ch18

Chapter 18
Futures Contracts and

Forward Rate
Agreements
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Learning Objectives
Outline features of futures contracts
Identify futures market instruments
and participants
Understand the different types of risks
that can be hedged using futures
Overview of forward rate agreements
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Chapter Organisation
18.1 Introduction
18.2 General Principles of Hedging
Using Futures
18.3 Main Features of Futures
Transactions
18.4 Futures Market Instruments
18.5 Futures Market Participants
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Chapter Organisation (cont.)

18.6 Hedging: Risk Management Using
Futures
18.7 Risks in Using Futures Markets for
Hedging
18.8 Forward Rate Agreements (FRAs)
18.9 Summary
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18.1 Introduction
Futures contracts and FRAs are called
derivatives because they derive their

price from an underlying physical
market product
Two main types of derivative contracts
Commodity (e.g. gold, wheat and cattle)

Financial (e.g. shares, government
securities and money market instruments)
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18.1 Introduction (cont.)

Derivative contracts enable investors
and borrowers to protect assets and

liabilities against the risk of changes in
interest rates, exchange rates and
share prices
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18.1 Introduction
Using Futures
Transactions
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18.2 General Principles of

Hedging Using Futures
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
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Hedging Using Futures (cont.)
The change in the market price of a
commodity or security is offset by a

profit or loss on the futures contract
Example: a farmer wants to sell wheat
in a couple of months. He is concerned
that the price is going to fall in the
meantime. How can he hedge this
price risk?
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Hedging Using Futures (cont.)
Solution
Enter into a wheat futures contract to sell
If wheat prices fall, the futures contract will rise

in value, offsetting the loss in the physical
market from the fall in the wheat price
If wheat prices rise, the futures contract will fall
in value, offsetting the gain in the physical
market from a rise in the wheat price
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18.1 Introduction
Using Futures
Transactions
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Transactions
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)
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Transactions (cont.)
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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 due
to unfavourable price movements in the
contract
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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
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Closing out of a contract
Involves entering into an opposite position
Example: if company S initially entered
into a sell one ten-year treasury bond
contract, it would close out the position
by entering into a buy one ten-year
treasury bond contract as illustrated in
Table 18.2
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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
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Contract delivery (cont.)
SFE (Sydney Futures Exchange) requires
financial futures in existence at the close
of trading in the contract month to be
settled with the clearing house by
standard delivery or cash settlement
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18.1 Introduction
Using Futures
Transactions
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18.4 Futures Market

Instruments
Futures markets can be established for
any commodity or instrument that
Is freely traded
Experiences large price fluctuations at
times
Can can be graded on a universally
accepted scale in terms of its quality
Is in plentiful supply, or cash settlement is
possible
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18.4 Futures Market

Instruments (cont.)
Example
Commodities
Mineral (e.g. silver, gold, copper, petroleum

and zinc)
Agricultural (e.g. wool, coffee, butter, wheat
and cattle)
Financial
Currencies (e.g. pound sterling and euro)

Interest rates (e.g. US 90-day bills, 3-month
euro deposits)
Share price indices (e.g. All Ordinaries)
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18.1 Introduction
Using Futures
Transactions
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18.5 Futures Market

Participants
Four main categories of participants
Hedgers
Speculators
Traders
Arbitragers
These participants provide depth and
liquidity to the futures market; thus,

improving its efficiency
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Four main categories of

participants
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: exporter has USD receivable in 90
days. To protect against fall in USD over next
3 months, exporter enters into a futures
contract to sell USD
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participants (cont.)
Speculators
Expose themselves to risk in the attempt to
make profit
Enter the market in the expectation that the
market price will move in a favourable
direction for them
Example: speculators who expect the price of
the underlying asset to rise will go long and
those that expect the price to fall will go short
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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
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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
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Futures
Hedging
18.9 Summary
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18.6 Hedging: Risk

Management Using Futures
Futures contracts may be used to
manage identified financial risk

exposures such as
Hedging the cost of funds

Hedging the value of a money market
investment
Hedging a foreign currency payable
Hedging the value of a share portfolio
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18.6 Hedging: Risk Management

