FINS1612 W10 Lecture

Futures Contracts and
Forward Rate
Agreements
Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
Slides prepared by Peter Phillips
19-1
LEARNING OBJECTIVES
Consider the nature and purpose of derivative products
Outline features of a futures transaction
Review the types of futures contracts available through a futures
exchange
Identify why participants use derivative markets and how futures
are used to hedge price risk

Identify risks associated with using a futures contract hedging
strategy
Explain and illustrate the use of an FRA for hedging interest rate
risk
Describe the use of a forward rate agreement for hedging interest
rate risk

19-2
CHAPTER ORGANISATION
19.1 Hedging using futures contracts
19.2 Main features of a futures transaction
19.3 Futures market instruments
19.4 Futures market participants
19.5 Hedging: risk management using futures
19.6 Risks in using futures markets for hedging
19.7 Forward rate agreements (FRAs)
19.8 Summary

19-3
19.1HEDGING USING FUTURES

CONTRACTS
Futures contracts and FRAs are called derivatives because they
derive their price from an underlying physical market product

Two main types of derivative contracts
1. Commodity (e.g. gold, wheat and cattle)
2. Financial (e.g. shares, government securities and money market
instruments)
Derivative contracts enable investors and borrowers to protect
assets and liabilities against the risk of changes in interest

rates, exchange rates and share prices

(cont.
)
19-4
19.1HEDGING USING FUTURES

CONTRACTS (CONT.)
Hedging involves transferring the risk of unanticipated
changes in prices, interest rates or exchange rates to

another party
A futures contract is the right to buy or sell a specific item
at a specified future date at a price determined today

The change in the market price of a commodity or
security is offset by a profit or loss on the futures contract
(cont.
)
19-5
HEDGING WITH FUTURES

CONTRACTS
Example: Farmer Joes 10 tonne wheat crop will be
harvested and ready for sale in 3 months time. What is the

risk that he needs to protect against?
Another
3 I
What
Should
months
it
do aboutand
this?
will be perfect!
Butmay
Farmer
You
Youlose
need
totohedge
Joeup
some
this
risk
using
people
say
20%
if you
Futures!!
Wheat
sell
in 3 prices
are falling!
months

19-6
Futures contract is an agreement to buy or sell a

specified asset at a specified time in the future.
Buy Futures/Long position = Agreement to buy an asset in
the future
Sell Futures/Short position = Agreement to sell an asset in
the future?
Does Farmer Joe short futures or long futures?

19-7
18-7
Decision Rule
(i)
What you want to do with the asset in the future, do in

the futures market now, or;
(ii)
Whatever position you have in the asset, take the

opposite position in the futures.
Farmer Joe;
(i)
Wants to sell wheat in the future therefore sells

futures/takes short position today.
(ii)
Has a long position in wheat, therefore takes a short

position in wheat futures.

19-8
18-8
Information
The current spot price of wheat is $300/tonne.
3 month wheat futures are trading at $300/tonne.
After 3 months the spot price of wheat falls to $250 per
tonne.

19-9
18-9
Futures Market
Today: 1 Jan 2011
Short 10 March 2011 ctrcts @$300/tonne
After 3 months (31 March 2011):
Long 10 March 2011 contracts @250/tonne
Futures Profit = $50/contract
Total Profit = $50 x 10 contracts
= $500.00
Physical Market
Today: 1 Jan 2011
Wheat is selling @ $300/tonne
After 3 months: (31 March 2011)
Wheat is selling @ $250/tonne
Loss on Physical Market = $50

Total Loss = $50 x 10 tonnes
= $500.00

19-10
18-10
HEDGING WITH FUTURES CONTRACTS

Who might have taken the other side of
Farmer Joes Futures position? What

happens to their profit/loss in the futures
market?
What if the entire market expected
wheat prices to fall?
What if the price of wheat in fact rose
during the hedging period?

