Ch 13 - Financial Futures Markets

PROCESS — How a Futures Trade Works

1 Open account, post initial margin (5–18%) → 2 Place market or limit order → 3 Clearinghouse records and guarantees the trade → 4 Daily mark to market → 5 Margin call if the position loses → 6 Offset before settlement, or deliver / cash-settle — Debt-security futures settle by delivery; index futures settle in cash.

Financial futures contract

Standardized agreement to deliver or receive a financial instrument at a set price and date.

Interest rate futures

Futures on debt securities such as T-bills, notes, bonds, and Eurodollar CDs.

Stock index futures

Futures to buy or sell a stock index at a set price and date; cash-settled.

Futures exchange

Organized market that clears, settles, and guarantees standardized futures trades.

CME Group

World's largest derivatives exchange, formed in 2007 by merging the CBOT and CME.

CFTC

Commodity Futures Trading Commission; approves contracts and prevents unfair trading.

Over-the-counter futures

Tailored contracts arranged by a bank that finds or acts as the counterparty.

Speculators

Trade futures to profit from expected price moves; provide liquidity.

Day traders vs position traders

Day traders close positions the same day; position traders hold for weeks or months.

Hedgers

Take futures positions to reduce exposure to rate or price moves.

Commission (floor) brokers

Execute futures orders for customers.

Floor traders (locals)

Trade futures for their own account.

Globex

CME's electronic platform, trading nearly around the clock.

Initial margin

Deposit required before a futures trade, typically 5–18% of contract value.

Marked to market

A futures position's value is revised daily to reflect current prices.

Margin call

Demand for more funds when a position moves unfavorably.

Market vs limit order

Market orders execute at the prevailing price; limit orders only within a set limit.

Open outcry

Floor brokers shout bids and offers to trade on the exchange floor.

Clearinghouse

Exchange function that records trades, guarantees payment, and supervises delivery.

PROCESS — Short Hedge vs Long Hedge

Short hedge: fear rising rates → sell futures → futures gain offsets asset loss · Long hedge: fear falling rates → buy futures → futures gain offsets lost income — Charlotte Insurance sold 50 T-bond futures at 98-16 and bought back at 94-16: $4,000 × 50 = $200,000 gain.

Contract face value

$1,000,000 for T-bill futures; $100,000 for Treasury bond futures.

Minimum price fluctuation

Smallest price change, e.g. 1/32 of a point = $31.25 per $100,000 contract.

Points and 32nds

T-bond futures quotes: 92-10 means 92 10/32 percent of par.

MBI futures

Municipal Bond Index futures on the Bond Buyer Index of 40 munis; cash-settled.

Bond Buyer Index

Index of 40 actively traded general obligation and revenue bonds.

Valuing interest rate futures

Price reflects the expected price of the underlying security at settlement.

Speculating on falling rates

Buy interest rate futures; security prices rise as rates fall.

Speculating on rising rates

Sell interest rate futures; security prices fall as rates rise.

Leverage in futures

Small margin magnifies returns: $9,000 on $10,000 margin is a 90% return.

Closing out a position

Taking the offsetting position before settlement; gain = sell price − buy price.

Short hedge

Selling futures to protect a long asset position against rising rates.

Long hedge

Buying futures to protect against falling rates or rising purchase prices.

Basis

Difference between the price of a security and the price of a futures contract.

Cross-hedging

Using futures on one instrument to hedge a different one; depends on correlation.

Hedge ratio

Futures principal needed per dollar hedged, e.g. 1.25 if the portfolio is 1.25× as volatile.

Net exposure

Difference between rate-sensitive asset and liability positions; what should be hedged.

PROCESS — Full Hedge with S&P 500 Futures

1 Portfolio value ÷ (index × $250) = contracts → 2 Sell that many contracts → 3 Market falls: futures gain offsets portfolio loss → 4 Market rises: portfolio gain offsets futures loss — $400,000 portfolio, index 1600: sell 1 contract. Index to 1520 → (1600 − 1520) × $250 = $20,000 gain.

S&P 500 futures

Valued at index × $250; settle in cash on the third Friday of Mar/Jun/Sep/Dec.

Mini S&P 500 futures

Valued at index × $50, for smaller investors.

Sector index futures

Futures on a sector component of an index, such as energy or technology.

Cost of carry

Net financing cost: financing cost minus the dividend yield on the index.

Speculating with index futures

Buy if expecting the market to rise; sell if expecting it to fall.

Hedging with index futures

Sell index futures to offset a stock portfolio's market risk.

Test of suitability

Check whether a hypothetical hedge would have worked over a prior period.

Proportion to hedge

Hedging part of a portfolio keeps some upside but less protection.

Dynamic asset allocation

Buying or selling index futures to change market exposure as expectations shift.

Program trading

Simultaneous trading of at least 15 stocks worth over $1 million.

Index arbitrage

Trading index futures against the underlying stocks when their prices diverge.

Arbitrageurs

Firms that profit from price discrepancies between related markets.

Circuit breakers

Trading halts after sharp declines to curb panic selling.

Single stock futures

Agreement to buy or sell 100 shares of one stock on a future date.

OneChicago

CBOE–CME venture that traded U.S. single stock futures (closed in 2020).

Regulation of single stock futures

Overseen by both the CFTC and the SEC.

Selling single stock futures

Like short selling, but no need to borrow the shares.

ETF futures

Futures contracts to buy or sell an exchange-traded fund at a set price.

Market risk

Value changes from market conditions; mainly a speculator's concern.

Basis risk

Hedged position doesn't move in tandem with the futures' underlying.

Liquidity risk

Price distortion from too few buyers or sellers when closing a position.

Credit risk

Counterparty default; exists OTC, not on exchanges that guarantee trades.

Prepayment risk

Hedged assets are prepaid early, leaving the hedge without its offset.

Operational risk

Losses from inadequate management or controls.

MF Global (2011)

Futures broker that used customer funds to cover losses and went bankrupt.

Peregrine Financial Group (2012)

Futures broker whose cash was over $100 million below reported; bankrupt.

Systemic risk in futures

OTC derivative defaults passing from one counterparty to the next.

Financial Stability Oversight Council

Dodd-Frank council, including the CFTC head, that monitors systemic risk.

Non-U.S. participation

Foreign institutions trade U.S. futures to hedge their U.S. holdings.

Foreign stock index futures

Futures on foreign indexes such as the Nikkei 225, FTSE 100, and Hang Seng.

LIFFE

London International Financial Futures Exchange; acquired by Euronext in 2001.

Currency futures contract

Standardized agreement to deliver or receive a foreign currency at a set rate and date.

Hedging with currency futures

Buy futures on currencies owed; sell futures on currencies to be received.