Forwards & Futures PDF

Module 10 - Risk Management Forwards & Futures Introduction to Forwards and Futures Contracts Used as ways individuals can hedge risk. Forwards: Not traded in financial market Futures: Are traded on financial market Forward Contracts Pre set prices to ensure profitability if there were a fut...

Module 10 - Risk Management Forwards & Futures Introduction to Forwards and Futures Contracts Used as ways individuals can hedge risk. Forwards: Not traded in financial market Futures: Are traded on financial market Forward Contracts Pre set prices to ensure profitability if there were a future decrease in market conditions or price changes Similar to forward rate agreement where bank and borrower lock in a forward interest rate. It is an agreement between to parties to buy or sell an asset at a specific price, at a future date The contract terms include the price, quantity, delivery date of the underlying asset Forward contracts are customised to the specific needs of the buyer and seller and are not traded on an exchange. Typically for commodities and foreign exchange Hedge against price fluctuations and manage risk. Everything is negotiable between buyer and seller. The investor is stuck with the contract until the item has been exchanged as it cannot be traded on financial markets. Futures Contract A contract to buy a specific quantity of a commodity or financial instrument at a specified price, with delivery set at a specified time in he future. The futures markets decide the items that can be traded. They have a future settlement date Most are cash settled rather than settled by the exchange of the contract item Futures contracts can be closed out by an offsetting trade before their settlement date. Can be sold and traded in market. The owner can take away ownership/liability. Both parties can sell contract to someone else in financial market. Futures are cash settled and can be closed out by an offsetting trade ↑ bakery can specify Dushels e g 253. g. Davery would enter into agreement W/standard uty e g 1000 bushels on forward exchange e %. > Exchange broken producer would have to go to Asx >e -..... dealer-private untract &or bahers delight between 2 individual parties Filians punterparty > - ↓ delivery good) No speculation sold on an as of rarely schement of physical I BD. Counterparty. very limited number of Untracts risk Accurs when through with on reunterparty ASX does not go counterparty If BD or jilian go to exchange, the counterparty becomes the exchange. ↳ Reason for middle person as a limits counterparty & the rish exchange will still honour the contract) money if unpaid cash rather , goods curt be exchange - Through market exchange Counterparty Risk: When the other party to a contract does not fulfill intended deeds at expiry e.g. bakers delight doesn’t exchange the cash for Jillian’s wheat. In a futures contract the counterparty is the exchange as parties go to exchange to receive their contracts, they don’t go to the other parties. In this case, there is low counterparty risk as the exchange fulfils the contract. The reason for this is to limit the counterparty risk Futures exchange as counter party’s purpose is to limit counterparty risk. Settlement is different between contracts: - Forwards: Physical settlement of produce/commodities - Futures: Cash settlement. Instead e.g. look at the value of wheat on expiration date and that will be the cash settlement. Futures Contract Specifications A futures contract specifies a minimum of four things: 1) The item being traded: With the available items decided by the exchange - E.g. commodities: wheat, or financial instruments: BABs - Including amount, quantity, quality, every detail of what is traded needs to be specified 2) The Settlement price: Agreed between buyer and seller of the futures contract 3) The future settlement date: E.g. second Friday in September - Tend to be fixed and second Friday every three months 4) How the contract can be settled: By delivery of contract item or by cash Long & Short Positions The buyer has the long position - This is the contractual obligation to buy the contract item on the settlement date at agreed price The seller has the short position - They have contracted to sell to the contract’s older on the settlement date at the agreed price An Example - Wheat Futures - someone is # Someone is willing to buy wheat (1st) @$119 phone in in June willing to sell wheat (200)& $129 ploune in June 2023 1) party will putIn "Buy ORDER" in futures Step 1) Buyer party puts in a “Buy Order” into the futures exchange market Buyer Step 2) Someone else puts in a “Sell Order” Step 3) These orders are then matched itive marked is a speculator