Using Futures (cont.)
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Futures
Hedging
18.9 Summary
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18.7 Risks 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
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Markets for Hedging (cont.)
Standard contract size
Example
90-day bank bill$1,000,000 face value

3-year T-bond$100,000 face value
Listed company share1000 shares
A perfect hedge may not be possible i.e. due

to contract size, the physical market exposure
may not exactly match the futures market
exposure
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Margin risk
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
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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 start date
The difference between the price in the physical
market and the futures market at end date
A perfect hedge requires zero initial and

final basis risk
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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
Select a futures contract that has price

movements that are highly correlated with the
price of the commodity or instrument to be
hedged
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Futures
Hedging
18.9 Summary
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18.8 Forward Rate

Agreements (FRAs)
The nature of the FRA
A 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
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18.8 Forward Rate

Agreements (FRAs) (cont.)
The nature of the FRA (cont.)
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
Disadvantages of FRAs include
Risk of non-settlement i.e. credit risk

No formal market exists
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18.8 Forward Rate

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18.8 Forward Rate

Settlement amount = FRA settlement rate - FRA agreed rate
365 P
365 P
365 ( D i s ) 365 ( D ic )
(18.2)
where :
i s the FRA settlement rate expressed as a decimal
ic the contract FRA agreed rate expressed as a decimal
D the number of days in the contract period
P the contract notional principal amount.
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18.8 Forward Rate

365 P
365 P
365 ( D i s ) 365 ( D ic )
where :
i s 0.1395 (on 19 April)
ic 0.1325 (19 September)
D 183 days (from 19 April to 19 October)
P $5 000 000.
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18.8 Forward Rate

365 5 000 000

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

$4 673 154.46 - $4 688 533.65
$15 379.19
Settlement
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18.8 Forward Rate

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Futures
Hedging
18.9 Summary
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18.9 Summary (cont.)

Limitations include margin calls,
imperfect hedging due to basis risk,

and availability
FRAs are over-the-counter contracts
specifying an agreed interest rate to
apply at a future date
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18.9 Summary (cont.)

A futures contract is 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
Futures 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
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Chapter 18

Futures Contracts and

Chapter Organisation (cont.)

derivatives because they derive their

Commodity (e.g. gold, wheat and cattle)

18.1 Introduction (cont.)

and borrowers to protect assets and

18.2 General Principles of

of unanticipated changes in prices,

18.2 General Principles of

commodity or security is offset by a

18.2 General Principles of

Enter into a wheat futures contract to sell

If wheat prices fall, the futures contract will rise

18.3 Main Features of Futures

Whether it is a buy or sell order

18.3 Main Features of Futures

18.3 Main Features of Futures

18.3 Main Features of Futures

I.e. repricing of the contract daily to reflect

Subsequent margin calls may be made,

18.3 Main Features of Futures

18.3 Main Features of Futures

18.3 Main Features of Futures

Manage a risk exposure or speculate

18.3 Main Features of Futures

18.4 Futures Market

any commodity or instrument that

18.4 Futures Market

Mineral (e.g. silver, gold, copper, petroleum

Currencies (e.g. pound sterling and euro)

18.5 Futures Market

liquidity to the futures market; thus,

Four main categories of

Four main categories of

Four main categories of

Four main categories of

Chapter Organisation (cont.)

18.6 Hedging: Risk

manage identified financial risk

Hedging the cost of funds

18.6 Hedging: Risk Management

18.6 Hedging: Risk Management

18.6 Hedging: Risk Management

18.6 Hedging: Risk Management

Chapter Organisation (cont.)

18.7 Risks in Using Futures

for hedging include the problems of

Standard contract size

18.7 Risks in Using Futures

90-day bank bill$1,000,000 face value

A perfect hedge may not be possible i.e. due

18.7 Risks in Using Futures

18.7 Risks in Using Futures

18.7 Risks in Using Futures

The difference between the price in the physical

A perfect hedge requires zero initial and

18.7 Risks in Using Futures

Use of a commodity or financial instrument to

Often necessary as futures contracts are

Select a futures contract that has price

Chapter Organisation (cont.)

18.8 Forward Rate