Chapter Fourteen Financial Futures. Hedgers A hedger is at risk if a given potential price movement happens. Hedgers seek to create a profit from this.

Presentation on theme: "Chapter Fourteen Financial Futures. Hedgers A hedger is at risk if a given potential price movement happens. Hedgers seek to create a profit from this."— Presentation transcript:

1 Chapter Fourteen Financial Futures

2 Hedgers A hedger is at risk if a given potential price movement happens. Hedgers seek to create a profit from this price movement in another market so as to create a gain in partial compensation for the loss If hedgers lose money in the hedge market, they must make money in the market being hedged because the price movement they feared has not happened Indeed, the bigger the loss on the futures hedge, the bigger the offsetting gain in the physical market

3 Future Contract A futures contract is a commitment to buy or sell a given quantity of an underlying product by a given date in the future at a price agreed now A futures transaction is a commitment, not an option Since no privilege is involved, no premium need be paid. For the same reason, a futures contract is riskier

4 Future Contract (cont.) The fact that the contract can go to delivery is crucially important. It means that the price of sugar in the futures exchange must relate to the real price of sugar. If it was cheaper, traders would use the futures exchange to buy it and sell it at profit in the cash market – arbitrage Forward is for those who want the physical commodity, futures for those who are speculating or hedging and are happy with cash settlement

5 Financial Futures There are four main types of financial contract; bonds, interest rates, currencies and equity indices, as well as commodities and even a weather future. Any buyer or seller who doesn’t close the position is automatically closed by the clearing house as the contract can’t go to delivery. If the buyer or seller is letting the contract go to delivery, they don’t need to take any action as the position will be closed for them The problem of correlation with the market price is solved by the convention that the expiry price is always the market price.

6 NYSE Liffe Contracts, June 2011 Contract type Individual contracts ___________________________________________________________________ Bonds Short, medium and long gilt futures, long gilt options, Japanese government bond futures Interest rates Euribor 3-month contract, Euribor futures, options, mid-curve options and 2-year mid curve options Euroswiss futures and option contracts including a variety of STIR (short-term interest rate) options Equities Futures and options contracts on equity indices – AEX, BEL20, PSI20, CAC 40, FTSE 100. Futures and options on 1000+ underlying companies across 20+ countries, as well as a broad range of index derivatives Individual share options on 250 leading European companies Options on five Exchange Traded Funds (ETFs) managed by Lyxor Asset Management Swapnotes 2-, 5- and 10-year euro and dollar Currencies $/€ futures (FDE) and options (DEX) and €/$ futures (FED) and options (EDX) In addition, there are a number of commodity contracts, main ones being: cocoa, robusta coffee and white sugar. __________________________________________________________________

7 Bond Futures Most bond futures contracts are based on a notional bond, that is, one that doesn’t exist There will be one bond in the list that is cheapest to deliver. The price in the trading pit will be based on this cheapest to deliver bond As a result, the list of bonds available for delivery is significant and the exchange will make changes from time to time

8 Interest Rate Futures Interest rate contracts create valuable opportunities for those at risk from interest rate changes to hedge that risk Interest rate contracts are cash settled – they cannot go to delivery. At expiry, any open positions are closed by the clearing house at the expiry price, which is always the market price

9 Users of Futures In general, corporates are not enthusiastic about use of futures exchanges For banks themselves, however, the exchanges have one key advantage – the security of the clearing house. At a time when counterparty risk is a major worry, increasingly this is a key benefit For fund managers, too, the index contracts provide secure, liquid trading and the chance to carry out asset allocation smoothly

10 Global derivative trading, million contracts, January to June 2011 Exchange Total _________________________________________________________________________ 1 Korea Exchange 2,124 2 CME Group, includes CBOT and Nymex 1,708 3 Eurex, includes International Securities Exchange 1,421 4 N YSE Euronext, includes all EU and US markets 1,169 5 National Stock Exchange of India 1,048 6 BM&F Bovespa, São Paulo, Brazil734 7 Nasdaq OMX Group, includes US and Nordic markets653 8 Chicago Board Options Exchange (CBOE), includes CFE and C2595 9 Multi Commodity Exchange of India568 10 Russian Trading Systems Stock Exchange 444 ___________________________________________________________________________ Source: Futures Industry Association, Annual Volume Survey