Transcript FINANCIAL INTERMEDIARIES AND FINANCIAL INNOVATION

Chapter 26
FINANCIAL
FUTURES MARKETS
Futures Contracts
 basic role: hedge against price risk
 exchange traded/created products: regulated
 originally: commodities (grains, coffee, gold etc.)
 now: financial futures
stock index futures
interest rate futures
currency futures
 value of a futures contract is derived from the value of
the underlying instrument
recent growth: volatility growth; can handle
Futures Contracts I
Contract between a buyer and a seller:
buyer agrees to receive an asset at a specified price
on a designated date.
seller agrees to delivery the asset at that price on
that date.
elements
futures price
settlement/delivery date
underlying asset (commodity)
Futures Contracts II
positions
long futures (buy, profit if price increases)
short futures (sell, profit if price decreases)
e.g. 27 Jan CME frozen pork bellies
FEB05 94.075, MAR05 95.050, APR05 96.700
if X buys and Y sells a MAR05 contract, and
the spot price at the end of March is
higher/lower…
Liquidating a Futures
Position
settlement dates
often: Mar, Jun, Sept, Dec
nearby futures contracts: closest to settlement date
most distant futures contracts: opposite (e.g. 1 yr)
liquidating a futures position
before settlement date: take an offsetting position
on settlement date: take delivery of the underlying
asset (v. cash settlement contracts) – c. 2%
open interest: liquidity measure - outstanding
unliquidated contracts
Role of Clearinghouse
every futures exchange has a clearinghouse
guarantees that buyer/seller satisfy their
obligations (buyer/seller of last resort)
if party defaults, steps in to take position
therefore risk centralised: exchange’s, not parties’
simplifies the unwinding of futures positions
prior to the settlement date
matching of buyers/sellers on liquidation
initial parties may not transact with each other: follow
clearinghouse’s instructions
Margin Requirements I
initial margin
minimum dollar amount per futures contract
can be interest-bearing securities
equity: margin posted + cumulative gains/losses: floats
settlement price: ‘representative’ closing price to
calculate equity account value
futures contracts marked-to-market daily:
buyer (seller) realizes a profit if the price increases
(decreases)
buyer (seller) realizes a loss if the price decreases
(increases)
Margin Requirements II
 maintenance margin
minimum level to which an equity position may fall due to
adverse price movements before
 variation margin
new deposits required to bring equity account back to the initial
margin level (must be cash)
[can also withdraw if prices move in favour]
 buying on margin (securities) v futures:
former: borrow to buy securities, using them as collateral
latter: typically no borrowing; both parties deposit margins
leverage: if 5% margin, can buy 20x contracts
Market Structure
Exchange Trading
pit with open outcry auction system
seat needed to trade (can lease one)
no market makers
floor traders
Locals: trade for own account, provide liquidity,
usually close positions by nightfall
floor or pit brokers: own account + (mostly) execute
orders
electronic trading systems: CME has pit +
GLOBEX2
How forward contracts
differ
 non-standard; terms individually negotiated
 no clearinghouse. Therefore:
default risk
thin markets
OTC
 intended to settle by delivery
 marking to market depends on parties’ wishes: may be
harder to price
 otherwise, identical to futures
The Role of Futures in
Financial Markets
use cash/spot or futures market to alter price
risk exposure?
factors: liquidity, transactions costs, taxes, leverage
price discovery in futures markets transmitted to
cash markets
arbitrageurs keep cash market prices in line
do futures markets lead to excess volatility or
just facilitate incorporation of more information?
(new risk management techniques, regulation
needed for new instruments)
CME contracts I
 commodity
feeder cattle & live cattle; lean hogs & pork bellies; milk &
butter; random length lumber…
 environmental
Asia/Pacific, Europe, US weather
 equity
stock market indices: S&P, NASDAQ, Nikkei, Goldman Sachs
Commodity Index
cash settlement
 foreign exchange
inc. cross rates (non$US), 3 new Cent Eur currencies
eFX 24 hr/day trading
CME contracts II
interest rates
T-bill: a T-bill w 13wks to maturity and face value
$1mn
Eurodollar CD
$US on deposit in banks outside the US
terms as T-bill; pay LIBOR
T-bond (CBT): hypothetical $100k, 20yr 6% coupon
CBT conversion factors allow settlement in existing bonds
Euroyen
3-month TIBOR or LIBOR; principal 100k ¥
fully fungible with Euroyen LIBOR, TIBOR on SGX
Euronext.liffe contracts I
universal stock futures, index futures
Short Term Interest Rate (STIR)
EONIA (Euro Overnight Index Average): ECB
unsecured inter-bank loans
3-mo Euro (EURIBOR, LIBOR), Sterling,
Swiss Franc (Euroswiss)
3-mo Euroyen (LIBOR, TIBOR)
Euronext.liffe contracts II
Government Bond Contracts
Long Gilt (8.75 – 13 yrs)
Schatz (2yr), Bund (10yr): German
government bonds
Japanese Government Bond (JGB)
commodities
cocoa, robusta coffee… no livestock
Euronext and Météo France =
NextWeather, but not yet