19-11
19.8 Summary

19-12
19.2MAIN FEATURES OF FUTURES

TRANSACTIONS (CONT.)
Orders and agreement to trade
Futures contracts are highly standardised and an order normally

specifies:
whether it is a buy or sell order
the type of contract (varies between exchanges)
delivery month (expiration)
price restrictions (if any) (e.g. limit order)
time limits on the order (if any)

(cont.
)
19-13

Margin requirements
Both the buyer (long position) and the seller (short position) pay an
initial margin, held by the clearing house, rather than the full price
of the contract
Margins are imposed to ensure traders are able to pay for any losses
they incur owing to unfavourable price movements in the contract

(cont.
)
19-14

Margin requirements (cont.)
A contract is marked-to-market on a daily basis by the clearing

house
i.e. repricing of the contract daily to reflect current market valuations
Subsequent margin calls may be made, requiring a contract holder

to pay a maintenance margin to top up the initial margin to cover
adverse price movements

(cont.
)
19-15

Closing out of a contract
Involves entering into an opposite position
Example:
Company S initially entered into a sell one 10-year Treasury bond

contract with company B
Company S would close out the position by entering into a buy one 10year Treasury bond contract for delivery on the same date, with a third
party, say company R
The second contract reverses or closes out the first contract and
company S would no longer have an open position in the futures
market

(cont.
)
19-16

Contract delivery
Most parties to a futures contract:
manage a risk exposure or speculate
do not wish to actually deliver or receive the underlying

commodity/instrument and close out of the contract prior to delivery date
ASX Trade24 requires financial futures in existence at the close of

trading in the contract month to be settled with the clearing house
in one of two ways
Standard deliverydelivery of the actual underlying financial security
Cash settlement

(cont.
)
19-17

Contract delivery (cont.)
Settlement details, including the calculations of cash settlement

amounts, for each contract traded on the ASX Trade24 are available
on the exchanges website at www.asx.com.au

19-18
19.8 Summary

19-19
19.3
FUTURES MARKET
INSTRUMENTS
Futures markets can be established for any commodity or
instrument that:
is freely traded
experiences large price fluctuations at times
can be graded on a universally accepted scale in terms of its quality
is in plentiful supply, or cash settlement is possible

(cont.
)
19-20
19.3FUTURES MARKET INSTRUMENTS

(CONT.)
Examples:
Commodities
Mineralsilver, gold, copper, petroleum, zinc
Agriculturalwool, coffee, butter, wheat and cattle
Financial
Currenciespound sterling, euro, Swiss franc
Interest rates
Short-term instrumentsUS 90-day treasury bills, three-month eurodollar

deposits, Australian 90-day bank-accepted bills
Longer-termUS 10-year T-notes, Australian three-year and 10-year

Commonwealth Treasury bonds
Share price indicesS&P/ASX 200 Index

(cont.
)
19-21
19.8 Summary

19-22
19.4
FUTURES MARKET
PARTICIPANTS
Four main categories of participants
1.
Hedgers
2.
Speculators
3.
Traders
4.
Arbitragers
These participants provide depth and liquidity to the
futures market, improving its efficiency

(cont.
)
19-23
19.4FUTURES MARKET PARTICIPANTS

(CONT.)
1. Hedgers
Attempt to reduce the price risk from exposure to changes in

interest rates, exchange rates and share prices
Take the opposite position to the underlying, exposed transaction
Example:
An exporter has USD receivable in 90 days. To protect against falls in USD

over the next three months, the exporter enters into a futures contract to
sell USD

(cont.
)
19-24

(CONT.)
2. Speculators
Expose themselves to risk in an attempt to make profit
Enter the market with the expectation that the market price will
move in a direction favourable for them
Example:
Speculators who expect the price of the underlying asset to rise will go
long and those who expect the price to fall will go short

(cont.
)
19-25

(CONT.)
3. Traders
Special class of speculator
Trade on very short-term changes in the price of futures contracts

