FINS1612 Chapter Notes - Chapter 19: Financial Instrument, Interest Rate Risk, Futures Contract
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Financial Institutions, Instruments and Markets
8th edition
Instructor's Resources Manual
Christopher Viney and Peter Phillips
Chapter 19
Futures contracts and forward rate agreements
Learning objective 1: Consider the nature and purpose of derivative products and the use of a
futures contract to hedge a specific risk exposure
• A derivative is a risk management product that derives its value from an underlying commodity
or financial instrument.
• A futures contract is a derivative product that may be used to manage risk exposures to interest
rates, exchange rates, share prices and commodity prices.
• The risk management function of a derivatives -based strategy is to lock-in a price today that will
apply at a future date.
• A futures contract is an agreement between two parties to buy, or sell, a specified commodity or
financial instrument at a specified date in the future, at a price that is determined today.
• The contracts are standardised by the contract size, the underlying commodity and delivery
dates.
• Basic futures strategy rule: conduct a transaction in the futures market today that corresponds
with the proposed physical market transaction due at a later date.
• For example, if a risk manager intends to buy at a later date in the share market, then they would
buy a share -based futures contract today. The open position is closed-out at the maturity date.
Learning objective 2: Discuss the main features of a futures transaction, including orders and
agreement to trade, calculations, margin requirements, closing out a contract and contract
delivery
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• Futures contracts are standardised exchange-traded contracts available on futures exchanges such
as the Chicago Board of Trade (USA) or ASX Trade 24 (Australia).
• Each exchange offers a set of futures contracts which are often based on underlying commodities
and financial instruments available in the local physical or spot markets.
• Most exchanges use electronic trading, although some open -outcry exchanges still operate.
• Buy or sell orders are placed through a broker.
• ASX Trade 24 quotes bond and bill futures contracts at an index of 100 minus the yield; for
example, a Treasury bond futures contract yielding 7.00 per cent is quoted at 93.000.
• Transactions are conducted through the exchange’s clearing house.
• An initial margin payment is paid to the clearing house.
• Contracts are marked-to-market each day. Maintenance margin calls may be required.
• An open position is closed out by buying or selling an identical contract, but opposite to the
initial futures contract.
• The exchange will specify if settlement is by standard delivery or by cash payment.
• By conducting two transactions—buy and sell—the party will make either a profit or a loss on
those transactions.
• If the intent of the hedging strategy was to protect against a rise in prices, the positive correlation
between the futures market and the physical market will ensure that if prices in the physical
market rise a profit will be made with the futures market transactions. This profit can then be
used to offset the increased cost associated with the price rise in the physical market.
Learning objective 3: Review the types of futures contracts offered through a futures exchange
• Futures contracts develop in markets in which an underlying asset is freely traded, the asset is
easily standardised, but may experience price volatility from time to time, and the product is
readily available or cash settlement is possible.
• Contracts tend to vary between international futures exchanges; contracts are often based on
local commodities and financial instruments.
• Commodity futures contracts include gold, wool and frozen orange juice, and financial futures
contracts include bonds, discount securities, currencies, shares and share indices.
Learning objective 4: Identify the participants in the futures market, including hedgers,
speculators, traders and arbitrageurs, and explain why they use futures contracts
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• Hedgers use the futures market to manage identified risk exposures; for example, if a borrower is
exposed to an increase in interest rates, they may sell a futures contract to hedge that risk
exposure.
• Speculators buy and sell futures contracts to try and make a profit on price movements; for
example, a speculator might anticipate a rise in a share price and take a long position in futures
to try and make a profit. Speculators increase price efficiency and liquidity in the futures market.
• Traders conduct transactions on their own account or for clients. They tend to conduct a large
number of very short-term trades with the intention of making small margins on each trade.
• Arbitrageurs try to make profits by conducting simultaneous transactions to take advantage of
any price differentials that might appear between markets.
Learning objective 5: Show how financial futures contracts may be used to hedge price risks,
including a borrowing hedge, an investment hedge, an FX hedge and a share portfolio hedge
• The basis of a hedging strategy is to open a futures position today that corresponds with the
transaction to be carried out in the physical or spot market at a later date.
• With a borrowing hedge, the risk manager will sell relevant futures contracts today. At a later
date it will close-out its futures market position by buying an identical futures contract. The
profit or loss made on the futures transactions will offset the net cost of borrowing.
• Similarly, with an investment hedge, the hedger will buy a futures contract today, and then close
out the position at the maturity date.
• Exposures to FX risk can also be hedged by either buying or selling a futures contract in the
required foreign currency.
• Share portfolio risk can also be hedged by buying or selling futures contracts based on specific
listed companies, or on a range of share -market indices.
Learning objective 6: Identify risks associated with using a futures contract hedging strategy,
including standard contract size, margin payments, basis risk and cross-commodity hedging
• While futures contracts are useful in hedging, it is important to recognise that a perfect hedge
may not be possible. Where the dollar value of a risk exposure is not perfectly matched by the
standardised dollar value of the futures contract, a small risk exposure will remain.
• A more significant risk arises from the fact that price movements in the physical market may not
be perfectly matched by price movements in the futures market. The difference in prices between
the two markets is referred to as basis risk. Initial basis risk may occur at the implementation of
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Document Summary
The open position is closed-out at the maturity date. Learning objective 2: discuss the main features of a futures transaction, including orders and agreement to trade, calculations, margin requirements, closing out a contract and contract delivery. This profit can then be used to offset the increased cost associated with the price rise in the physical market. Learning objective 4: identify the participants in the futures market, including hedgers, speculators, traders and arbitrageurs, and explain why they use futures contracts. Speculators increase price efficiency and liquidity in the futures market: traders conduct transactions on their own account or for clients. At a later date it will close-out its futures market position by buying an identical futures contract. The profit or loss made on the futures transactions will offset the net cost of borrowing. The difference in prices between the two markets is referred to as basis risk. Initial basis risk may occur at the implementation of.
