The Nature of Futures

Futures and the Use of Futures Agreement to buy or sell an

asset for a certain price at a
for Hedging certain time

Available on a wide range of

underlyings
Exchange traded
P. D. Nimal Specifications need to be defined:
What can be delivered,
Where it can be delivered, &
When it can be delivered
2

How a Futures Contract Comes? Closing Out Positions

March 5 Investor in NY At about the same time , The vast majority of futures contracts do not lead
call broker “A” to buy another investor in Kansas to delivery. Most of them close out their positions
5000 bushels of corn for might call broker “B” to sell before the delivery period.
delivery in July 5000 bushels of corn for
delivery in July Closing out a position means entering into the
opposite type of trade from the original one.
Broker “A” pass Broker “B” pass
instructions to long one instructions to short one For Ex. NY investor, bought (Long) a July corn
future contract to a future contract to a futures contract on march 5, can close out the
trader in the floor of the trader in the floor of the position by selling (i.e., shorting) a July corn
exchange exchange
contract on April 20.

The gain or loss is the difference between futures

price between march 5 and April 20.
The two floor traders would meet, agree
on a price to be paid for the corn in July,
and the deal would be finalized
3 4
Operations of Margins Operations of Margins cont…
Margins are maintained to minimize An investor takes a long position in 2
the possibility of a loss through a December gold futures contracts on
default on a contract June 5
A margin is cash or marketable
securities deposited by an investor contract size is 100 oz.
with his or her broker futures price is US$400 per oz.
margin requirement is US$2,000/contract
(US$4,000 in total)
The balance in the margin account is
adjusted to reflect daily settlement maintenance margin is US$1,500/contract
(US$3,000 in total) Option2.xls

5 6

A Possible Outcome Delivery

Daily Cumulative Margin
If a futures contract is not closed out
Futures Gain Gain Account Margin
Price (Loss) (Loss) Balance Call before maturity, it is usually settled by
Day (US$) (US$) (US$) (US$) (US$) delivering the assets underlying the
400.00 4,000
contract. When there are alternatives
5-Jun 397.00 (600) (600) 3,400 0
about what is delivered, where it is
. . . . . .
.
.
.
.
.
.
.
.
.
.
.
.
delivered, and when it is delivered, the
13-Jun 393.30 (420) (1,340) 2,660 + 1,340 = 4,000
party with the short position chooses.
. . . . . .
. . . . .
. . . . . . < 3,000
19-Jun 387.00
. .
(1,140)
.
(2,600)
.
2,740 + 1,260 = 4,000
. . A few contracts (for example, those on
. . . . . .
. . . . . . stock indices and Eurodollars) are settled
26-Jun 392.30 260 (1,540) 5,060 0 in cash
7 8
 Convergence of Futures to Spot
Convergence of Futures to Spot (Hedge initiated at t1 and closed out at t2)

Futures
Price
Futures
Spot Price
Price
Spot Price Futures Spot
Price Price

Time Time Time

(a) (b) t1 t2

9 10

Hedging Strategies Using Futures

Basis Risk (Long & Short Hedges)

Basis is the difference between A long futures hedge is appropriate when you
know you will purchase an asset in the future
spot & futures and want to lock in the price

A short futures hedge is appropriate when

you know you will sell an asset in the future
& want to lock in the price
Basis risk arises because of the
uncertainty about the basis when
Choose a delivery month that is as
the hedge is closed out
close as possible to, but later than,
the end of the life of the hedge
11 12
Long Hedge Example
Suppose that June 8, a company knows that it needs to purchase
20000 bbl of crude oil at some time in Oct. or Nov. Oil
futures contracts are sold for delivery in every month.
F1 : Initial Futures Price Contract size is 1000 bbl.
F2 : Final Futures Price How do you hedge the risk?

S2 : Final Asset Price December futures price on June 8 is $118/bbl. The

company finds that it needs to buy crude oil on 10th Nov.
thus, they closes out their futures contracts on that date.
The spot and futures prices on that date are $120 and
You hedge the future purchase of an asset $119.1/bbl.

by entering into a long futures contract What is the gain on the futures contract?
What is the value of the basis when the contract is closed
out?
What is the effective price paid?
Cost of Asset=S2 – (F2 – F1) = F1 + Basis What is the total amount of dollars paid?

