W10 The Futures Market Summary lecture PDF

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W10: The Futures Market INTRODUCTION TO FUTURES CONTRACTS  Futures Contracts – a contract to buy a specific quantity of a commodity or financial instrument at a specified price with deliver set at a specified time in the future.  How do futures differ from other contracts?  Futures contract specifications o 1) The item being traded o 2) The future settlement date o 3) How the contract can be settled o 4) The settlement price  Long & Short Positions o Buyer has long position o Seller has short position  Cash settlement o A trader can close-out their position at any time prior to the settlement date by taking a offsetting position in the same contract THE ROLE OF FUTURES MARKETS  Role of futures market include: risk-transfer function and the price discovery function  The risk-transfer function o Financial futures were introduced to manage the risk posed by volatile financial variables o Traders of future contracts can:  Hedge an exposure to adverse movement in future spot values  Speculate on anticipated movements in the spot price.  A long position will profit by a rise in the value of the contract item  A short position profits from a fall in the value of a the contract item  The price discovery function o By establishing forward prices, price discovery is performed as long as the contracts actively traded.  Liquidity o High liquidity in financial futures is a result of:  1) The low cost of trading contracts  2) A limited amount of settlement dates  3) Standardised contracts SPI FUTURE CONTRACTS  Specifications of SPI future contract o Contract unit: $25 per index point o Price quotation: the index level o Contract months: Mar/Jun/Sep/Dec o Settlement day: Third Thursday of the settlement mth  SPI Futures – The long and short position o The long position:  Profits from an increase in futures price  But risks making a loss if future price falls o The short position  Profits from a fall in futures price  But risk making a loss if future prices rises

 Uses of SPI Futures o The contracts can hedge the risk of a fall in the index through a short position in SPI futures. o SPI Futures for Speculators  Long position o SPI Futures for Hedges  Short position BAB FUTURE CONTRACTS  Specification of a BAB futures contract: o Contract unit: 90-day with FV $1 million o Price Quotation: 100.00 minus annual yield 2 d.p. o Contract months o Settlement day  BAB Futures – The long and short position o The long position:  profits from an increase in the futures price (a fall in interest rates)  but risks making a loss if the futures price falls (if interest rates rise) o The short position:  profits from a decrease in the futures price (a rise in interest rates)  but risks making a loss if the future price rises (if interest rate fall)  BAB futures as a Hedge Instrument o BAB futures can be used to create an offsetting position to hedge the exposure by:  1) selling BAB futures now  2) closing-out the futures position (by buying the same BAB futures) at the same time as BABs are sold in the money market  Hedging with BAB futures o The interest rate exposure of a bill facility can be managed through a strip hedge  Basis risk o BAB futures will only produce an exact hedge when the issue of BABs coincides with the last day of trading on the BAB futures contracts o Bill issues on other days will involve basis risk – the chance the hedge instrument will not precisely manage a risk exposure  Comparison of BABs and FRAs o BABs are standardised, FRAs meet client specifications and hence are more precise hedges o BABs futures are traded where as FRAs do not have a secondary market, hence a BAB futures hedge can easily be terminated. THE ASX FUTURES MARKET  The ASX futures market specifies the contract in terms of: o The contract item, contract dates, quotation method delivery arrangements  Mandatory close-out – the clearinghouse closes out all positions on the contract’s settlement date at thee spot rate  The Clearinghouse – manages default risk through novation and a system of margin payments. o Initial margins, daily resettlements...