Topic 10 - Futures Contracts And Forward Rate Agreements

This article is a topic within the subject Capital Markets and Institutions.

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 636-669.

Derivative Products – Futures And Forward Rate Agreements (FRA)

Futures contracts & forward rate agreements are derivatives as their price is derived from an underlying physical market product. It is a risk management function that locks in a price today that will apply at a future date. The 2 main types of derivative contracts are financial (shares, government securities etc.) & commodities (gold, wheat, cattle).

Futures Contracts – Hedging

A Futures Contract is an exchange traded agreement/contract to buy/sell a specified amount of a commodity or financial instrument at a price determined today for delivery or payment at a future date. It removes uncertainty – risk.

HEDGING involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party. Hedging occurs as the change in the market price of a commodity/security is offset by a profit/loss on the futures contract. Derivatives allow protection assets & liabilities against the risk of changes in interest/exchange rates & share prices.

• Futures Strategy Rule - conduct a transaction in the futures market today that corresponds with the proposed physical market transaction due at a later date

Example: a farmer wants to sell wheat in a few months, but is concerned the price will fall, how can the farmer hedge his risk? He sells a wheat futures contract

• If wheat prices fall, the gain in the futures contract offsets the loss in the physical market from the fall in the wheat price
• If wheat prices rise, the loss in the futures contract offsets the gain in the physical market from the rise in the wheat price

Main Features of Futures Transactions – Margin Requirements

Futures contracts are highly standardised, specifying buy or sell order, type of contract, delivery month, order time limits or price (order) restrictions etc. In Australia, they are quoted as 100% less the yield to maturity (variations between countries).

Margin Requirements

Both the buyer (long position) & seller (short position) pay an initial margin (2-10%, similar to collateral), held by the clearing house, rather than the full price of the contract. Margins are imposed to ensure traders are able to pay for any losses incurred from unfavourable price movements. Contract are marked to market on a daily basis (repriced to current values) & subsequent margin calls can be made that requires a holder to pay a maintenance margin to top up the initial margin to cover adverse price movements.

Closing Out A Contract

Involves entering into an opposite position. ‘S’ sold a 10 year T bond futures contract to ‘B’. ‘S’ needs to buy a 10 year T bond futures contract for delivery on the same date with a 3rd party. This reverses/closes out the 1st contract & ‘S’ does not have an open position in the futures market (able to reclaim initial margin).

Contract Delivery

Most parties use futures to manage risk exposure or speculate for profits & don’t wish to receive the underlying instrument & close out the contract prior to delivery date. Settlement with the clearing house can be cash (usual) or standard delivery (underlying instrument).

Future Market Instruments

Futures markets can be established for any commodity or instrument that is:

• Freely Traded
• Experiences Large Fluctuations
• Universally Accepted Quality Scaling Grade (standardised)
• Plentiful Supply, or Cash Settlement is Possible

Examples include commodities (minerals, agriculture) & financials (currencies, interest rates – ST (bills), LT (bonds) & shares).

Contract Sizes

Futures Market Participants

1. Hedgers – attempt to reduce price risk from exposures to changes in interest/exchange rates or share prices due to an open position in underlying markets
   • Take a position opposite to the underlying exposed transaction
2. Speculators – expose themselves to risk in an attempt to make profit, expect the change in market price to be favourable
   • Take on the risks hedgers seek to avoid & provide information on expectations
   • Straddle – buy/sell different delivery day contracts. Spread Position – buy/sell related same delivery date contracts
3. Traders – conduct transactions in their own account, not on behalf of clients, provide liquidity
   • Special class of speculator that trades on very short term changes (intra-day)
4. Arbitrageur – simultaneously buy/sell to take advantage of price differentials between markets without risk

Future Contract Examples - Prescribed Textbook

The Borrowing Hedge

This type of futures strategy is used when the finance manager expects borrowing costs to rise. Movements in the physical market are offset by movements in the futures market.

The Investment Hedge

This type of strategy is used if yields are expected to fall.

The Foreign Exchange Hedge

This type of hedge is used to protect against adverse currency movements.

The Share Market Hedge

This type of hedge is used to protect against adverse share market movements.

Risks Of Using Futures Markets For Hedging

• Standard Contract Size – owing to contract size, physical market exposure may not exactly match futures market hedge
  • May make a perfect hedge impossible (over or under exposure)
• Margin Risk – initial margin required when entering a futures contract
  • Further cash is required (margin call) if prices move adversely
  • Opportunity costs associated with margin requirements & cash flow risks
• Basis Risk
  • Initial Basis – the difference between price in the physical market & futures market at the beginning of a hedge
  • Final Basis – the difference between price in the physical market & futures market at the completion of a hedge
• Cross Commodity Hedging – the use of another commodity or instrument to hedge a risk associated with another similar (highly correlated price movements) commodity or security, will not always be a perfect match
  • Won’t move exactly as the price of the exposure in the physical market

Forward Rate Agreements (FRA)

A FRA is an over the counter (OTC) product enabling the management of an interest rate risk exposure. It is an agreement between 2 parties on an interest rate level that will apply at a future date allowing the borrower & lender to lock in interest rates. Unlike a loan, no exchange of principal occurs (the notional amount) as the payment between parties is the difference between the agreed interest rate & the actual interest rate at settlement.

Forward Rate Agreement Specifications

• An agreed fixed date
• Notional principal amount of the interest cover
• The settlement date (when compensation is paid),
• contract period on which the FRA interest cover is based (end date)
• Reference rate to be applied at settlement date

Timeline And Structure

Settlement Amount

The above shows the formula for calculating the settlement amount. If a company locks in a specific rate today & borrowing rates rise (at the FRA settlement date), the FRA dealer pays the company. If rates fall, meaning the company is now able to borrow at a lower rate, the company pays the FRA dealer.

The settlement amount should offset a higher or lower than expected borrowing cost which effectively ensures the company is locking in a borrowing rate at the beginning of the contract.

Advantages And Disadvantages

• Advantages
  • OTC Tailor Made – great flexibility with contract period & contract amount
  • No Margin Payments
• Disadvantages
  • Risk of Non-Settlement (credit risk)
  • No Formal Market Exists – concerns about closing an FRA position can be overcome by entering into another FRA agreement opposite to the original agreement (harder to close)

End

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References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.