Week 10 Lecture (FINS1612)

Futures Contracts and
Forward Rate Agreements
Copyright 2012 McGraw-Hill Australia Pty Ltd

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips 19-1
Slides prepared by Peter Phillips
LEARNING OBJECTIVES
Consider the nature and purpose of derivative products
Outline features of a futures transaction
Review the types of futures contracts available through a futures
exchange
Identify why participants use derivative markets and how futures are
used to hedge price risk
Identify risks associated with using a futures contract hedging strategy
Explain and illustrate the use of an FRA for hedging interest rate risk
Describe the use of a forward rate agreement for hedging interest rate
risk

CHAPTER ORGANISATION
19.1 Hedging using futures contracts
19.2 Main features of a futures transaction
19.3 Futures market instruments
19.4 Futures market participants
19.5 Hedging: risk management using futures
19.6 Risks in using futures markets for hedging
19.7 Forward rate agreements (FRAs)
19.8 Summary

19.1 HEDGING USING FUTURES
CONTRACTS
Futures contracts and FRAs are called derivatives because they derive
their price from an underlying physical market product
Two main types of derivative contracts

1. Commodity (e.g. gold, wheat and cattle)
2. Financial (e.g. shares, government securities and money market instruments)
Derivative contracts enable investors and borrowers to protect assets

and liabilities against the risk of changes in interest rates, exchange rates
and share prices
(cont.)
19.1 HEDGING USING FUTURES
CONTRACTS (CONT.)
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
The change in the market price of a commodity or security is offset by

a profit or loss on the futures contract
(cont.)
HEDGING WITH FUTURES CONTRACTS
Example: Farmer Joes 10 tonne wheat crop will be harvested and ready for
sale in 3 months time. What is the risk that he needs to protect against?
Another
What 3 I
Should
months
do aboutand it
this? Butmay
You Farmer
You need to hedge
will be perfect! Joeup
lose some
thispeople
to
risk using
20% if you say
Futures!!
Wheat
sell in 3
prices are
months
falling!

Futures contract is an agreement to buy or sell a specified asset at a
specified time in the future.
Buy Futures/Long position = Agreement to buy an asset in the future
Sell Futures/Short position = Agreement to sell an asset in the future?
Does Farmer Joe short futures or long futures?

PPTs to accompany Financial Institutions, Instruments and Markets 7e by Viney and Phillips
18-7
19-7
Decision Rule
(i) What you want to do with the asset in the future, do in the futures
market now, or;
(ii) Whatever position you have in the asset, take the opposite position in
the futures.
Farmer Joe;
(i) Wants to sell wheat in the future therefore sells futures/takes short
position today.
(ii) Has a long position in wheat, therefore takes a short position in wheat
futures.

18-8
19-8
Information
The current spot price of wheat is $300/tonne.
3 month wheat futures are trading at $300/tonne.
After 3 months the spot price of wheat falls to $250 per tonne.

18-9
19-9
Futures Market Physical Market
Today: 1 Jan 2011 Today: 1 Jan 2011

Short 10 March 2011 ctrcts @$300/tonne Wheat is selling @ $300/tonne
After 3 months: (31 March 2011)

After 3 months (31 March 2011):
Wheat is selling @ $250/tonne
Long 10 March 2011 contracts @250/tonne
Futures Profit = $50/contract Loss on Physical Market = $50

Total Profit = $50 x 10 contracts Total Loss = $50 x 10 tonnes
= $500.00 = $500.00

18-10
19-10
HEDGING WITH FUTURES CONTRACTS
Who might have taken the other side of Farmer

Joes Futures position? What happens to their
profit/loss in the futures market?
What if the entire market expected wheat prices
to fall?
What if the price of wheat in fact rose during the
hedging period?

