Futures Contracts Flashcards
What is a futures contract?
An exchange-traded, standardised contract obligatingthe buyer purchase, and the seller to sell, an asset at a predetermined future date and price.
What are they key features of future contracts?
- Standardised contracts with standardised terms set by the exchange (quantity, delivery date, asset type etc.)
- Traded on exchanges: Highly liquid and regulated environment
- Counterparties are not exposed to each other’s default risk due to clearing house guarantee.
- Gains/losses are settled daily (market to market daily)
- An investor may, at any time, close or reverse a futures position. Flexibility to exit before maturity.
What is the convergence principle?
As the delivery period for a futures contract is approached, the price of the futures contract converges to the spot price of the underlying asset.
If at maturity (time of delivery) the Futures price > Spot price: Arbitrageurs sell futures, buy spot, deliver the underlying asset (and profit from the difference) –> Futures price falls
(vice versa if F < S)
What is the purpose of margin accounts?
To reduce the frequency of contract defaults and to ensure that funds are available to pay traders when they make a profit (protection against credit risk).
What is the initial margin?
A security deposit required when entering a futures contract.
Typically a small percentage of the total contract value.
Acts as collateral to cover potential losses.
What is the maintenance margin?
A minimum balance threshold that must be maintained in the maregin account.
If the margin account falls below this level due to adverse price movements, the trader receives a margin call.
What is daily resettlement?
The daily adjustment of the balance in a margin account to reflect a trader’s gains/losses. The value of the futures contract is reset to zero at the end of each trading day (marked to market). The value of the contract is zero at the end of each trading day because any gain or loss from a position in the contract due to a change in spot price will have been realised at the end of the trading day through a cash flow from the losing party’s (party that made a loss that day) margin account to the winning party’s margin account.
If the futures price increases from one day to the next, funds flow from the margin account of traders with short positions to traders with long positions. If the futures price decreases from one day to the next, funds flow in the opposite direction, from traders with long positions to traders with short positions.
Why is a perfect hedge rarely feasible in practice?
A perfect hedge is difficult because:
- Mismatched maturities: The hedging instrument and the exposure may not mature at the same time. The hedge may require the futures contract to be closed out before its delivery month.
- Basis risk: The futures price and the spot price of the hedged asset may not move perfectly in sync. The basis may change over time.
- Asset mismatch: The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract.
- Liquidity constraints: It may not be practical to trade the exact quantity needed.
- Timing issues: Entry and exit points may not align with cash flow timing.
What is basis?
Basis = Spot price of asset to be hedged – Futures price of contract used
If the asset to be hedged and the asset underlying the futures contract are the same, the basis should be zero at the expiration of the futures contract. Prior to expiration, the basis may be positive or negative.
How does one choose the futures contract to use for hedging?
This choice has two components:
1. The choice of the asset underlying the futures contract
2. The choice of the delivery month
When there is no futures contract on the asset being hedged, choose the contract whose futures price is most closely correlated with the price of the asset being hedged.
A contract with a later delivery month than the expiration of the hedge is usually chosen. The reason is that futures prices are in some instances quite erratic during the delivery month. Moreover, a long hedger runs the risk of having to take delivery of the physical asset if the contract is held during the delivery month. Taking delivery can be expensive and inconvenient. (Long hedgers normally prefer to close out the futures contract and buy the asset from their usual suppliers.)
In general, basis risk increases as the time difference between the hedge expiration and the delivery month increases. A good rule of thumb is therefore to choose a delivery month that is as close as possible to, but later than, the expiration of the hedge.
What is cross hedging?
Cross-hedging is when a hedger uses a futures contract with a different but correlated underlying asset to hedge price risk.
This is typically done when:
- No futures exist for the exact asset.
- The available futures contract has a strong historical correlation with the hedged asset.
However, it introduces basis risk, the risk that the price movements between the hedged asset and the futures asset diverge.
What is a basis point?
0.01%
