Mechanics of the Financial
Derivatives Markets
&
Hedging with Futures
Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull 2012
Futures quotes
The settlement price is used for calculating daily gains/losses
and margin requirements.
Change: the change in the settlement price from the previous
day. For the June 2010 gold futures contract, the settlement
price on May 26, 2010, was $1,213.40, up $15.40 from the
previous trading day. In this case, an investor with a long
position in one contract would find his margin account balance
increased by $15.40.
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Futures quotes
Trading volume: The trading volume is the number of
contracts traded in the same day.
Open interest: the number of contracts outstanding
at the end of the previous day.
The trading volume can be greater than both the
open interest. This indicates that many traders who
entered into positions during the day closed them out
before the end of the day.
Traders who do this are referred to as day traders.
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Patterns of Futures Prices
Futures prices can show a number of different
patterns.
Markets where the futures price is an increasing
function of the time to maturity are known as normal
markets.
Markets where the futures price decreases with the
maturity of the futures contract are known as inverted
markets.
Classify the futures market of gold…
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Patterns of Futures Prices
The term contango is used to describe situations
where the futures price is an increasing function of the
maturity of the contract.
The term backwardation is used to describe situations
where the futures price is a decreasing function of the
maturity of the contract.
Strictly speaking, these terms refer to whether the
price of the underlying asset is expected to increase
or decrease over time.
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Delivery
The period during which delivery can be made is
defined by the exchange and varies from contract to
contract.
The decision on when to deliver is made by the party
with the short position.
When this party decides to deliver, his broker issues a
notice of intention to deliver to the exchange clearing
house. This notice states how many contracts will be
delivered and, in the case of commodities, also
specifies where delivery will be made and what grade
will be delivered.
The exchange then chooses a party with a long
position to accept delivery.
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Delivery: Example
Investor A: short position on a futures contract.
Investor B: long position.
The exchange cannot be certain that it will be Investor
B who will take the delivery.
Investor B may well have closed out his position by
trading with investor C, who (like Investor A) has a
short position.
The exchange passes the notice of intention to deliver
on to the party with the oldest outstanding long
position.
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Delivery: Example
Parties with long positions (like B) must accept
delivery notices.
However, if the notices are transferable, long
investors have a short period of time, usually half an
hour, to find another party with a long position that is
prepared to accept the notice from them.
For all contracts, the price paid is usually the most
recent settlement price.
If specified by the exchange, this price is adjusted for
grade, location of delivery, etc.
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Delivery: Critical Days
There are three critical days for a contract.
The first notice day is the first day on which a notice of
intention to make delivery can be submitted to the
exchange.
The last notice day is the last such day.
The last trading day is generally a few days before the
last notice day.
To avoid the risk of having to take delivery, an
investor with a long position should close out his
contracts prior to the first notice day.
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Types of Orders
Market order: it is a request that a trade be carried out
immediately at the best price available in the market.
Limit order: it specifies a particular price. The order
can be executed only at this price or at one more
favourable price to the investor. Thus, if the limit price
is $30 for an investor wanting to buy, the order will be
executed only at a price of $30 or less. There is no
guarantee that the order will be executed at all,
because the limit price may never be reached.
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Types of Orders
Stop order or stop-loss order: it specifies a particular
price. The order is executed at the best available price
once a bid is made at that particular price or a less
favourable price.
Suppose a stop order to sell at $30 is issued when the
market price is $35. It becomes an order to sell when
and if the price falls to $30. The purpose of a stop
order is usually to close out a position if unfavourable
price movements take place. It limits the loss that can
be incurred.
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Types of Orders
Stop-limit order: it is a combination of a stop order and
a limit order. The order becomes a limit order as soon
as a bid is made at a price equal to or less favourable
than the stop price.
Example
What a stop-limit order to sell at 20.30 with a limit of
20.10 means?
It means that as soon as there is a bid at 20.30 the
contract should be sold providing this can be done at
20.10 or a higher price.
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Types of Orders
Market-if-touched (MIT) or board order: it is executed
at the best available price after a trade occurs at a
specified price or at a price more favourable than the
specified price.
Discretionary order or market-not-held order: it is
traded as a market order except that execution may
be delayed at the broker’s discretion in an attempt to
get a better price.
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Accounting in Futures Markets
Accounting standards require changes in the market
value of a futures contract to be recognised when they
occur unless the contract qualifies as a hedge.
If the contract does qualify as a hedge, gains or
losses are generally recognised for accounting
purposes in the same period in which the gains or
losses from the item being hedged are recognised.
The latter treatment is referred to as hedge
accounting.
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Accounting: Example
Consider a company with a December 31 year end.
In September 2011 it buys a March 2012 corn futures
contract for the delivery of 5,000 units and closes out
the position at the end of February 2012.
Suppose that the futures prices are 250 cents per unit
when the contract is entered into, 270 cents per unit
at the end of 2011, and 280 cents per unit when the
contract is closed out.
If the contract does not qualify as a hedge, the gains
for accounting purposes are:
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Accounting: Example
Year 2011
5,000 x (2.70 – 2.50) = $1,000
Year 2012:
5,000 x (2.80 – 2.70) = $500
If the contract qualifies for hedge accounting, the
entire gain of $1,500 is realised in 2012 for
accounting purposes.
A hedger would be taxed on the whole profit of $1,500
in 2012.
A speculator would be taxed on $1,000 in 2011 and
$500 in 2012.
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Accounting: Exercise
Suppose that in September 2012 a company takes a
long position in a contract on May 2013 crude oil
futures.
One contract is for the delivery of 1,000 barrels.
