DERIVATIVE MARKETS

FINANCIAL FUTURES MARKETS

● Generate large returns to speculators and
because they entail a high degree of risk

● These markets can also be used to reduce

the risk of financial institutions
Financial Futures Contract
- standardized agreement to deliver or receive a specified
amount of a specified financial instrument at a specified price
and date

❖ Buyer- buys the Futures Contract

❖ Seller- delivers the instrument for the specified price
Popular Futures Contracts
➢ Interest Rate Futures- usually used for debt securities

➢ Stock Index Futures- stock indexes; allows for the buying and
selling of a stock index for a specified price at a specified date
 Markets for Financial Futures

Future Exchanges Over-the Counter

Market
- organized marketplace where -some specialized futures contracts
standardized futures are sold ”over the counter” rather
contracts can be traded than an exchange, whereby a
financial intermediary (such as a
commercial bank or an investment
bank) finds a counterparty or serves
as the counterparty

- More personalized compared to

futures contract
Purpose of Trading Futures Contracts
➢ either to speculate on prices of securities

➢ Or to hedge existing exposure to security price movements

➢ Financial institutions usually use future contracts to reduce

risk
Purpose of Trading Futures Contracts
❑ Speculators- take positions to profit from expected changes in the
price of futures contracts over time
❑ Day Traders- attempt to capitalize in 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 prized. Many hedgers
maintain large portfolios of stocks or bonds takes a futures position to
hedge their risk
Speculating in Interest Rates Futures
Speculating in Interest Rates Futures
Speculating in Interest Rates Futures
Speculating in Interest Rates Futures
❑ Closing out Futures Position
- A spectator’s gain (or loss) in based on the difference between the
price at which a futures contract is sold and the price at which the that
same type of contract is purchased
Speculating in Interest Rates Futures
Hedging with Interest Rates Futures
- The difference between a financial institution’s volume of rate
sensitive assets and rate sensitive liabilities represents its
exposure to interest rate risk

- Short hedge is usually used. It is the sale of futures contract on

debt securities or an index that is similar to its assets
Hedging with Interest Rates Futures
Hedging with Interest Rates Futures
Stock Index Futures
- Is an agreement to purchase or sell an index at a specified price
and date
- ex. The purchase of an S&P 500 (which represents a composite
of 500 large corporation) futures contract obligates the
purchaser to purchase the S&P 500 index at a specified
settlement date for a specified amount
Speculating in Stock Index Futures
- 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. Conversely, participants who expect the
stock market to perform poorly before the settlement date
may consider selling S&P 500 index futures.
Speculating in Stock Index Futures
Speculating in Stock Index Futures
- Thus Boulder was able to capitalize on its expectations even
though it did not have sufficient cash to purchase stock.
- If stock prices had declined over the period of concern, the S&P
500 futures price would have decreased and Boulder would have
incurred a loss on its futures position
Hedging with Stock Index Futures
- Stock index futures are also commonly used to hedge the market
risk of an existing stock portfolio
Ex.
Hedging with Stock Index Futures
- If the stock portfolio moves in tandem with the S&P 500, a full
hedge would involve the sale of the amount of the futures
contracts whose combined underlying value is equal to the
market value of the stock portfolio being hedged.
Hedging with Stock Index Futures
Ex.
Hedging with Stock Index Futures
-if the stock market experiences higher prices over the month, the S&P 500
index will rise and create a loss on the futures contract. However, the
value of the manager’s stock portfolio will have increased to offset the
loss
Single Stock Futures
- Is an agreement to buy or sell a specified number of shares of a specified
stock on a specified future date
Risk of Trading Futures Contracts
- Users of futures contracts must recognize the various types of risk
exhibited by such contracts and other derivative instruments
Market Risk
- Refers to fluctuations in the value of instrument as a result of market
conditions
- If expectations about market conditions are wrong, they may suffer losses
on their futures contracts
- Firms that use futures contracts to hedge are less concerned about market
risk because if market conditions cause a loss on their derivative
instruments, they should have a partial offsetting gain on the positions that
they were hedging
Basis Risk
- 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
Liquidity Risk
- Potential price distortions due to lack of liquidity
- Ex. A firm may purchase a particular bond futures contract to speculate on
expectations of rising bond prices. However, when it attempts to close out
its position by selling an identical futures contract, it may find that there are
no willing buyers for this type of futures contract at that time. In this case,
the firm will have to sell the futures contract at a lower price. Users of
futures contracts may reduce liquidity risk by using only those futures
contracts that are widely traded.
Credit Risk
- 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.
Prepayment Risk
- refers to the possibility that the assets to be hedged may be prepaid earlier
than their designated maturity.
- Ex. Suppose that a commercial bank sells Treasury bond futures in order to
hedge its holdings of corporate bonds and that, just after the futures
position is created, the bonds are called by the corporation that initially
issued them. If interest rates subsequently decline, the bank will incur a loss
from its futures position with- out a corresponding gain from its bond
position (because the bonds were called earlier).
Operational Risk
- which is the risk of losses as a result of inadequate management or controls.
- For example, firms that use futures contracts to hedge are exposed to the
possibility that the employees responsible for their futures positions do not
fully understand how values of specific futures contracts will respond to
market con- ditions. Furthermore, those employees may take more
speculative positions than the firms desire if the firms do not have adequate
controls to monitor them.
-
Exposure of Futures Market to
Systemic Risk
- To the extent that traders of financial futures contracts or other derivative
securities are unable to cover their derivative contract obligations in over-
the-counter transactions, they could cause financial problems for their
respective counterparties. This could expose the futures market to
systemic risk whereby the intertwined relationships among firms may cause
one trader’s financial problems to be passed on to other traders (if there is
not enough collateral backing the contracts).
Currency Futures Contracts
- a standardized agreement to deliver or receive a specified amount of a
specified foreign currency at a specified price (exchange rate) and date.

- 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.