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Financial Banking Lecture notes - Financial Futures
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Financial Banking Lecture notes - Financial Futures
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Financial FuturesA futures contract is a standardized agreement between two parties to buy/sell something (such as a
bond, bill, currency or stock) at a predetermined price at a predetermined date in the future. The
contract specifies: the amount of the asset to be traded, the exchange on which the contract is
traded, the delivery date and whether it will be a cash or physical settlement. Like other financial
instruments, futures and forwards contracts can be used for both managing risks and assuming
speculative positions. There are different types of futures contracts:
- short-term interest rate futures
- currency futures
- stock-index futures
- commodity futures
The futures market has grown rapidly over time, as the table shows that the turnover of futures
contracts traded on international exchanges has constantly increased.
The main reasons for the rapid growth of futures market are:
1. Futures markets offer a low-cost means of managing risk exposure. Many futures markets
are more liquid than the spot market in the underlying asset.
2. Futures markets enable traders to take speculative positions on price movements for a low
initial cash payment.
3. Futures contacts do not bear counterparty risk (the risk that a counterparty to a contract will
fail to settle the contract), as all contracts are guaranteed by the exchange on which they are
traded.
4. Futures contracts enable speculators to speculate on price falls as well as price rises in order
to get decent returns.
Despite futures contracts having a high degree of similarity, there are some practical differences:
- The futures contract is a standardized notional agreement between two parties to exchange
a specified amount of the asset at a fixed future date for a predetermined price, but with a
forward contract the amount to be exchanged is negotiable.
- Futures contracts are traded on an exchange, while forward contracts are over-the-counter
instruments where the exchange is made directly between two parties.
- Futures contracts are guaranteed by the exchange whereas forward contracts are not and
therefore involve a higher counterparty risk, whereas futures contracts do not have this risk.
- Futures contracts have greater liquidity than forward contracts. This is because they are
standardised so they can easily be sold to another party at any time up until maturity at the
, prevailing futures price, with the trader taking a profit or loss. Therefore it is more
convenient for traders because they can get out of the contract obligations easily, whereas
forward contract obligations cannot be transferred to a third party so they are relatively
illiquid assets.
The exchange clearing house is responsible for settling/guaranteeing contracts, monitoring and
reporting on trading positions and collecting margin payments. The clearing house is usually
separately incorporated and independent from the exchange. To limit the exchange’s exposure
(amount of money it could lose), exchange regulations require that each counterparty makes an
initial deposit with the exchange; which is called the initial margin. If, then, one of the parties starts
to make a loss greater than the initial margin, further deposits are required on a daily basis from the
losing party in order to maintain their open position. This is called the variation margin. Marking to
market is the process of monitoring the profit and loss positions of each party by using the prevailing
market price. If a trader fails to settle a margin payment, the exchange has the right to close the
trader’s position by taking an offsetting (counteracting) contract in order to limit the potential
exposure to that trader’s position so that the exchange itself will not suffer because of this trader.
Stock-index futures are notional commitments to buy or sell a given amount of stock on a specified
date in the future at a predetermined price. The table shows the S&P 500 index futures, at $250 per
index point.
September and December are the expiration months of the contract. The opening price is the price
at which contracts start trading in the morning (which is not necessarily the same as the previous
day’s closing price). The settlement price is the price used for marking to market, which is usually
based on the last trade of the day, but if there were little trade at the end of the day then the
settlements committee can set a settlement price that differs from the closing price. The change is
the change in price compared to the previous day’s settlement price. The high and low figures show
the trading range of the contract throughout the day (the highest and lowest price of the stock).
Estimated volume is the estimated number of contracts exchanged during the day, and open interest
is the number of contracts open as of the previous trading day (so the outstanding number of
contracts obligated for delivery). There are many futures prices: the September contract in the
example is the near contract and the December contract is a distant contract. Each contract is made
up of two parties: the party that buys the futures contract is said to be long futures, the party that
sells the futures contract is said to be short futures. The contract specification sets out the details of
the contract, for example the delivery day, whether cash or physical settlement, the smallest
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