It closes out its position in March 2013.
The futures price (per barrel) is $68.30 when it enters
into the contract, $70.50 when it closes out its position,
and $69.10 at the end of December 2012.
What is the company’s total profit? When is it realised?
How is it taxed if it is (a) a hedger or (b) a speculator
assuming that the company has a December 31 year-
end.
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Profits from Forward and Futures Contracts
Investor A is long £1 million in a 90-day forward contract
and investor B is long £1 million in 90-day futures contracts.
Each futures contract is for the purchase or sale of £62,500.
Investor B must purchase a total of 16 contracts.
The spot exchange rate in 90 days proves to be $1.7000
per £.
Investor A makes a gain of $200,000 on the 90th day.
Investor B makes the same gain, but spread out over the
90-day period. On some days investor B may realise a loss,
whereas on other days he makes a gain.
In total, when losses are netted against gains, there is a
gain of $200,000 over the 90-day period for both investors.
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Profits from Forward and Futures Contracts
Question
What is the main difference between the gains and
losses under the two contracts?
Answer
Under the forward contract, the whole gain or loss is
realised at the end of the life of the contract.
Under the futures contract, the gain or loss is realised
day by day because of the daily settlement procedures.
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Exercise 1
On July 1, 2012, a Japanese company enters into a
forward contract to buy $1 million with yen on January
1, 2013.
On September 1, 2012, it enters into a forward contract
to sell $1 million on January 1, 2013.
Describe the profit or loss the company will make in $
as a function of the forward exchange rates on July 1,
2012 and September 1, 2012.
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Exercise 2
One orange juice futures contract is on 15,000 kilos of
frozen concentrate.
Suppose that in September 2011 a company sells a
March 2013 orange juice futures contract for $1.20 per
kilo.
In December 2011 the futures price is $1.40 per kilo.
In December 2012 the futures price is $1.10 per kilo.
In February 2013 it is closed out at $1.25 per kilo.
Assuming that the company has a December 31 year
end: What is the accounting and tax treatment of the
transaction if the company is classified as a) a hedger
and b) a speculator?
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Hedging with Futures
A short hedge is appropriate when a company owns an
asset and expects to sell that asset in the future. It can
also be used when the company does not currently
own the asset but expects to do so at some time in the
future.
A long hedge is appropriate when a company knows it
will have to purchase an asset in the future. It can also
be used to offset the risk from an existing short
position.
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Hedging with Futures
A perfect hedge is one that completely eliminates the
hedger’s risk. A perfect hedge does not always lead to
a better outcome than an imperfect hedge. It just leads
to a more certain outcome.
Consider a company that hedges its exposure to the
price of an asset. Suppose the asset’s price
movements prove to be favourable to the company. A
perfect hedge totally neutralises the company’s gain
from these favourable price movements. An imperfect
hedge, which only partially neutralises the gains, might
well give a better outcome.
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Hedging with Futures
The examples with hedging considered so far have been
almost too good to be true.
The hedger was able to identify the precise date in the
future when an asset would be bought or sold.
The hedger was then able to use futures contracts to
remove (almost) all the risk arising from the price of the
asset on that date.
In practice, hedging is often not quite as straightforward
as this. Some of the reasons are as follows:
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Hedging with Futures
1. The asset whose price is to be hedged may not be
exactly the same as the asset underlying the futures
contract.
2. The hedger may be uncertain as to the exact date
when the asset will be bought or sold.
3. The hedge may require the futures contract to be
closed out before its delivery month.
These problems give rise to what is termed basis risk.
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The Basis
The basis in a hedging situation is as follows:
Basis = Spot price of asset to be hedged
- Futures price of contract used
If the asset to be hedged and the asset underlying the
futures contract are the same, the basis should be zero
at the expiration of the futures contract.
Prior to expiration, the basis may be positive or
negative.
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The Basis
As time passes, the spot price and the futures price for
a particular month do not necessarily change by the
same amount. As a result, the basis changes.
An increase in the basis is referred to as a
strengthening of the basis.
A decrease in the basis is referred to as a weakening
of the basis.
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The Basis
The figure illustrates how a basis might change over
time in a situation where the basis is positive prior to
expiration of the futures contract.
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The Basis Risk
Note that basis risk can lead to an improvement or a
worsening of a hedger’s position.
Consider a short hedge. If the basis strengthens (i.e.,
increases) unexpectedly, the hedger’s position
improves.
If the basis weakens (i.e., decreases) unexpectedly,
the hedger’s position worsens.
For a long hedge, the reverse holds: If the basis
strengthens unexpectedly, the hedger’s position
worsens.
If the basis weakens unexpectedly, the hedger’s
position improves.
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The Basis: Exercise 1
On March 1, a US company expects to receive 50m
euros at the end of July.
Euro futures contracts have delivery months of March,
June, September, and December.
One contract is for the delivery of 12.5m euros. The
company shorts four September euro futures contracts
on March 1.
When the euros are received at the end of July, the
company closes out its position.
The futures price on March 1 in cents per euro is 0.7800
and the spot and futures prices when the contract is
closed out are 0.7200 and 0.7250, respectively.
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The Basis: Exercise 2
It is June 8 and a company knows that it will need to
purchase 20,000 barrels of crude oil at some time in
October or November.
The contract size is 1,000 barrels.
The company decides to use the December contract for
hedging and takes a long position in 20 December
contracts.
The futures price on June 8 is $68.00 per barrel.
The company finds that it is ready to purchase the crude oil
on November 10. It therefore closes out its futures contract
on that date.
The spot price and futures price on November 10 are
$70.00 per barrel and $69.10 per barrel.
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