WEEK 1: INTRODUCTION TO FUTURES Futures: A contract between two parties where one party buys something from the other at a later date, at a price agreed today. The parties are subject to daily settlement of gains and losses and are guaranteed against the risk that either party might default because losses are contributed daily using margin account. Forwards: A forward is an OTC (over-the-counter) agreement between two parties for one party to buy something from the other at a later date at a price agreed upon today. No daily settlement. At the end of the life of the contract one party buys the asset for the agreed price from the other party. Losses are not contributed daily using margin account. Profit from a Long forward or futures position Profit from a short forward or futures position Spot price (Locked in price) = $29 Futures price (Maturity price) = $36 Buy at $29 when the market price at the date of maturity is $36 Therefore, Profit= $7 Spot price= $29 Futures price=$24 Buy at $29 when the market price at the date of maturity is $24 Therefore, Loss= $5 Spot price (Locked in price)= $29 Futures price (Maturity price)= $36 Sell at $29 when the market price at the date of actual trade is $36 Therefore, Loss= $7 Spot (Locked in price)= $29 Futures (Maturity price)= $24 Sell at $29 when the market price at the date of actual trade is $24 Therefore, Profit= $5
Opening and closing a contract Opening a contract Closing a contract (Close out/close a position) Enter into contract via online trading account Enter into opposite trade before expiration e.g. Net position is zero and exchange closes position Contract does not lead to delivery as it is inconvinent for speculators and can be expensive due to storage and transport costs. Only cash settlement. Contract not closed out prior to expiration Cash settled: Exchange closes out the position, left with margin account balance. Deliverable: Settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. SPI 200 futures Each point move in the futures contract is worth $25 Long: Contract price increases from 5500 to 5501. Profit is $25 per contract Contract price decreases from 5500 to 5499. Loss is $25 per contract Suppose an investor is bullish (long futures), Market goes up by 50 points. The buying investor close out before expiration by shorting and gained 50 points profit. Total Profit is 50 points x $25/point = $1250 If the market falls to 5480 the investor loses 20 points x $25/point = $500. Suppose an investor was bearish, he would short the index on May 1. If market drops from 5500 to 5480 (goes down 20 points), selling investor close out on 20 May by longing position and gained 20 points profit. Total profit is 20 points x $25/point= $500 If market increases from 5500 to 5550 (goes up 50 points), selling investor close out on 20 May by longing position and loses 50 points. Total loss is 50 points x $25/point= $1250 Why not just speculate on the index through an ETF (exchange- traded fund)? Leverage example: Investor has 80k SPI200 margin is 8k
Option 1: put 80k into ETF Option 2: long 10 SPI200 futures (10 x 8k=80k) Market goes up 10%: Option 1: 80k 88k, so profit is 8k Option 2: 4500points 4950 points so profit is 450 points per contract (each point is worth $25) total profit (10 contracts): 450points x $25 x 10= $112,500 However, if market goes down, option 1 does not lose much but option 2 loses all the money you put in and more. Convergence of Futures Price to Spot price Futures market and Spot market are different markets. As futures approaches expiration, futures price converges to the spot price. Otherwise, there is an arbitrage opportunity (risk free opportunity due to mispricing) Assume futures is above the spot at maturity F T > S T, Sell overvalued security and buy undervalued one Arbitrageurs sell a futures contract, buy the asset and deliver on futures contract. Future price increases and spot price will decrease. Continue until prices are equal (subject to transaction costs) Assume futures is below the spot at maturity F T < S T, Arbitrageurs buy a futures contract, take delivery on futures contract (however delivery is not immediate, so not perfect arbitrage) and sell the asset. Margins When two investors enter a trade without an exchange, they are exposed to default risk. The role of exchange is to organize trading so this risk is minimised. A margin is a cash or marketable securities desposited by an investor with his broker. The balance in the margin account is adjusted daily to reflect daily settlement (marking to market). Margins minimize the possibility of a loss through a default on a contract. For instance, an invester entered into contract and has the obligation to buy underlying asset at $100, but at maturity date, the