hedging with stock index futures ? Hedge market risk of an existing portfolio
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Financial Markets (Bilingual Teaching)
? Hedge is more effective if investor’s portfolio is diversified like underlying index for the futures contract 6) Circuit breakers on stock index futures
? Suspends trading on specific stocks or stock indexes after a specified market decline
? Gives investors a chance to evaluate information or meet margin calls before trading resumes
? Impacts program trading which has been linked to market volatility
8. Risks of Trading Futures Contracts 1) Market risk
? Speculators win or lose based on changing market value of futures contracts
? Hedgers, with a position in the underlying asset, are not significantly impacted by contract price volatility 2) Basis risk
? Futures contract prices do not vary in exactly the same way as the underlying asset’s price
? Price correlation of contract and underlying asset impacts the ability to hedge market risk
? Cross hedging involves using a futures contract with an underlying asset different from the asset to hedge, for
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