Futures. An educational series by Clearwater Analytics explaining the many complex asset classes available to institutional investors today.

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Henry Page
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1 UNDERSTANDING ASSET CLASSES An educational series by Clearwater Analytics explaining the many complex asset classes available to institutional investors today. Futures The North American futures market that we know today originated with 19th-century farmers bringing their crops to market. For example, a corn farmer would bring all the season s corn to the market without any idea of what the supply and demand of corn would be that year. Sometimes, their supply would exceed demand and their crops would go to waste. But if a consumer needed corn out of season, when supply was scarce, they were forced to pay high prices. To solve this problem, farmers and consumers came together at central markets to agree to forward delivery of their crops: the first example of a futures concept in action. Today, variations of futures contracts are used across the business sphere. For example, when purchasing a newspaper subscription, the subscriber enters into an agreement to receive a daily newspaper for a certain price every month for the next year. The subscriber has secured a price now to receive a product in the future, and is protected from the risk of rising newspaper prices. Futures contracts are similarly used to protect against uncertainties of the unpredictable investment market and to hedge against the risk of changing market rates. Portfolio duration allows investors to view exposure to changing market rate risk, and they can use futures contracts to lock in certain rates and hedge against that risk.

2 What are Futures? A futures contract (future) is a standardized financial contract in which a buyer agrees to purchase an underlying asset at a predetermined future date (delivery date) and at a particular price (the forward price). The assets that futures are written on include physical commodities and financial instruments. Futures are considered a derivative because their value is based on their specific underlying asset. The futures exchange is a centralized marketplace for buyers and sellers from around the world to enter into futures contracts. Entering into a position in the futures market does not necessarily mean participating in exchanging actual large quantities of physical commodities; participants primarily enter contracts to hedge risk or speculate price changes. The market is extremely liquid and has the potential for both very large losses and very large gains. Who Invests in Futures? Buyers invest in futures for two reasons: hedging and speculating. Investors implementing a hedging strategy are typically anyone in the business of investing, including farmers, manufacturers, importers, exporters, and more. A hedging investor can buy or sell to secure a future price of a commodity with the intention to sell or buy at a later date. The future can protect them against price change risks, or it can secure a satisfactory price margin between the cost of the commodity and the retail cost of their final product. This is also helpful when a party expects to receive payment in a foreign currency and wants to protect against future unfavorable currency valuation movements. Futures also attract speculators. Speculators goals are to profit from the price changes that the hedging investors want to protect themselves against. The speculator does not want to actually own the asset the future is written on, but rather buy and sell contracts to profit off rising and declining prices. Most of Clearwater s clients use futures on underlying interest rates to hedge risk on the duration of their securities along with changing market rates. Characteristics of Futures Futures are traded in a batch manner, which means that a future on 100 underlying assets could be traded as a single unit or contract. The price on a future is quoted at the expected price of one unit of the underlying instrument. The contract s notional value is calculated by the formula price x batch size (contract size) x units x price scalar. When an investor opens a futures contract, a minimum amount of money must be deposited into a margin account, called the Initial Margin Requirement (IMR). The IMR serves as a guarantee from the exchange against any default risk from either party entering into the contract. The IMR is typically 5% to 10% of the future contract s notional. Whereas margin in the stock market is the use of borrowed money, the IMR in the futures market is used to debit any dayto-day losses. The IMR account will increase or decrease daily as market values of the positions change. Example of a Futures Contract Format Company A wants to sell a particular amount of oil in the future, and Company B wants to purchase that particular amount of oil in the future. The two companies make a contract to agree to the purchase and delivery of the oil at a future date and specific price, such as six months at $55 per barrel. At the end of six months, the price of oil has decreased to $50 per barrel. Company A loses $5 per barrel from the declining oil prices on the cash market in those six months, but they gain those $5 per barrel back on the future contract they entered into with Company B. Now, let s look at it from a speculator s perspective. If the futures contract was for a year instead of six months, then t the end of six months, Company A could close their position in the futures contract and profit $5 per barrel for however many barrels the contract covered. Company A could be an investor with no intention of ever selling or possessing oil and was just speculating that the price of oil would decline. An account also has a Maintenance Margin Requirement, with a certain minimum allowed by the margin account. If market values of the positions decrease and the balance goes below this Maintenance Margin Requirement, the holder of the account is required to post additional cash or collateral to bring the balance back up to the IMR. In such an instance, brokers are required to make a margin call and request the necessary funds to bring an investor s margin account back up to the initial amount. After margin calls, funds typically must be delivered immediately or the brokerage has the right to liquidate the investor s position and the right to any additional deficit from the closing of the contract. In some cases, for hedging

