Menu
Home
Log in / Register
 
Home arrow Business & Finance arrow Finance
< Prev   CONTENTS   Next >

FINANCIAL FUTURES CONTRACTS AND MARKETS

Given the default risk and liquidity problems in the interest-rate forward market, another solution to hedging interest-rate risk was needed. This solution was provided by the development of financial futures contracts by the Chicago Board of Trade starting in 1975.

Following the Financial News. Financial Futures

The prices for financial futures contracts for debt instruments are published daily. In the Wall Street Journal, these prices are found in the "Commodities" section under the "Interest Rate" heading of the "Future Prices" columns. An excerpt is reproduced here.

Following the Financial News. Financial Futures

Source: Wall Street Journal, March 21, 2006, p. C11.

A financial futures contract is similar to an interest-rate forward contract, in that it specifies that a financial instrument must be delivered by one party to another on a stated future date. However, it differs from an interest-rate forward contract in several ways that overcome some of the liquidity and default problems of forward markets.

To understand what financial futures contracts are all about, let's look at one of the most widely traded futures contracts—that for Treasury bonds, which are traded on the Chicago Board of Trade. (An illustration of how prices on these contracts are quoted can be found in the Following the Financial News box, "Financial Futures".) The contract value is for $100,000 face value of bonds. Prices are quoted in points, with each point equal to $1,000, and the smallest change in price is one thirty-second of a point ($31.25). This contract specifies that the bonds to be delivered must have at least fifteen years to maturity at the delivery date (and must also not be callable—that is, redeemable by the Treasury at its option—in less than fifteen years). If the Treasury bonds delivered to settle the futures contract have a coupon rate different from the 6% specified in the futures contract, the amount of bonds to be delivered is adjusted to reflect the difference in value between the delivered bonds and the 6% coupon bond. In line with the terminology used for forward contracts, parties who have bought a futures contract and thereby agreed to buy (take delivery of) the bonds are said to have taken a long position, and parties who have sold a futures contract and thereby agreed to sell (deliver) the bonds have taken a short position.

To make our understanding of this contract more concrete, let's consider what happens when you buy or sell a Treasury bond futures contract. Let's say that on February 1, you sell one $100,000 June contract at a price of 115 (that is, $115,000). By selling this contract, you agree to deliver $100,000 face value of the long-term Treasury bonds to the contract's counterparty at the end of June for $115,000. By buying the contract at a price of 115, the buyer has agreed to pay $115,000 for the $100,000 face value of bonds when you deliver them at the end of June. If interest rates on long-term bonds rise, so that when the contract matures at the end of June, the price of these bonds has fallen to 110 ($110,000 per $100,000 of face value), the buyer of the contract will have lost $5,000, because he or she paid $115,000 for the bonds but can sell them only for the market price of $110,000. But you, the seller of the contract, will have gained $5,000, because you can now sell the bonds to the buyer for $115,000 but have to pay only $110,000 for them in the market.

It is even easier to describe what happens to the parties who have purchased futures contracts and those who have sold futures contracts if we recognize the following fact: At the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered. To see why this is the case, consider what happens on the expiration date of the June contract at the end of June when the price of the underlying $100,000 face value Treasury bond is 110 ($110,000). If the futures contract is selling below 110—say, at 109—a trader can buy the contract for $109,000, take delivery of the bond, and immediately sell it for $110,000, thereby earning a quick profit of $1,000. Because earning this profit involves no risk, it is a great deal that everyone would like to get in on. That means that everyone will try to buy the contract, and as a result, its price will rise. Only when the price rises to 110 will the profit opportunity cease to exist and the buying pressure disappear. Conversely, if the price of the futures contract is above 110—say, at 111—everyone will want to sell the contract. Now the sellers get $111,000 from selling the futures contract but have to pay only $110,000 for the Treasury bonds that they must deliver to the buyer of the contract, and the $1,000 difference is their profit. Because this profit involves no risk, traders will continue to sell the futures contract until its price falls back down to 110, at which price there are no longer any profits to be made. The elimination of riskless profit opportunities in the futures market is referred to as arbitrage, and it guarantees that the price of a futures contract at expiration equals the price of the underlying asset to be delivered.1

Armed with the fact that a futures contract at expiration equals the price of the underlying asset makes it even easier to see who profits and who loses from such a contract when interest rates change. When interest rates have risen so that the price of the Treasury bond is 110 on the expiration day at the end of June, the June Treasury bond futures contract will also have a price of 110. Thus, if you bought the contract for 115 in February, you have a loss of 5 points, or $5,000 (5% of $100,000). But if you sold the futures contract at 115 in February, the decline in price to 110 means that you have a profit of 5 points, or $5,000.

 
Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
 
Subjects
Accounting
Business & Finance
Communication
Computer Science
Economics
Education
Engineering
Environment
Geography
Health
History
Language & Literature
Law
Management
Marketing
Philosophy
Political science
Psychology
Religion
Sociology
Travel