(i.e. intra-day changes)
Provide liquidity to the market

(cont.
)
19-26

(CONT.)
4. Arbitragers
Simultaneously buy and sell to take advantage of price differentials

between markets
Attempt to make profit without taking any risk
Example:
Differentials between the futures contract price and the physical spot
price of the underlying commodity

19-27
19.8 Summary

19-28
19.5HEDGING: RISK MANAGEMENT

USING FUTURES
Futures contracts may be used to manage identified
financial risk exposures such as:
Hedging the cost of funds (borrowing hedge)
Hedging the yield on funds (investment hedge)
Hedging a foreign currency transaction
Hedging the value of a share portfolio

19-29
HEDGING THE COST OF FUNDS

(BORROWING HEDGE)

19-30
HEDGING THE VALUE OF A SHARE

PORTFOLIO

19-31
19.8 Summary

19-32
19.6RISKS IN USING FUTURES

MARKETS FOR HEDGING
The risks of using the futures markets for hedging include
the problems of:
standard contract size
margin risk
basis risk
cross-commodity hedging

(cont.
)
19-33

MARKETS FOR HEDGING (CONT.)
Standard contract size
Owing to contract size the physical market exposure
may not exactly match the futures market exposure,

making a perfect hedge impossible
Table 19.6

(cont.
)
19-34


(cont.
)
19-35

Margin payments
Initial margin required when entering into a futures
contract
Further cash required if prices move adversely (i.e.
margin calls)
Opportunity costs associated with margin
requirements

(cont.
)
19-36

Basis risk
Two types of basis risk
Initial basis
Final basis
The difference between the price in the physical market and the
futures market at commencement of a hedging strategy
The difference between the price in the physical market and the
futures market at completion of a hedging strategy
A perfect hedge requires zero initial and final basis risk

(cont.
)
19-37

Cross-commodity hedging
Use of a commodity or financial instrument to hedge a risk

associated with another commodity or financial instrument
Often necessary as futures contracts are available for few

commodities or instruments
Selection of a futures contract that has price movements

that are highly correlated with the price of the commodity or
instrument to be hedged

19-38
19.8 Summary

19-39
19.7FORWARD RATE AGREEMENTS

(FRAS)
The nature of the FRA
An FRA is an over-the-counter product enabling the management of

an interest rate risk exposure
It is an agreement between two parties on an interest rate level that will

apply at a specified future date
Allows the lender and borrower to lock in interest rates
Unlike a loan, no exchange of principal occurs
Payment between the parties involves the difference between the agreed
interest rate and the actual interest rate at settlement

(cont.
)
19-40

(FRAS) (CONT.)
The nature of the FRA (cont.)
Disadvantages of FRAs include:
risk of non-settlement, i.e. credit risk
no formal market exists
The FRA specifies:
FRA agreed date, fixed at start of FRA
notional principal amount of the interest cover
FRA settlement date when compensation is paid
contract period on which the FRA interest rate cover is based (end date)
reference rate to be applied at settlement date

(cont.
)
19-41

(FRAS) (CONT.)

(cont.
)
19-42

(FRAS) (CONT.)
Settlement amount = FRA settlement rate - FRA agreed rate
where
365 P
365 P
365 (D i s ) 365 (D ic )
is = reference rate at the FRA settlement rate, expressed as a
decimal
ic = the fixed FRA agreed rate, expressed as a decimal
D = the number of days in the contract period
P = the FRA notional principal amount

(cont.
)
19-43

(FRAS) (CONT.)
Using an FRA for a borrowing hedge

Example: On 19 September this year a company wishes to
lock in the interest rate on a prospective borrowing of $5 000
000 for a six-month period from 19 April next year to 19
October of the same year. An FRA dealer quotes 7Mv13M
(19) 13.25 to 20. On 19 April the BBSW on 190-day money is
13.95% per annum.
365 P
365 P
365 (D i s ) 365 (D ic )
is =
ic =
D=
P=
0.1325 (on 19 April)