3 investors who have physical ownership of the underlying asset or spread traders who have a balanced position on offsetting contracts, the margin requirements are reduced or waived. Regulations Futures are regulated and exchanged in a specific market. The Commodity Futures Trading Commission (CFTC) is an independent agency of the U.S. government responsible for regulating the U.S. futures market. The market is also regulated by the National Futures Association (NFA), which is subject to CFTC supervision. The NFA is a self-regulatory body authorized by the U.S. Congress. In order to issue, buy, or sell futures, a broker and/or firm must be registered with the CFTC. If illegal activity is suspected, the CFTC is authorized to seek criminal prosecution through the Department of Justice. Long vs. Short The holders of the long position in a futures contract agree to buy and receive the underlying asset, while the holders of the short position agree to sell and deliver the underlying asset. If an investor is hedging and looking to protect themselves from future price changes on an asset they want to buy in the future, they would enter into a long position to protect against future rising prices. If a hedging investor is looking to sell and wants to secure a price now to protect against declining prices, they would enter into a short position. Speculators enter into positions in anticipation of changing prices. That is, instead of seeking protection from changing prices, speculators go long in anticipation of rising prices and short in anticipation of declining prices. Speculators also use spreads as an alternative strategy in the futures market. Spreads involve looking for advantages from price differences in two different futures contracts. Some popular spreads strategies include calendar spreads, intermarket spreads, and inter-exchange spreads. Underlying Security: Leverage The futures market is risky because of highly leveraged prices that can lead to large gains or large losses. Leverage is the cash amount of commodities an investor has control over compared with the level of capital committed. An investor s position in a futures contract can be highly leveraged because the initial deposit into the margin account needed is relatively small compared to the contract s notional exposure. If an investment is highly leveraged, a small price change can translate into a very large gain or a very large loss. For example, let s say an investor purchases a futures contract on an index currently standing at 1700 with a margin deposit of $12,000, and the value of the contract is worth $100 times the index. This means the contract s notional is ($100 x 1700 = $170,000) and for every point gained or lost, $100 will be gained or lost. If after a period of time the index realized a gain of 5%, the index would rise 85 points to 1785, giving the investor a profit of $8,500 or 70.83%. Likewise, if the index realized a loss of 5%, then the investor would experience a loss of $8,500 and there would likely be a margin call for additional funds. Pricing Prices for futures are quoted just as they would be for one unit of the underlying in the cash market. The difference between future prices and cash market prices is that future prices have minimum price movements. These minimums are established by the exchange and are referred to as ticks. If a certain commodity has a minimum price movement of a tenth of a cent, then a futures contract of 1,000 units will have a minimum price movement of $1.00 ($0.001 x 1,000). Futures also have a daily minimum price change limit. At the beginning of the day, the exchange sets an upper and lower limit. If the price reaches either limit at any point during the day, trading for that asset shuts down for the rest of the day. Daily price limits are often abolished the month the contract expires due to increased volatility. Types of Settlement As mentioned previously, futures positions are settled daily, and margin accounts are deducted or credited based on the daily market value movements on positions. As a result, most transactions are settled in cash, and the asset is bought or sold in the cash market. Due to the competitive nature of the market, prices in the cash and futures market tend to move parallel to each other, merging to a common price as the contract approaches expiration. The contract is settled on the date that either party decides to close out the position. Reporting Challenges Futures can be challenging for reporting because of how their market value is calculated when compared with more traditional