Suisition The difference between contract exchange and share exchange is that traders are exchange shares at current prices where as investors in contracts are buying and selling contracts based on speculations of future prices based n current spot rates. These two parties, and any other parties are speculators in the market, they are traders. They don’t want to hedge risk, they are in the market for speculation and profit making Nick buys one June wheat futures contract at $129 per tonne and Elizabeth sells at this price and quantity This is called a Pales diagram. This is a 45 degree line. Contract specifies Nick will buy 20 tonnes of wheat in June 2023 at $129 per tonne. Elizabeth will sell at this price and quantity. *Graphsnowtha WMHS, Nick buys wheat as he speculates the price will go up. As June approaches, say wheat price increase, his profit increases too as spot prices increase. Therefore, as soon as he buys the $129 per tonne contract, he can sell it as it’s already making a profit. Elizabeth wants to sell her wheat contract as she believes prices will decrease. She sells at $129 per tonne. If the price does go down, she will buy wheat in the market at a lower price and sell it to Nick at $129 per tonne. 2013  Say there is physical delivery in a low but possible chance in the futures market. Assume June 2023 comes and the clearinghouse brings the two parties together. Nick pays $129*20 tonnes to the clearinghouse. The clearinghouse pays this to Elizabeth. She then takes 20 tonnes of wheat, gives it to the clearinghouse and the clearinghouse disburses it to Nick or the buyer. BUT THESE PARTIES DO NOT REQIURE THE COMMODITIES ON EXCHANGE THEY ONLY DO IT FOR THE SPECULATION OR PFIRCES Therefore physical delivery is something that does not take place in the market and why it is primarily kept for forward contracts Instead, there is cash settlement Cash Settlement A trader can close out their position at any time prior to the settlement date by taking an offsetting position in the same contract - This results in a profit or loss which is the difference between the selling and buying value - If they don’t do this prior to settlement, the settlement will happen on the final day of the contract. Even most deliverable contracts are cash settled Cash settlement overcomes the need for the futures market to arrange physical settlement. Nick decides to close out on June 2023 contract. He goes to market in May 2023 but in the market, the price of wheat has increased to $165 as the underlying asset has increased in price. Means Nick will make a profit. Nick closes out by cash settlement through a reversing trade. He decides to sell one June 2023 contract at the current futures contract price. This is different than the price at which settlement will take place but it;s become valuable. Nick now has a short position as he is a seller. Bernie buys one wheat contract at $169 per tonne and he now has the long position. The market’s clearinghouse recognises Nick’s long position has been cancelled out when he took a short position in the same contract. Cash Settlement Formula for Futures Contracts: - Clearinghouse to Pay = (P2 - P1) * Qty - E.g. Settlement = (165-129)*20 = $720 Elizabeth and Bernie are still in the market and the exchange is their counterparty. The Role of the Futures Market Risk Transfer Function - Futures markets were first established to manage risk associated with volatile agricultural commodity prices. - This posed risks for buyers and sellers - Financial futures were introduced to manage the risk posed by volatile financial variables - Including interest rates, exchange rates and share prices - Futures markets are also attractive to speculators. - Traders of futures contracts can: - Hedge an exposure to an adverse movement in future spot value - Speculate an anticipated movement in spot prices - A long position will profit by a rise in the value of the contract item - This is because if the prices rise, they’ve already agreed to a cheaper purchase price which means they can sell it for more in the future and receive a capital gain. - A short position will profit from a fall in the contract item’s value - This is because if they’ve agreed to the exchange of an item at a higher contract price, they’ve gained profit as they were able to sell at this higher price before it fell. - A hedging example - SPECULATORS ONLY HAVE ONE 45 DEGREE LINE AS THEY ARE NOT HEDGING THE RISK BY MAKING UP WITH OTHER PRICING. - Julian and Bakers delight were hedgers of risk. - Julian posses an underlying or core exposure to the volatile price of wheat. - If Julian has a contract and the price increases, she makes a profit - If she has a contact and the