Module 4.1

Question 1

Background on Financial Futures (1 of 6)

Answer 1

A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date. Financial futures contracts are traded on organized exchanges, which establish and enforce rules for such trading. The operations of financial futures exchanges are regulated by the Commodity Futures Trading Commission (CFTC).

Question 2

Popular Futures Contracts

Answer 2

Interest Rate Futures Debt securities such as Treasury bills, Treasury notes, Treasury bonds, and Eurodollar CDs. Settlement dates occur Mach, June, September, and December. Stock Index Futures Allows for the buying and selling of a stock index for a specified price at a specified date. There are various index future contracts. (Exhibit 13.1)

Question 3

Exhibit 13.1 Stock Index Futures Contracts

Answer 3

Question 4

2.Markets for Financial Futures

Answer 4

§Futures Exchanges

§Provide an organized marketplace where standardized futures contracts can be traded.

§Clear, settle, and guarantee all transactions.

§Most financial futures contracts in the U.S. are traded through the CME Group, a merger of the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) as of July 2007.

§Over-the-Counter Market

§A financial intermediary finds a counterparty or serves as the counterparty.

§More personalized and can be tailored to specific preferences.

Question 5

Purpose of Trading Financial Futures

Answer 5

§Financial futures are traded to speculate on prices of securities or to hedge existing exposure.

§Speculators in financial futures markets take positions to profit from expected changes in the futures prices.

§Day traders attempt to capitalize on price movements during a single day.

§Position traders maintain their futures positions for longer periods of time.

§Hedgers take positions in financial futures to reduce their exposure to future movements in interest rates or stock prices.

Question 6

Exhibit 13.2 Institutional Use of Futures Markets

Answer 6

Question 7

6.Trading Requirements

Answer 7

Customers open accounts at brokerage firms and establish margin deposits with the brokers.

■Type of Orders

■With a market order, the trade is executed at the prevailing price.

■With a limit order, the trade is executed if the price is within the limit specified by the customer.

■How Orders Are Executed

■Although most trading now takes place electronically, some trades are still conducted on the trading floor.

■Floor brokers receive transaction fees in the form of a bid-ask spread.

Question 8

Interest Rate Futures Contracts (1 of 5)

Answer 8

§Interest rate futures contracts specify a face value of the underlying securities, a maturity of the underlying securities, and the settlement date when delivery would occur.

§There is a minimum price fluctuation for each contract.

For financial institutions that trade in municipal bonds, there are Municipal Bond Index (MBI) futures

Question 9

Characteristics of Municipal Bond Index Futures

Answer 9

Question 10

1.Valuing Interest Rate Futures

Answer 10

§The price of an interest rate futures contract reflects the expected price of the underlying security on the settlement date.

§Participants in the Treasury bond futures market monitor the economic indicators that affect Treasury bond prices. (Exhibit 13.4)

§Participants in the Treasury bond futures market also monitor indicators of inflation, such as the consumer price index and the producer price index.

Question 11

Framework for Explaining Changes over Time in the Futures Prices of Treasury Bonds and Treasury Bills

Answer 11

Question 12

Speculating in Interest Rate Futures:

Answer 12

2.Speculators who anticipate future movements in interest rates can anticipate the direction of Treasury security values and therefore how valuations of interest rate futures will change.

§Payoffs from Speculating in Interest Rate Futures (See Exhibit 13.5).

§Impact of Leverage — Because investors commonly use a margin account to take futures positions, the return from speculating in interest rate futures should reflect the degree of financial leverage involved.

§Closing Out the Futures Position — Most buyers or sellers offset their positions by the settlement date.

Question 13

Potential Payoffs from Speculating in Financial Futures

Answer 13

Question 14

3.Hedging with Interest Rate Futures

Answer 14

In the short run, an institution may consider using financial futures to hedge its exposure to interest rate movements.

§Using Interest Rate Futures to Create a Short Hedge — Financial institutions commonly take a position in interest rate futures to create a short hedge, which represents the sale of a futures contract.

§Cross-Hedging

§The use of a futures contract on one financial instrument to hedge a position in a different financial instrument.

§The effectiveness of a cross-hedge depends on the correlation between the changes in market values of the two instruments.

Question 15

Trade-off from Using a Short Hedge

Answer 15

§A financial institution that hedges may be able to reduce the variability of its earnings over time.

§However, it is virtually impossible to perfectly hedge the sensitivity of all cash flows to interest rate movements.

§Using Interest Rate Futures to Create a Long Hedge

§Some financial institutions use a long hedge to reduce exposure to the possibility of declining interest rates.

§Hedging Net Exposure

§Because interest rate futures contracts entail transaction costs, they should be used only to hedge net exposure, which is the difference between asset and liability positions.

Question 16

Comparison of Probability Distributions of Returns; Hedged versus Unhedged Positions

Answer 16

Question 17

Stock Index Futures (1 of 6)

Answer 17

§The purchase of an S&P 500 futures contract obligates the purchaser to purchase the S&P 500 index at a specified settlement date for a specified amount.

§Stock index futures contracts have settlement dates on the third Friday in March, June, September, and December.

