FIN 4329 Derivatives Part 1: Futures Markets and Contracts.

FIN 4329

Derivatives Part 1:

Futures Markets and Contracts

Copyright 2004, Dr. Jeffrey M. Mercer 2

Introduction

A forward contract is an agreement between two parties in which the buyer agrees to buy from the seller an underlying asset at a future date (called the expiration date) at a price established at the start of the contract (called the forward price).

Both parties have commitments. The buyer is called the long - said to have taken the

long position. The seller is called the short - said to have taken the

short position. Note that no money changes hands until expiration.


Delivery and Settlement For a deliverable contract, at expiration the short delivers the u.a. and

the long pays for it. This is called delivery settlement.

For a cash-settlement contract, at expiration the two parties settle up based on the net cash value of the contract. Cash-settlement is used when delivery of the u.a. is impractical

(e.g., the S&P 500 Index).


Default Risk

Forward contracts are subject to default, in that one party might be unable/unwilling to carry through with their commitment.

Only the party who has a “loss” can technically default (i.e., you would not walk away if you had a gain).

How much is at risk? Only the “gain” coming to one party, not the forward price.


Termination by “Offsetting”

One can effectively terminate a forward position by later taking a second, offsetting position. An initial long can be offset with a subsequent short, and vice versa.

This can be done with the same party or with a different party.


Structure of Forward Markets

Not a centralized market. Dealers (mostly big BHC’s and

securities/investment firms) make a market and specialize. CSFB, Goldman Sachs, etc.

Dealers transact with end users (those who wish to lay off risk) or other dealers so that they do not have large exposures.


Futures

Like a forward contract, a futures contract is an agreement between two parties in which the buyer agrees to buy from the seller an underlying asset at a future date (called the expiration date) at a price established at the start of the contract (called the futures price).

Key differences: Futures contracts are initiated (“opened”) on an

organized futures exchange. Futures contract specifications are “standardized.” Futures contracts trade on an organized exchange (a

secondary market); “pit trading.”


Public Standardized Transactions

Forward contract transactions are private transactions.

Futures contract transactions are recorded and reported – but not the direct identity of the parties.

What are the “terms” of a forward or futures contract? Price –only term established by the two parties. All other terms (next slide) are established by the

exchange – they are “standardized.”


Terms of a Futures Contract

Specifications and grades of underlying asset. Expiration dates

Months and days How far in the future

Contract size (e.g., 5000 bushels) Price quotation unit Settlement specifics Delivery location Standardization creates liquidity. Traders can easily

offset (buy if previously sold; sell if previously bought).


Daily Settlement

Each futures exchange has a clearinghouse. Capitalized by clearing members. Guarantees all trades.

Buyer to every seller. Seller to every buyer.

Requires margin. Settles gains/losses every day. Called marking to market.


Margin and Marking to Market

Margin Initial margin requirement

Set by the clearinghouse. Based on risk exposure. Usually small. Creates leverage.

Maintenance margin Lower than initial requirement Minimum end-of-day balance allowable (based on

settlement price) before margin call Margin call; must bring balance back to initial level.

Amount necessary is variation margin.


Delivery and Settlement

Most futures contracts are offset before expiration. What happens if a contract is not terminated through

offset? It depends on whether the contract calls for cash

settlement or delivery. For a deliverable contract, at expiration the short

delivers the u.a. and the long pays for it. This is called delivery settlement.

For a cash-settlement contract, at expiration the two parties settle up based on the net cash value of the contract. Cash-settlement is used when delivery of the u.a.

is impractical (e.g., the S&P 500 Index).


Short-Term Interest Rate Futures

Primary short-term interest rate futures are Eurodollar futures (IMM of CME) Federal Funds futures (CBOT)


Eurodollar Futures Contracts

The contract is based on the LIBOR rate on a 90-day Eurodollar deposit with $1,000,000 par (maturity) value.

The futures contract is quoted as 100 minus the LIBOR rate (in percent) that is priced into the contract.

100 minus the Rate is called the IMM Index, so traders reference the IMM Index when quoting the futures “price.”



Say we see the IMM Index at 97.75. This implies that the discount rate on LIBOR being priced into the contract is 2.25%.

The actual futures price would then be

375,994$360

900225.01000,000,1$Price

x



So we can speak to the “price” of the futures contract in three separate ways:

1. The LIBOR rate itself (2.25%)

2. The IMM Index (97.75)

3. The actual contract price ($994,375)



Note that as LIBOR declines, the IMM Index and the futures price increase.

So eurodollar futures prices are inversely related to interest rates.

For every one basis point move in LIBOR (say from 2.25% to 2.26%, or IMM Index from 97.75 to 97.74), the contract price changes by $25.

The minimum tick size is one basis point, or $25.00 in price.



The available expirations are the next two months plus March, June, September, and December out ten years.

So at any point in time you can “lock in” floating rate payments tied to 3-month LIBOR.

We can therefore observe the market’s expectation of 3-month LIBOR (i.e., LIBOR forward rates) from the futures market.


Federal Funds Futures Contracts

The contract is based on the average daily fed funds overnight rate for the delivery month.

The contract size is $5,000,000. The price is quoted as 100 minus the average

daily fed funds overnight rate for the delivery month (e.g., a 2.25 percent rate is quoted as 97.75).



The contract price, at a rate of 2.25%, would be

The minimum tick size is one-half basis point, or $20.835 in price, calculated as (0.01)x(0.01)x(0.5)x(30/360)x($5,000,000).

625,990,4$360

300225.01000,000,5$Price

x



The available expirations are the next 24 months.

Open interest in the nearby contract is almost 200,000 contracts.

Cash settlement.


Intermediate- and Long-Term Interest Rate Futures Contracts The two most popular are T-note and T-bond

Futures. T-notes have original maturities from 2 to 10

years. T-bonds have original maturities greater than

10 years. This is the only significant difference. The futures contracts are basically the same. We’ll focus on the T-bond contract.


T-Bond Futures Contracts

The contract is based on the delivery of a U.S. T-bond with any coupon rate but with a remaining maturity of at least 15 years, and $100,000 par value.

At any time, there are many different issues, with very large outstanding principal balances, that will satisfy this condition.

That is, many different bonds are “deliverable.” The short, then, will want to deliver the “cheapest”

bond he can find.

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FIN 4329 Derivatives Part 1: Futures Markets and Contracts.

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