FINS1612 Lecture Notes - Lecture 10: Forward Rate Agreement, Futures Contract, Futures Exchange
Monday, 8 May 2017
Capital Markets & Institution
Futures & Forwards
-Hedging Using Futures Contracts:
•Futures & FRAs called derivatives because they are contracts whose price is
derived from some underlying physical market product
-Physical market - market in which a commodity or financial instrument is traded
-Commodity (e.g. gold, wheat, cattle)
-Financial (e.g. shares, govt securities & money market instruments)
•Derivative contracts enable investors & borrowers to protect assets & liabilities
against risk of changes in interest rates, exchange rates & share prices
•Hedging: Transferring risk of unanticipated changes in prices, interest rates or
exchange rates to another party
-Perfect hedge - profit perfectly offsets losses otherwise made
•Futures contract - agreement to buy or sell specific item at a specified future date at
a predetermined price today
-Buy futures/long position - agreement to buy an asset in future
-Sell futures/short position - agreement to sell an asset in future
-Long position - benefit if price rises (ie already owning certain asset)
-Decision rule:
(i) What you want to do with asset in future, do in futures market now
(ii) Whatever position you have in asset, take opposite position in futures
•Change in market price of a commodity or security is offset by a profit or loss on the
futures contract
-Main Features of a Futures Transaction:
•Orders & Agreement to Trade
-Futures contracts highly standardised & order normally specifies:
•Buy or sell order
•Type of contract (e.g. 10-year Treasury bond contract)
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Monday, 8 May 2017
•Delivery month (expiration)
•Price restrictions (if any; e.g. limit order)
•Time limits (if any; must be completed by a nominated date or order withdrawn)
-Market order - instruction to a broker to buy or sell at current market price
-Limit order - instruction to broker to buy or sell up/down to a specified price &
within a certain time
-Bid - buy price offered for a financial asset
-Offer - sell price offered for a financial asset
-Clearing house - records transactions conducted on an exchange & facilitates
value settlement & transfer (ASX Clear - futures)
-Novation - process by which one party to a contract is replaced with another party
•Margin Requirements
-Both buyer (long position) & seller (short position) pay an initial margin, rather
than full price of contract
•Initial margin - deposit lodged with a clearing hours to cover adverse price
movements in a futures contract
-Margins imposed to ensure traders able to pay for any losses they incur owing to
unfavourable price movements in the contract
-Contract is marked-to-market on a daily basis by the clearing house
•Periodic re-pricing of an existing contract to reflect current market valuations
-Subsequent margin calls may be made, requiring holder to pay a maintenance
margin to top up initial margin to cover adverse price movements
•Closing out of a Contract
-Close out - future strategy: buy or sell a futures contract before maturity date that
is in opposition to the initial futures contract position (with third party)
•Second contract reverses (closes out) first contract & company would no
longer have an open position in the futures market
•Contract Delivery
-Most parties to a futures contract:
•Manage a risk exposure or speculate
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