19.8 Summary

19.2 MAIN FEATURES OF FUTURES
TRANSACTIONS (CONT.)
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)
(cont.)
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
owing to unfavourable price movements in the contract
(cont.)
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
(cont.)
Closing out of a contract
Involves entering into an opposite position

Example:
Company S initially entered into a sell one 10-year Treasury bond contract with company B
Company S would close out the position by entering into a buy one 10-year Treasury bond
contract for delivery on the same date, with a third party, say company R
The second contract reverses or closes out the first contract and company S would
no longer have an open position in the futures market
(cont.)
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
ASX Trade24 requires financial futures in existence at the close of trading in
the contract month to be settled with the clearing house in one of two
ways
Standard deliverydelivery of the actual underlying financial security
Cash settlement
(cont.)
Contract delivery (cont.)
Settlement details, including the calculations of cash settlement amounts, for each
contract traded on the ASX Trade24 are available on the exchanges website at
www.asx.com.au

19.8 Summary

19.3 FUTURES MARKET INSTRUMENTS
Futures markets can be established for any commodity or

instrument that:
is freely traded
experiences large price fluctuations at times
can be graded on a universally accepted scale in terms of its quality
is in plentiful supply, or cash settlement is possible
(cont.)
19.3 FUTURES MARKET INSTRUMENTS
(CONT.)
Examples:
Commodities
Mineralsilver, gold, copper, petroleum, zinc
Agriculturalwool, coffee, butter, wheat and cattle
Financial
Currenciespound sterling, euro, Swiss franc
Interest rates
Short-term instrumentsUS 90-day treasury bills, three-month eurodollar
deposits, Australian 90-day bank-accepted bills
Longer-termUS 10-year T-notes, Australian three-year and 10-year
Commonwealth Treasury bonds
Share price indicesS&P/ASX 200 Index
(cont.)
19.8 Summary

19.4 FUTURES MARKET PARTICIPANTS
Four main categories of participants
1. Hedgers
2. Speculators
3. Traders
4. Arbitragers
These participants provide depth and liquidity to the futures market,

improving its efficiency
(cont.)
(CONT.)
1. 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:
An exporter has USD receivable in 90 days. To protect against falls in USD over
the next three months, the exporter enters into a futures contract to sell USD
(cont.)
(CONT.)
2. Speculators
Expose themselves to risk in an attempt to make profit

Enter the market with the expectation that the market price will move in a direction
favourable for them
Example:
Speculators who expect the price of the underlying asset to rise will go long and those who
expect the price to fall will go short
(cont.)
(CONT.)
3. 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
(cont.)
(CONT.)
4. 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

19.8 Summary

19.5 HEDGING: RISK MANAGEMENT
USING FUTURES
Futures contracts may be used to manage identified financial

risk exposures such as:
Hedging the cost of funds (borrowing hedge)
Hedging the yield on funds (investment hedge)
Hedging a foreign currency transaction
Hedging the value of a share portfolio

HEDGING THE COST OF FUNDS (BORROWING
HEDGE)

HEDGING THE VALUE OF A SHARE PORTFOLIO

19.8 Summary

19.6 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
(cont.)
FOR HEDGING (CONT.)
Standard contract size
Owing to contract size the physical market exposure may not
exactly match the futures market exposure, making a perfect hedge
impossible
Table 19.6
(cont.)
FOR HEDGING (CONT.)
(cont.)
FOR HEDGING (CONT.)
Margin payments
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
(cont.)
FOR HEDGING (CONT.)
Basis risk
Two types of basis risk

Initial basis
The difference between the price in the physical market and the futures
market at commencement of a hedging strategy
Final basis
The difference between the price in the physical market and the futures
market at completion of a hedging strategy
A perfect hedge requires zero initial and final basis risk
(cont.)
FOR HEDGING (CONT.)
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
Selection of a futures contract that has price movements that are highly
correlated with the price of the commodity or instrument to be hedged

19.8 Summary

19.7 FORWARD RATE AGREEMENTS (FRAS)
The nature of the FRA
An 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
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
(cont.)
(CONT.)
The nature of the FRA (cont.)
Disadvantages of FRAs include:

risk of non-settlement, i.e. credit risk
no formal market exists
The FRA specifies:

FRA agreed date, fixed at start of FRA
notional principal amount of the interest cover

FRA settlement date when compensation is paid
contract period on which the FRA interest rate cover is based (end date)
reference rate to be applied at settlement date
(cont.)
(CONT.)
(cont.)
(CONT.)
Settlement amount = FRA settlement rate - FRA agreed rate
365 P 365 P

