Investment Management and Capital Markets

Lecture 6 : Futures

Futures:
A class of derivative securities whose value depends on the value of an underlying asset.

Financial markets are used by investors, speculators, share traders and arbitrageurs.
The growth of derivatives can be traced from the early 70’s since when stock market
volatility has been much higher.

Futures contracts are standardised contracts between two parties

- to exchange pre-agreed amounts of an asset

- at a fixed price and

- fixed date in the future.

The asset on which the future is based, the `underlying asset’ can be a commodity or
financial security, in which substantial trading takes place.

Eg from FT:

Metals; copper, Gold, Silver, Platinum

Energy: crude oil, heating oil, gas oil, natural gas, unleaded gasoline

Grains; wheat, maize, potatoes, soyabean, soyabean oil

Softs; cocoa, cotton, coffee, sugar, orange juice

Financial; Gilt, Bond, Index

Contracts usually provide, at expiry, for the seller to deliver the underlying asset
or for cash settlement.

A large majority of users of the Futures ands Options markets use it to hedge
(or protect) the value of their portfolios against adverse circumstances.

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Difference between Futures and Forwards

- forwards are for tailor made amounts, dates; futures are standardised.
- forward contracts are with private parties, the counter party in a futures contract is the
exchange.
- with the involvement of the Exchange in a futures contract, default risk is removed.

The Futures Exchange

LIFFE (London International Financial Futures and Options Exchange) is an

exchange where financial futures and options are traded, through its members.

LIFFE is a self regulated organisation whose members include Banks, commodity

brokers, discount houses, and share traders. Members have to meet stringent
capital adequacy requirements before being accepted.

LIFFE members act as principals. Matched trades are registered with the LCH
(London Clearing House).

As the price of futures varies with the price of the underlying asset, a credit risk arises
against the party adversely affected by the price movement.

The Clearing House therefore requires both parties to deposit an `initial margin’
which is adjusted on a daily basis with a `variation margin’ in case the movement
exceeds a pre-agreed figure: `marked to market’. In this way, the Clearing House
ensures performance of the contract.

The Clearing House acts as a counterparty in a futures contract, so that buyers and sellers
may not be aware of each other’s identity.

The popularity of futures:

-The futures market is extremely liquid, more liquid than the shares market. The high
liquidity of futures is often an indicator to the market price.
- There is no specific cost to futures, as there might be for other derivative
instruments.
- Futures markets work through margins and a mark to market basis: enabling
Geared operation.
- Operation of futures through a creditworthy exchange (developed market) removes
the credit risk.

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How futures are priced.

The principle of pricing futures can be understood from the following:

Assume a non-return paying asset is trading at a spot price, So, with a Futures price Fo.
If I borrow a sum So from the market to buy this asset, I run a bank borrowing of So,
and hold the asset. Simultaneously I sell the asset in the futures market for Fo.

At the expiry of the futures, that is at time t, if `r’ was the rate of interest, then my bank
borrowing will be So(1+rt).

It stands to reason that when I deliver the asset against the futures contract, I will
Realise Fo, with which I repay the bank loan.

This is an action anyone in the market can undertake, so it cannot generate profits.

Thus the fair price for the future is: Fo = So(1+rt).

In general, the pricing of a futures contract is determined as below:

F = S (1+ CCt)

where `F’ is the futures price;

`S’ is the Spot price of the asset and

`CC x t ’ is the carry cost for time `t.’

`Closing out’ is the process of taking/making delivery of the contract before expiry
to meet the obligations under the contract.

Fo- So is also called the `basis Risk’.

At expiry, the futures price converges to the spot price of the underlying asset:

Basis risk =0.

This becomes intuitively clear from the pricing formula:

- as `t’ becomes smaller and smaller, closer to expiry,

So = So (1+ 0. t) = Fo

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Futures can be used for hedging, speculation and arbitrage.

Speculation: implies taking a position involving risk.

Long Futures Short Futures

Gain (loss) on expiry Gain (loss) on expiry

+ +

Ft,St
Fo Ft,St Ft,St Fo Ft,St
Share price `S’ `S’
- -

Fo is the price of futures at time `o’; Ft,St are different scenarios at expiry.

Hedging: minimising risk by taking an offsetting position in another asset.

Eg if you hold long position of a share, and want to cover against fall in value over
the futures period, sell futures.
Assumed that futures (Fo) is at fair price = S (1 + rT); share is non-dividend paying.
At expiry (Ft,St) gain/loss on the futures is offset by the loss/gain on the share. The
outcome is the same in all states of `S’

Sold futures Long share

Gain
Payoff in all states at expiry
Ft,St Ft,St
So Fo
Loss

Arbitrage: making profits with (i) no additional investment or (ii) risk.

Scenario 1: Fo < fair price = So (1+rT) for non-dividend paying share.

Strategy: buy futures as they are cheap - sell share short now - deposit proceeds
in bank- at maturity take delivery of share out of proceeds (which now include
interest) - return share borrowed. Your profit is the difference between the fair price
of future and the actual future which you bought at the time when you entered into
the contract.

Scenario 2: Futures Fo > fair price = So(1+rT).

Strategy: Sell futures, borrow money now and buy share; The cost of your share will
amount to the fair price of the future = So(1+rT). Deliver share at maturity for
futures price. Your profit is the difference between the futures price at which you sold
at and the fair price of the future at the time when you entered into the contract.

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Equity Index Futures

An index future based on the FTSE-100 was formulated in 1984.

