Financial Markets and Institutions

Based on
Financial Institutions and Markets (9ed)
Jeff Madura

Taught by
Nguyen Thang
FPT School of Business (FSB)

Original Slides by
South-Western/Cengage Learning

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 13
Financial Futures Markets

Chapter Objectives

The specific objectives of this chapter are to:

■ explain how financial futures contracts are valued,
■ explain how interest rate futures contracts are used to speculate or hedge,
based on anticipated interest rate movements,
■ explain how stock index futures contracts are used to speculate or hedge,
based on anticipated stock price movements, and
■ describe how financial institutions participate in the financial futures markets.

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 Background on Financial Futures

1. Purpose of Trading Financial Futures

a. Futures contract: specifies

1.) deliver or receive a specified amount

2.) on a specific date

3.) for the specified price

b. Purpose

1.) to speculate on prices

2.) to hedge (reduce risk of) existing position

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 Background on Financial Futures

Structure of the Futures Market

a. OTC Trading

b. Electronic Trading

c. Trading through a Brokerage Firm

d. Type of Orders

e. How Orders are executed

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 Valuation of Financial Futures

1. Impact of the Opportunity Cost

a. There’s no dividends in owning the futures

b. Owning the underlying asset may result in a payment such as

the S&P 500 dividends from owning the stock.

c. Owning the futures contract allows a small down payment

and may generate interest income from investing the difference.

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 Explaining Price Movements of Bond Futures
Contracts
1. Prices driven by economic forces
2. Treasury bond price movements:
a. Futures tend to move with bond prices

b. When indicators signal an increase in economic growth, interest

rates increase, bond prices decline and futures prices fall.

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 Speculating with Interest Rate Futures

1. Impact of Leverage
Since initial payments are usually very small relative to the total

contract market value,

- the return is magnified substantially!

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 Closing Out the Futures Position

a. Because futures are most often used as a hedging or speculating

strategy, actual delivery or receiving never takes place.

b. Closing out done by an offset to the original position.

c. Owning both a contract to receive as well as to deliver, the

obligations net out.

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 Hedging with Interest Rate Futures

1. Features of Hedging
a. Using Interest Rate Futures to Create a Short Hedge

1) Tradeoff from Using a Short Hedge

2) Cross-Hedging

b. Using Interest Rate Futures to Create a Long Hedge

c. Hedging Net Exposure

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 Bond Index Futures

1. Municipal Bond Index (MBI) futures

2. Based on the Bond Buyer Index of 40 actively traded general
obligation and revenue bonds.

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 Stock Index Futures

1. Valuing Stock Index Futures Contracts

a. Indicators Monitored by Participants in Stock Index Futures

2. Speculating with Stock Index Futures

3. Hedging with Stock Index Futures

a. Test of Suitability of Stock Index Futures

b. Determining the Proportion of the Portfolio to Hedge

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 Speculating with Stock Index Futures

4. Dynamic Asset Allocation with Stock Index

Futures

5. Prices of Stock Index Futures versus Stocks

6. Arbitrage with Stock Index Futures

7. Circuit Breakers on Stock Index Futures

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 Single Stock Futures

a. A contract to buy or sell a single stock (usually 100 shares)

b. Settlement dates are quarterly

c. Offer potentially high returns (with high risk)

d. Closing out involves taking opposite position anytime before

settlement date

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 Risk of Trading With Futures Contracts

1. Market risk
2. Basis risk
3. Liquidity risk
4. Credit risk
5. Prepayment risk
6. Operational risk

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 Institutional Use of Futures Markets

1. Commercial banks
2. Savings institutions
3. Securities firms
4. Mutual funds
5. Pension funds
6. Insurance companies

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 Exhibit 13.9 Institutional Use of Futures Markets

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 Globalization of Futures Markets

1. Non-U.S. Participation
2. Foreign Stock Index Futures
3. Currency Futures Contracts

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