price decreases, she makes a loss because she’s got a fixed input cost - Because she’s got a long, underlying risk exposure, she takes a short futures contract - She has a current long exposure as she possess and has the wheat - She will later have a short exposure as she will become the seller - On the other hand, Bakers Delight has a short underlying wheat exposure as they do not own wheat at the moment. - Their fear is the price of wheat will go up in the future and so they lock it in with a long futures contract as they become the buyers of the contract In both of these scenarios, the hedging lines in the Pales Diagram will cancel each other out as they have locked in the price. They have hedged the risk by Jillian agreeing a price to sell in the future and BD agreeing a price to buy in the £future. 2) The Price Discovery Function Futures markets perform price discovery (by establishing forwards prices) as long as the contracts are actively traded Discovery of what the future price of the commodity will be - Not all futures contracts are liquid - Trading volumes for BAB, SPI, 3 year and 10 year Treasury Bond futures are very large, and can be interpreted as revealing forward prices. E.g. the forward yields by BAB futures trading are used by the FRA and interest-rate swap dealers. Similar to setting a forward price of a financial instrument in an FRA AIDS in knowing what price to set as the future rate or price in a time period form today. Liquidity Futures contracts are highly liquid due to: 1) The very low cost of trading contracts - The futures contracts themselves are free, there is no payment for entering a contract - The reason it is free, is both parties have equal obligations to buy and sell to each other. - Out of pocket expenses include margin payments and brokers commissions - Low cost 2) A limited amount of settlement dates - There is a limited amount of settlement dates as there is a limited amount of contracts therefore, there is a greater volume in those limited amounts. - E.g. there is only 4 delivery months. If there was 200 the liquidity would be spread among this but as there is only four, each delivery date gather much greater funds. 3) Standardised contracts - Standardised to enable all investors to be interested in investing. If it were non standardised only a limited amount of investors would be interested. 4) They trade very easily in the market Part E. The ASX Futures Market The ASX Futures Market Used to be known as Sydney Futures exchange (was seperate) ASX now conducts Aus futures market and enforces trading rules to ensure the market is fair and orderly The SFE established in 1960 as market for wool futures Trading in financial futures has dominated for 1) 30 day inter-bank cash rate futures 2) 90 day BAB futures 3) 3 year and 10 year bond futures 4) SPI futures Futures Contracts The ASX futures market specifies the contracts in terms of: - The Contract Item: E.g. 90 day BABs with FV of $1mil - The Contract/Settlement Dates: Commonly March, June, September, December usually 2nd Friday - The Quotation Method: such as 100 minutes the yield or yield they will be trading at for BAB and Bond futures - The Delivery Arrangements: usually non-deliverable contracts that require cash settlement The Trading System The ASX provides an automated trading system (called ASXTrade24) specifically for futures contracts into which, orders are submitted by brokers or their on-line trader clients. 24 hours trading, divided into night and day, this enables foreign trading, so too are most exchanges across the world No distinction between primary and secondary market, contracts trade until their contract date at which time, all open positions must be settled. The market’s clearinghouse organises the settlement of trades and their mandatory close-out. The Clearinghouse ASX Clear (Futures) clears and settles transactions Remember if this were a forward contracts Participants A and C and B and D will trade and buy/sell directly with each other rather than there being a counterparty in the middle as they are over the counter exchanges. It manages default risk through: 1) The notation of trades: the clearinghouse is the counterparty to each transaction (Sells to the buyer and buys form the seller). - This means every trader has obligations only to the clearinghouse. - ASX is the intermediary - They will never have an open position with only one side conducting a buy. They cancel each other out 2) A system of margin payments - When entering into a short or long futures contract, the. Party has to post a margin payment - The margin payment is not a cost, it is a deposit put down. This is a way for clearinghouse to ensure the risk of being