4 Example of a Futures Settlement Returning to our previous oil example with Company A and B, a delivery exercise of the contract would be Company B purchasing and receiving the oil from company A for $55 per barrel. For a cash settlement, the final day of the contract Company A s account would be credited by $5 per barrel while Company B s account would be debited by the same amount. Instead of exercising the contract, the companies could cash settle for the amount in their accounts and then purchase or sell the oil in the cash market. Even though Company A would sell the oil at $50 per barrel instead of $55, they made a profit of that difference when cash settling the futures contract. assets. Futures are unique in that the current market value of a future is the difference between the current quoted price and the entry price for that position. Because of the entry price, market value has to be calculated at lot level. Minimum price movements, or ticks, present another reporting challenge. Tick sizes can vary for certain futures contracts, which can cause confusion when calculating the market value. Reconciliation complexities around the margin variation balance presents another reporting challenge. The inherent relationship between the margin balance and the futures contracts means that investment data reconciliation is often more complicated than for more traditional assets. Regulatory Reporting Implications SSAP 86 contains the applicable NAIC guidance for all derivatives, including futures. The guidance focuses on the three categorizations of applicable derivative strategies: hedging, income generation, and replication. The NAIC requires that futures be reported on schedule DB part B of insurers filings. Quarterly holdings, annual disposals, and holding reports must be disclosed. The DB reports can be challenging for insurers to automate, given the level of subjectivity and strategy-based decisions that need to be made. Key Considerations yields and hedge against risk of market fluctuations, they also have potential for very serious losses. Investors evaluating futures for their portfolio need to consider their own tolerance for loss, especially because any changes to market value flow through the holding gain and loss amounts and impact the income statement directly. How Clearwater Streamlines the Integration of Futures Clearwater s ability to automate reconciliation and general ledger accounting, along with the intuitive Clearwater interface, gives futures investors increased flexibility to create, view, and evaluate a variety of reports. Clearwater s seamless, automated reconciliation eases reporting scalability concerns and helps investors overcome futures complex reporting needs. Clearwater follows the fair value accounting guidance 1 for derivatives, where all changes in market value flow through the income statement. As such, all changes in market value for futures flow through the holding gain/loss amounts (similar to a security designated as trading under FAS115 2 ) and impact the income statement directly. Clearwater takes an unrealized gain/loss approach in reporting the market value of futures contracts. Factoring in the contract size in this approach makes for more accurate reporting on the leveraged portfolio return For more information on how Clearwater can help you integrate and simplify your investment accounting, reporting, and analytics, contact Clearwater at info@clearwateranalytics.com. This material is for informational purposes only. The information in this paper (namely Benchmark Survey Report data and discussions about the accounting and reporting implications of non-traditional asset types) are from sources Clearwater Analytics considers reliable, but Clearwater Analytics provides no warranties regarding the accuracy of the information. Further, contributions by Clearwater Analytics herein should not be construed as legal, financial, investment, or tax advice, and any questions regarding the reader s individual circumstances should be addressed to that reader s lawyer, accountant, or investment advisor. Investors looking to hedge their risk against market swings or speculate on price changes often look to futures as a potentially valuable addition to their portfolios. While futures can generate high

5 About Clearwater Analytics Clearwater Analytics is the leading provider of web-based investment portfolio accounting, reporting, and reconciliation services for corporate treasuries, insurance companies, and investment managers. Clearwater aggregates, reconciles, and reports on more than $1.7 trillion in assets across thousands of accounts daily. For more than a decade, Clearwater has helped firms such as Knights of Columbus, CopperPoint Mutual Insurance Company, Group Health Companies, The Main Street America Group, SBLI, C.V. Starr & Co., Sagicor, Wilton Re., and WellCare streamline their investment and accounting operations. Clearwater remains committed to continuous improvement and encourages insurers to rethink how they approach their investment accounting and reporting challenges. INQUIRIES sales@clearwateranalytics.com info@clearwateranalytics.com WORLDWIDE OFFICES Boise, Idaho Edinburgh, U.K.

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