365 (D i s ) 365 (D ic )
where
is = reference rate at the FRA settlement rate, expressed as a decimal
ic = the fixed FRA agreed rate, expressed as a decimal
D = the number of days in the contract period
P = the FRA notional principal amount
(cont.)
(CONT.)
Using an FRA for a borrowing hedge
Example: On 19 September this year a company wishes to lock in the
interest rate on a prospective borrowing of $5 000 000 for a six-month
period from 19 April next year to 19 October of the same year. An FRA
dealer quotes 7Mv13M (19) 13.25 to 20. On 19 April the BBSW on
190-day money is 13.95% per annum.
365 P 365 P

365 (D is ) 365 (D ic )
is = 0.1325 (on 19 April)

ic = 0.1395 (on 19 September)
D= 183 days (from 19 April to 19 October)
P= $5 000 000
(cont.)
(CONT.)
Using an FRA for a borrowing hedge (cont.)
365 5 000 000 365 5 000 000

Settlement
365 (183 0.1395) 365 (183 0.1325)
$4 673 154.46 - $4 688 533.65
- $15 379.19
As interest rates have risen over the period, the settlement

of $15 379.19 is paid by the FRA dealer to the company
(cont.)
(CONT.)
Main advantages of FRAs
Tailor-made, over-the-counter contract, providing great flexibility with respect to
contract period and the amount of each contract
Unlike a futures contract, an FRA does not have margin payments
Main disadvantages of FRAs

Risk of non-settlement (credit risk)
No formal market exists and concern about difficulty closing out FRA position
is overcome by entering into another FRA opposite to the original agreement

19.8 Summary

19.8 SUMMARY
A futures contract
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
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
Limitations include margin calls, imperfect hedging owing to basis risk, and availability
(cont.)
19.8 SUMMARY (CONT.)
FRAs
Over-the-counter contracts specifying an agreed interest rate to apply at a future

date
Advantages include:
flexibilitythey are tailor-made
no margin calls
Disadvantages include:
non-settlement or credit risk
lack of formal market


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Futures Contracts and

Forward Rate Agreements

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Two main types of derivative contracts

Derivative contracts enable investors and borrowers to protect assets

A futures contract is the right to buy or sell a specific item at a specified

The change in the market price of a commodity or security is offset by

Copyright 2012 McGraw-Hill Australia Pty Ltd

Buy Futures/Long position = Agreement to buy an asset in the future

Sell Futures/Short position = Agreement to sell an asset in the future?

Does Farmer Joe short futures or long futures?

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

The current spot price of wheat is $300/tonne.

3 month wheat futures are trading at $300/tonne.

Copyright 2012 McGraw-Hill Australia Pty Ltd

Today: 1 Jan 2011 Today: 1 Jan 2011

After 3 months: (31 March 2011)

Futures Profit = $50/contract Loss on Physical Market = $50

Copyright 2012 McGraw-Hill Australia Pty Ltd

Who might have taken the other side of Farmer

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Futures contracts are highly standardised and an order normally specifies:

the type of contract (varies between exchanges)

time limits on the order (if any)

A contract is marked-to-market on a daily basis by the clearing house

Subsequent margin calls may be made, requiring a contract holder to pay a

Involves entering into an opposite position

Contract delivery (cont.)

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Futures markets can be established for any commodity or

Copyright 2012 McGraw-Hill Australia Pty Ltd

These participants provide depth and liquidity to the futures market,

Attempt to reduce the price risk from exposure to changes in interest

Expose themselves to risk in an attempt to make profit

Special class of speculator

Simultaneously buy and sell to take advantage of price differentials between

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Futures contracts may be used to manage identified financial

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

standard contract size

Initial margin required when entering into a futures contract

Two types of basis risk

Use of a commodity or financial instrument to hedge a risk associated with

Copyright 2012 McGraw-Hill Australia Pty Ltd

Copyright 2012 McGraw-Hill Australia Pty Ltd

The nature of the FRA

An FRA is an over-the-counter product enabling the management of an

Disadvantages of FRAs include:

no formal market exists

The FRA specifies:

notional principal amount of the interest cover

reference rate to be applied at settlement date

is = 0.1325 (on 19 April)

Using an FRA for a borrowing hedge (cont.)

365 5 000 000 365 5 000 000