§The securities underlying the stock index futures contracts are not actually deliverable, so settlement occurs through a cash payment.

§Like other financial futures contracts, stock index futures can be closed out before the settlement date by taking an offsetting position.

Question 18

1.Valuing Stock Index Futures

Answer 18

§The value of a stock index futures contract is highly correlated with the value of the underlying stock index.

§In general, the underlying security (or index) tends to change by a much greater degree than the cost of carry, so changes in financial futures prices are primarily attributed to changes in the values of the underlying securities (or indexes).

§Indicators of Stock Index Futures Prices — The economic indicators that signal changes in bond futures prices can also affect stock futures prices, but not necessarily in the same manner.

Question 19

2.Speculating in Stock Index Futures

Answer 19

§Stock index futures can be traded to capitalize on expectations about general stock market movements.

§Speculators who expect the stock market to perform well before the settlement date may consider purchasing S&P 500 index futures.

§Participants who expect the stock market to perform poorly before the settlement date may consider selling S&P 500 index futures.

Question 20

3.Hedging with Stock Index Futures

Answer 20

§Stock index futures are used to hedge the market risk of an existing stock portfolio.

§Test of Suitability of Stock Index Futures
The suitability of stock index futures can be measured by the sensitivity of the portfolio’s performance to market movements over a period prior to taking a hedge position.

§Determining the Proportion of the Portfolio to Hedge Portfolio managers do not necessarily hedge their entire stock portfolio, because they may wish to be partially exposed in the event that stock prices rise. (Exhibit 13.7)

Question 21

Net Gain (on Stock Portfolio and Short Position in Stock Index Futures) for Different Degrees of Hedging

Answer 21

Question 22

4.Dynamic Asset Allocation with Stock Index Futures

Answer 22

§Investors switch between risky and low-risk investment positions over time in response to changing expectations.

§Stock index futures allow portfolio managers to alter their risk-return position without restructuring their existing stock portfolios.

5.Arbitrage with Stock Index Futures

§Securities firms act as arbitrageurs by capitalizing on discrepancies between prices of index futures and stocks.

§Index arbitrage involves the buying or selling of stock index futures with a simultaneous opposite position in the stocks that the index comprises.

Question 23

6.Circuit Breakers on Stock Index Futures

Answer 23

§The CME Group imposes circuit breakers on several stock index futures, including the S&P 500 futures contract.

§By prohibiting trading for short time periods when prices decline to specific threshold levels, circuit breakers may allow investors to determine whether circulating rumors are true and to work out credit arrangements if they have received a margin call.

Question 24

Single Stock Futures

Answer 24

§Agreements to buy or sell a specified number of shares of a specified stock on a specified future date.

§They are regulated by the Commodity Futures Trading Commission and the Securities and Exchange Commission.

§Settlement dates are on the third Friday of the delivery month on a quarterly basis (March, June, September, and December) for the next 5 quarters as well as for the nearest 2 months.

Question 25

1.Market Risk

Answer 25

§Refers to fluctuations in the value of the instrument as a result of market conditions.

2.Basis Risk

§The risk that the position being hedged by the futures contracts is not affected in the same manner as the instrument underlying the futures contract.

§Applies only to those firms or individuals who are using futures contracts to hedge.

3.Liquidity Risk

§Refers to potential price distortions due to a lack of liquidity.

Question 26

4.Credit Risk

Answer 26

§The risk that a loss will occur because a counterparty defaults on the contract.

§This type of risk exists for over-the-counter transactions in which a firm or individual relies on the creditworthiness of a counterparty.

5.Prepayment Risk

§Refers to the possibility that the assets to be hedged may be prepaid earlier than their designated maturity.

6.Operational Risk

§The risk of losses as a result of inadequate management or controls.

Question 27

7.Systemic Risk

Answer 27

§The intertwined relationships among firms may cause one trader’s financial problems to be passed on to other traders.

§The credit crisis demonstrated that some financial institutions had high exposure to risk because their derivative security positions were intended to enhance profits rather than to hedge portfolio risk.

§The Financial Reform Act in 2010 created the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the U.S. and making regulatory recommendations to reduce risks to the financial system.

Question 28

Globalization of Futures Markets (1 of 2)

Answer 28

1.Non-U.S. Participation in U.S. Futures Contracts

§Financial futures contracts on U.S. securities are commonly traded by non-U.S. financial institutions that maintain holdings of U.S. securities.

§These institutions use financial futures to reduce their exposure to movements in the U.S. stock market or interest rates.

2.Foreign Stock Index Futures

§Created both for speculating on and hedging against potential movements in foreign stock markets. (Exhibit 13.8)

Question 29

13.8 Popular Foreign Stock Index Futures Contracts

Answer 29

Question 30

3.Currency Futures Contracts

Answer 30

§A standardized agreement to deliver or receive a specified amount of a specified foreign currency at a specified price (exchange rate) and date.

§The settlement months are March, June, September, and December.

Purchasers of currency futures contracts can hold the contract until the settlement date and accept delivery of the foreign currency at that time, or they can close out their long position prior to the settlement date by selling the identical type and number of contracts before then