13 14

Short Hedge Example

Suppose that March 1, a US company expects to sell 50m yen at the
end of July. Yen Futures have delivery months of March,
June, September and December. One contract is for
F1 : Initial Futures Price 12.5m yen
F2 : Final Futures Price How do you hedge the risk?
S2 : Final Asset Price We suppose that futures price on March 1 in cents per
yen is 0.78 and the spot and futures prices when the
contract is closed out are 0.72 and 0.725 respectively.
You hedge the future sale of an asset by What is the gain on the futures contract?
entering into a short futures contract What is the
out?
value of the basis when the contract is closed

What is the effective price obtained?

What is the total amount of dollars obtained by the
company?
Price Realized=S2+ (F1 – F2) = F1 + Basis
15 16
Choice of Contract Optimal Hedge Ratio
when there is no futures contract on the same asset

Proportion of the exposure that should optimally be

hedged is
When there is no futures contract on
the asset being hedged where

σS is the standard deviation of ∆S, the change in the

Choose the contract whose futures price spot price during the hedging period,
is most highly correlated with the asset
price. This is known as cross hedging. σF is the standard deviation of ∆F, the change in the
futures price during the hedging period

ρ is the coefficient of correlation between ∆S and ∆F.

17 18

Example Arguments in Favor of Hedging

A company knows that it will buy 1 m gallons of jet Companies should focus on the main
fuel in three months. The standard deviation of the
change in the price per gallon of jet oil over a three- business they are in
month period is 0.032. the company chooses to
hedge by buying futures contracts on heating oil.
The Std. of the change in the futures price over a
three-month period is 0.04 and the correlation They should take steps to minimize risks
between the three-month change in the price of jet arising from interest rates, exchange
fuel and the three-month change in the futures price
is 0.8. rates, and other market variables
What is the optimal hedge ratio?
If one heating oil futures contract is on 42000, how
many contracts they have to buy?
These risk exposes can be hedged by
using derivatives

19 20
Arguments against Hedging Stock Index Futures
Shareholders are usually well diversified and A stock index tracks changes in the
can make their own hedging decisions. value of a hypothetical portfolio of
stocks. (ex. S&P 500 futures, Nikkei
It may increase risk to hedge when 225 futures)
competitors do not.

Explaining a situation where there is a loss The percentage increase in the stock
on the hedge and a gain on the underlying index is set equal to the percentage
can be difficult (see BS 3.1 in p-62). increase in the value of the
hypothetical portfolio.
21 22

Hedging Using Index Futures Example

Stock Index Futures can be used for hedging a Value of S&P 500 is 1,000
diversified portfolio
To hedge the risk of a portfolio the number of contracts Current price of futures is 1010
that should be shorted is Value of Portfolio is $5.05 million
Risk-free rate is 5%
Dividend yield on index is 1% per annum
Beta of portfolio is 1.5
where P is the value of the portfolio, β is its beta, and F 1-contract is for delivery of 250 times the index
is the value of the Futures underlying one futures
contract
What position in futures contracts on the S&P 500 is
necessary to hedge the portfolio?
23
 Reasons for Hedging an Equity
Example Cont… Portfolio
Index futures are used for hedging May want to be out of the market for a while.
4-months to mature Hedging avoids the costs of selling and
Hedging for next 3-months repurchasing the portfolio

Suppose the index turns out to be 900 in 3-months Suppose stocks in your portfolio have an
and the futures price is 902. Calculate average beta of 1.0, but you feel they have
the gain/loss on the FC and been chosen well and will outperform the
Portfolio expected value in 3-months market in both good and bad times.
Total expected value with hedging
Hedging ensures that the return you earn is
the risk-free return plus the excess return of
your portfolio over the market.

Changing Beta Hedging the Price of an Individual Stock

What position is necessary to reduce the beta of the Not Similar to hedging a portfolio
portfolio to 0.75? (short position in)

Does not work equally because only the

systematic risk is hedged
What position is necessary to increase the beta of the
portfolio to 2.0? (Long position in) The unsystematic risk that is unique to the
stock is not hedged

Options on the stock could be used