0.1395 (on 19 September)
183 days (from 19 April to 19 October)
$5 000 000

(cont.
)
19-44

(FRAS) (CONT.)
Using an FRA for a borrowing hedge (cont.)
365 5 000 000

365 5 000 000
Settlement
365 (183 0.1395) 365 (183 0.1325)

$4 673 154.46 - $4 688 533.65
- $15 379.19
As interest rates have risen over the period, the settlement
of $15 379.19 is paid by the FRA dealer to the company

(cont.
)
19-45

(FRAS) (CONT.)
Main advantages of FRAs
Tailor-made, over-the-counter contract, providing great flexibility with

respect to contract period and the amount of each contract
Unlike a futures contract, an FRA does not have margin payments
Main disadvantages of FRAs
Risk of non-settlement (credit risk)
No formal market exists and concern about difficulty closing out FRA
position is overcome by entering into another FRA opposite to the original
agreement

19-46
19.8 Summary

19-47
19.8
SUMMARY
A futures contract
An agreement between two parties to buy or sell a specified

commodity or instrument at a specified date in the future, at a price
specified today
May be used as a hedging strategy by opening a position today that

requires a closing transaction that is the reverse of the exposed
transaction in the physical market
Limitations include margin calls, imperfect hedging owing to basis

risk, and availability

(cont.
)
19-48
19.8
SUMMARY (CONT.)
FRAs
Over-the-counter contracts specifying an agreed interest rate to

apply at a future date
Advantages include:
flexibilitythey are tailor-made
no margin calls
Disadvantages include:
non-settlement or credit risk
lack of formal market

19-49

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Futures Contracts and

Copyright 2012 McGraw-Hill Australia Pty Ltd

are used to hedge price risk

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.1HEDGING USING FUTURES

derive their price from an underlying physical market product

Derivative contracts enable investors and borrowers to protect

assets and liabilities against the risk of changes in interest

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.1HEDGING USING FUTURES

changes in prices, interest rates or exchange rates to

at a specified future date at a price determined today

security is offset by a profit or loss on the futures contract

HEDGING WITH FUTURES

harvested and ready for sale in 3 months time. What is the

Copyright 2012 McGraw-Hill Australia Pty Ltd

Futures contract is an agreement to buy or sell a

Copyright 2012 McGraw-Hill Australia Pty Ltd

What you want to do with the asset in the future, do in

Whatever position you have in the asset, take the

Wants to sell wheat in the future therefore sells

Has a long position in wheat, therefore takes a short

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Loss on Physical Market = $50

Copyright 2012 McGraw-Hill Australia Pty Ltd

HEDGING WITH FUTURES CONTRACTS

Farmer Joes Futures position? What

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.2MAIN FEATURES OF FUTURES

Futures contracts are highly standardised and an order normally

whether it is a buy or sell order

the type of contract (varies between exchanges)

delivery month (expiration)

price restrictions (if any) (e.g. limit order)

time limits on the order (if any)

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.2MAIN FEATURES OF FUTURES

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.2MAIN FEATURES OF FUTURES

A contract is marked-to-market on a daily basis by the clearing

i.e. repricing of the contract daily to reflect current market valuations

Subsequent margin calls may be made, requiring a contract holder

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.2MAIN FEATURES OF FUTURES

Involves entering into an opposite position

Company S initially entered into a sell one 10-year Treasury bond

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.2MAIN FEATURES OF FUTURES

Most parties to a futures contract:

manage a risk exposure or speculate

do not wish to actually deliver or receive the underlying

ASX Trade24 requires financial futures in existence at the close of

Standard deliverydelivery of the actual underlying financial security

Copyright 2012 McGraw-Hill Australia Pty Ltd

19.2MAIN FEATURES OF FUTURES

Settlement details, including the calculations of cash settlement

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

experiences large price fluctuations at times

can be graded on a universally accepted scale in terms of its quality