the counterparty is minimised. a) Initial Margins: The clearinghouse ensures it has sufficient funds from the losing position to pay the winning position. - They are required from both buyer and seller when a position is first traded to open their margin accounts - Amount varies between contracts and in response to recent volatility to ensure it is sufficient to cover the maximum loss likely in one day. - It is sent as a percentage of the value of the contract - Parties can earn interest on this margin payment - As the value of commodity becomes higher or lower, the party’s margin amount increases and decreases depending on market values. If the short position holder for example sees an increase in their margin payment, they become a winner for the day. As his position is worth more and can buy at a lower price. - Money will be deducted form the other losing party and put into the winners account that day. - Margins cannot go to 0 and so there is a daily resettlement b) Daily Resettlement: Daily margin payments are required form the losing side when the balance in it’s margin account falls below the initial/maintenance level - This is marking to markets - Otherwise, the clearinghouse will close out the position - Winners receive their margin payments aback and for holders of losing contracts, the payments meet the cash settlement. - Losing side will receive a message from ASX saying they are on the losing side as she is selling and commodity price had increased meaning she is making a loss from sellling lower, so ASX are now taking an amount and putting it into winning side - At the end of the day, when the market closes for that specific session, there is a marking to market, where ASX will mark result for that period until the closure of the next market period. It is taking a specific point every single day at the same time to find the value of the underlying contract. If the price has gone up, the long contract is worth more and the short contract is worth less. If the price goes down, the long contract is worth less and short contract is worth more. - If it falls below a certain level, the losing [arty will get prompted to top up their margin. - You can withdraw if it is higher than the initial amount. - At end of day, when you settle for cash the amount in margin account will be equal to the profit or loss made given no withdrawals were made. Futures Markets Participants Hedgers: Take a position in the futures market that has an opposite profit or loss payoff to their exposure in the physical market Speculators: Futures do not require a large investment required that is needed in a physical futures market. Speculators speculate on price changes in commodity values. Futures contracts are highly leveraged and so can make large profits or large losses. - Extremely important to the market as they are the main adders of liquidity. Without them, there would not be enough hedgers in the market to trade with each other. Arbitrageurs: Take positions in different markets simultaneously in order to profit from price differences - Somebody taking opposing positions in different market simultaneously - E.g. might take a long position in wheat in Aus market and also a short position in wheat in the Chicago Board of Trade market - The individual trading in these markets would think that the price of these markets would equal each other Traders like the market’s low costs and high liquidity. Part C. SPI Futures Contracts · a lot of commodities promote the Futures The Specifications of the SPI Futures Contract price Contract unit: ATM is $25 per index point for the S&P/ASX200 can lock in purchase today at 'safe' price & receive at laker dake Price quotation: Being the index level value on exchange is in cento & per standard weight e g Ibs. Contact Months Buyer will closeout position early to avoid receiving Settlement Day physical settlement. Cash Settled/Settlement type An SPI future is a futures contract over the share price index S&P/ASX200 There are bid and offer prices If investors believe market will increase before June 2024, they will buy a long position as they expect the price to inflate at the maturity date. If they sell it, they will make a profit. · ·.. · SPI Futures: The Long Position The long position - Profits form an increase in the futures price - Risks making a loss if the price decreases as they would have bought the contract for more than wat it was worth SPI Futures: The Short Position The short position: - Profits from price decreases as it meant they sold their contract at the right time - They make a loss from price increases as it means they sold the contract too low Uses of SPI Futures SPI Futures hedge risk of a decrease