An index future contract is an agreement with the exchange to buy or sell a basket
of shares made up of the FTSE 100 at a preagreed price on a fixed date in the future.

Contracts on this future are cash settled.

It is priced at £10 of the index point.

When the future expires it has the value of the index.

Example:

An investor buys one FTSE index contract at 5500 for delivery in December .
(goes long). This has a value of 5500 x 10 = £ 55,000

If on the expiry date, the index has fallen to 5250; the buyer’s loss is
250 x 10 = £ 2,500.

If on the expiry date, the value of the contract is 5850, the buyer’s gain is
350 x 10 = £ 3,500 .

Gain
Short Long
Π

5250 5300 5400 5500 5600 5700 5850

Index Value

Loss

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Pricing Stock Index Futures

If the basket of Index shares was bought now, it would involve an outlay
(cash price) on which interest would be payable. This would of course be offset
by dividends received from the basket of shares.

If you buy the future, you do not have a cash outlay just now
(except for the margin money)

The fair price of the index future is therefore =

Cash price + interest expenses - expected dividend.
Ie Cash price plus the `cost of carry’ as it is called.

Example

You are now in September. Interest costs are 6.5% pa, expected dividend
income is 3.00 % pa.
(i) If the index is trading today at 5,450
determine the fair price of the March Index future.
(ii) If the March future is priced at 5600, advise.
(iii) If the March future is priced at 5,500 advise.

(i) March fair price =

Present price x (1+int) - dividend income

= 5450 x (1.0325) - 5450 x (0.015) = 5,545.

(ii) If March futures price = 5,600

Buy the index shares now; sell the Index futures for March:
Gain = 5,600 –5,545 = 55 ticks / contract (£550)

(iii) If March futures price = 5,500.

This is more complicated

(Short) Sell the index shares now, buy the March Index futures now.
Place the amount realised in deposit to earn 5450(1.0325) = 5627. You will
have to compensate broker from whom you borrowed shares for loss on
dividends 5450(0.015) = 82 tick;
So your net earnings are 5627-82= 5545; You cash settle at 5,500.
Your Gain = 45 ticks per contract (£450).
Note transaction costs will eat into such profits

What are the above strategies called?

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Hedging example

It is now November 2002, the FTSE-100 index is currently at 5491.

Short term interest rates are at 6.5% per annum; dividend yield on FTSE
Stocks is at 2.5%. Ignore taxes.
A Fund manager has a well diversified portfolio of shares with a beta of 0.8
and a current value of £ 2 m. He would like to hedge his portfolio upto the end
of June 2003.
(i) What is the correct price for the June end future?
(ii) Advise the strategy he should follow (assume futures available at fair price)
and compare the hedged and unhedged positions if at the end of June, 03 the FTSE
Index is
(a) 6000
(b) 5,200.

Suggested solution

First check on Futures pricing using existing interest rates of 6.5% and dividend yield
of 2.5% and assuming 7 months to futures expiry:

5491 x (1+ (0.065-0.025)7/12) = 5620 = Fair price of future

To hedge the portfolio the fund manager has the following options:

- to sell the portfolio and deposit the cash in a bank

(this is the cash hedge).
- to sell Index futures for an amount covering exposure to the fall in the
index (suitably beta adjusted as it is a diversified fund).

When the fund manager follows the first option, he is position at the end of June will
be £ 2.0 x 1.038 = £ 2.076 mn. From this must be deducted transaction costs say
(0.5%, one way; 1.0% two ways)

Many fund managers prefer the second alternative because of the transaction costs
and difficulty of reconstituting an identical portfolio.

When he holds his existing portfolio of shares and hedges through futures:

(i) he earns a dividend of 1.46% = £ 29,200 plus

(ii) the outcome of the futures contract which offsets the fall in portfolio value, if the
index falls; or the opposite.

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 Gain/loss

Hedged outcome

5491 5620 Index

Held Portfolio Short future

(ii) Futures position:

No of contracts to be sold =

Face value of exposure x β of portfolio / value of futures contract

= Pds 2 m x 0.8 x (1+ (0.065-0.25)x7/12)/ 5620 x 10 = 29.12, say 29 contracts

(a) At the end of June the FTSE Index futures value is 6000.

You have to close out the futures position by buying 29 contracts at 6000.

Loss on futures = (6000-5620) x 10 x 29 = £ 110, 200

Gain on portfolio = (( 5491- 6000 ) / 5491 ) x 2m x 0.8 = £ 148,315

Dividend income on held portfolio for 7 months = £ 29,200

Net position = + £ 67,315

(b) FTSE Index falls to 5,200

Gain on futures= (5620- 5200) x 29 x 10 = £ 121,800

Loss on portfolio = ( (5200- 5491) ) / 5491 x 2m x 0.8 = £ 84,793

Dividend income on held portfolio for 7 months = £ 29,200

Net position = + £ 66,207

(Note that on the downside position, the futures strategy has performed well.
On the upside position the lock in futures restricted portfolio gains.)

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Comparison with cash hedge:

Cash hedge: Cash option yields £ 2.076 mn

Hedged outcome, if market moves upward = £ 67,315

Hedged outcome, if market moves downward = £ 66,207

The hedge efficiency through futures is good and better than the cash hedge
Ie cash conversion if transaction costs are taken into account.

The slight imbalance in numbers on the two sides is also due to the rounding of the
futures contracts required to hedge the portfolio.

Rework the calculations for 30 contracts and recommend whether the number of
contracts should be rounded on the upper or lower side of the no of contracts
required.

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