underlying asset is only worth $2. There is a huge credit risk as the investor can just default at maturity and not buy the asset. To protect the sellers interests, over the period, as the price of underlying asset drops, the loss is taken from the buyers margin account daily. So if the buyer defaults, they are essentially only defaulting on a day s losses. On June 15, an investor takes long position in 15 October corn futures contracts. Contract size: 100 bushels Futures price: US $2.00/bushel Margin requirement: US $200/contract Maintenance margin: US $180/contract Total margin requirement: 15 contracts x $200= $3000 Total maintenance margin: 15 x $180=$2700 As soon as your margin account goes below the maintenance margin $2700, the investor will receive a margin call from his broker. The investor will need to top up to his margin account to starting point ($3000 in this example)
Day Futures Price Daily Gain (Loss) Cumulative Gain (Loss) Margin Account Balance Margin Call 2.00 3,000 15-Jun 2.15 225 225 3,225 16-Jun 2.05-150 75 3,075 17-Jun 1.95-150 -75 2,925 18-Jun 1.65-450 -525 2,475 525 = 3,000 19-Jun 1.42-345 -870 2,655 345 = 3,000 20-Jun 1.82 600-270 3,600 15-Jun: Price gone up to 2.15. Profit 15c per bushel. 15c x 100 bushel x 15 contracts= $225 profit. Margin account increases by 225 16- Jun: Price gone down 2.05. Loss 10c per bushel. 10cx100 bushel x 15 contracts= $150 loss. Margin account decreases by 150 Price and trading information Open: Price when futures contract starts trading High: The highest price during the day Low: The lowest price during the day Last: The last traded price during the day Sett: The daily settlement price declared by the exchange at which all contracts are marked to market. Usually midpoint of closing bid & offer - may be different from last traded price. Settlement Change: difference between yesterday s & today s settlement price. Open Interest: Total no of contracts that haven t been liquidated by an offsetting transaction or physical delivery. o no of long positions = no of short positions Open Interest Change: number of net new positions Volume: during a specified period is no of purchases = no of sales When a new trade occurs, open interest may increase, decrease or stay the same. (tutorial) The volume of trading in a day can be greater than the open interest if the market is dominated by day traders (speculators) as they are only interested in short term price movement during the day. Everyone will be trading out before the market closes for the day. Regulation Regulation is designed to protect the public interest. Price limits are one example. Approximately 2/3 of exchanges use price limits (mainly on commodities). Price limits are also partial subsitute for margins because size of a loss for a day is limited by price limits so not as much margins are needed. Regulators try to prevent questionable trading practices by individuals on the floor of the exchange or outside groups. For example, price limits on US soybeans (CME): Close soybeans: 600c/bushel Next day: price limits of soybeans is 570c - 630 c (within 30c above or below close price of soybeans). Circuit breaker: closes the market when limit is hit. If limit hit, expanded to $0.45cents next 3 days. After that, the limit is at $0.45c/bushel with no expansion. The limit size is based on volatility of underlying asset.
WEEK 2: HEDGING WITH FUTURES Short and Long Hedges Objective: take a futures position that minimises risk as far as possible Short futures hedge when: Sell an asset in the future and want to lock in price Asset is owned or will be owned Long futures hedge when: Purchase an asset in the future and want to lock in price Short Hedge example: On April 20, a farmer negotiates to sell 50,000 bu of corn at the spot price on June 20 June 20 is futures maturity date- no basis risk Quotes are as given: Spot price of corn on April 20 $3.50/bu June corn futures price $3.35/bu (each contract is for 5000bu) After futures gain and losses the price received by the farmer should be $3.35/bu Scenario 1: Spot price June 20 $3.10/bu Spot: Farmer sells corn at ($3.10)(50,000)=$155,000 Futures gain: ($3.35-$3.10)($50,000)=$12,500 Total received: $155,000+$12,500=$167,500 Price/bu=$167,500/50,000=$3.35 Offsetting pay off: Spot loss= (3.50-3.10)(50000)= $20000 ( because price goes down) Futures gain=$12500 ( because price goes down) Total loss=$ 7500 $3.10 $0.25 -$0.4 $3.10 Spot price April $3.50 $3.35 Scenario 2: Spot price June 20 $3.70/bu Spot: Sell corn at ($3.70)(50,000) = $185,000 Futures: Loss ($3.70 $3.35)(50,000) = $17,500 Total received: $185,000 $17,500 = $167,500. Price/bu = $167,500 / 50,000 = $3.35 Offsetting pay off: Spot gain (3.70-3.50)(50000)= $10000 Futures loss=$17500 Total loss=$7500