in the price index through a short position in the PSI futures. If the index decreases the futures are closed out at a profit and this protects the portfolio’s value. Speculators can profit id they are able to correctly predict an increase or decrease in the value of an index, but risk making a loss if they are wrong. Example: SPI Futures for Speculation at $25 per index point - - - Prfit Or LASS a) Contract = = Usell-VBuy atyx#7 points pnce per -4431 + point) $25) - b) = = (10x 5000 25) (18x4931 x75) x - $17, 258 Example: SPI Futures for Hedging Eqiuty portfolio managers may want to hedge against their risk exposure for fluctuations of the share price index. They have a long underlying portfolio and so will sell a short position contract to hedge against their risk. How can managers hedge the risk of a decrease in share prices? If an equity manager in May, forecasts the SPI of the ASX200 will decrease by September, in Ma, they would take a short position future contract. SPI futures are trading at 5500 proystill $25 per osp - If the portfolio is worth $55 Million, the portfolio manager would take a short position in: - Number of contracts = Value of total exposure Value of Hedge Position :# of untract = 55 000 , 200 , 5588x25 = 400 untract X · The value of the (5 , 500 - 5, mgr has contract whos value has portfolio decreases 150) dropped by = 1) Have initial equity losing money & closed bought contract 2) manager out and therefore made same 6 3636%. 51508 $55Million · dropped amount = - profit or Loss = · = 6. 3836% = - $3 500 , 000 Usell-Vouy (400 5588 (5) x x $3 588 , , overall lost & stayed the same. , - (400 + 5, 158 x $25) This is when > - closes but manager position 888 Part D. BAB Futures Contracts The Specifications of a BAB Futures Contract Contract Unit: 90 day BAB with FV of $1mil Price Quotation: 100.00 minus annual % yield, to 2dp. E.g. Contract Months Settlement Day Settlement Type; being cash settled. In Australia, the prices of BABs represent 100 minus the BAB yield. Bid is higher than offer yield as higher interest means lower prices. BAB Futures Price vs BAB Futures Value BAB Futures as a Hedge Issuers of BABs are exposed to the risk of higher interest rates as this would mean lower prices meaning the issuer would receive less proceeds form the bill issue To protect form igher rates, the issuer would create an offsetting position to hedge the exposure by selling short BAB futures now. At maturity date, the seller would close out the position by executing an opposing trade at the same time as the BABs are sold in the money market. The Hedge Outcome of the Hedge Overall proves that the locked in rate will be the return rate at settlement when adding the spot market BAB value with the profit made on the futures contract. Basis Risk Risk that a hedge instrument does not precisely manage risk exposure and so does not exactly deliver the forward rate. BAB futures will only produce exact hedge when issue of BABs coincides with the last day of trading on the BAB futures constracts as both transactions will then take place at the same rate Bill issues on other day will involve basis risk where there is a chance the hedge instrument will not precisely manage the risk exposure. Comparing BABs and FRAs BAB futures and FRAs can perform the same heading purpose. The main difference between them is: - BABs futures are standardised contracts where as FRAs meet client’s specifications, FRAs generally more precise hedges - BAB futures are traded where as FRA don’t have 2nd market and therefore can be easily terminated. BAB futures is more important because it is the forward interest rate market. clearinghouse Money Mut Share Mlet Futures = = = AustraClear CHESS ASX clear Future nates as of 2152024 ore = 4 968 %. · ⑨ US Forward nate 5 199 % or F =. 02 gr,. 12 , (1 04968) = Approximate Method The :. - (1 85199) I. Itz 84968)2 ir2 =? 5 199 % = = 12. F2. The Exact Method 12 F2 1(1 =. & 4 968 % = 1(1 05199) Fl = re (nxorn) ((n (2 11 968 %) = - ,r = 122 = 9 936% ire = 4 737 % - + 1) xoV(n (1 -. * - 1) 5 199 %). 5 199 % -... 0 047375) =. = 4 738 %. (3dec) 82 0 198% =. & * Japan Forward rate or = ore = 0 898 %. F2 Fi & 0 298% or 8 898 %. ir1 =? =. The Exact Method 12 (1 =. 00290)2 - (1 00098) 152 I. ,52 12 0 00482368 =. = 0 482 %. 82 = = ir 152 = 0 482 % - + 0. 8987) 0 898 % -... = 3 112%. ⑧ · & 3 112 % F, ·F 2. (1. 83112)2 8 0275822. = 0 588%.. = = 3 467% (1 33467) irz ) (1 298 % Rate The Exact Method +z. it2 or 2 8r, 1 (2x0 (3de2 ) Germany Forward = =. & or Approximate Method The 2 758 %. (3de2) = it 3 467 %. The = ? Approximate Method ire = irz = (2 x. 6 224 %. - 2 757 % -. ) 3 112% - - (1x3 3 467 %.. ) 467 % = (n + g(n) ((n - - 1) + -n - 1)