Tài chính doanh nghiệp - Chapter 19: Futures contracts and forward rate agreements

Chapter 19Futures contracts andforward rate agreementsWebsites:www.asx.com.auwww.cme.comwww.cbot.comwww.liffe.comwww.hkex.com.hkwww.sgx.comLearning objectivesConsider the nature and purpose of derivative productsOutline features of a futures transactionReview the types of futures contracts available through a futures exchangeIdentify why participants use derivative markets and how futures are used to hedge price riskIdentify risks associated with using a futures contract hedging strategyExplain and illustrate the use of an FRA for hedging interest rate riskDescribe the use of a forward rate agreement for hedging interest rate riskChapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.1 Hedging using futures contractsFutures contracts and FRAs are called derivatives because they derive their price from an underlying physical market productTwo main types of derivative contracts1. Commodity (e.g. gold, wheat and cattle)2. Financial (e.g. shares, government securities and money market instruments)Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes in interest rates, exchange rates and share prices(cont.)19.1 Hedging using futures contracts (cont.)Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another partyA futures contract is the right to buy or sell a specific item at a specified future date at a price determined todayThe change in the market price of a commodity or security is offset by a profit or loss on the futures contract(cont.)19.1 Hedging using futures contracts (cont.)Example: A farmer wants to sell wheat in a couple of months, but is concerned that the price is going to fall in the mean time. How can the farmer hedge this price risk?SolutionEnter into a wheat futures contract to sellIf wheat prices fall, the futures contract will rise in value, offsetting the loss in the physical market from the fall in the wheat priceIf wheat prices rise, the futures contract will fall in value, offsetting the gain in the physical market from a rise in the wheat priceChapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.2 Main features of futures transactionsAlthough futures contracts are highly standardised, variations exist between countries owing to:The types of contract being based on the underlying security traded in that country ASX Trade24 (formerly Sydney Futures Exchange) Commonwealth Treasury bonds; CBOT (Chicago Board of Trade) US Treasury bondsDifferences in the quotation conventionClean price bond quotation in US and European markets— present value of a bond less accrued interestYield to maturity bond quotation in Australian markets(cont.)19.2 Main features of futures transactions (cont.)Orders and agreement to tradeFutures contracts are highly standardised and an order normally specifies:whether it is a buy or sell orderthe type of contract (varies between exchanges)delivery month (expiration)price restrictions (if any) (e.g. limit order) time limits on the order (if any)(cont.)19.2 Main features of futures transactions (cont.)Margin requirementsBoth the buyer (long position) and the seller (short position) pay an initial margin, held by the clearing house, rather than the full price of the contractMargins are imposed to ensure traders are able to pay for any losses they incur owing to unfavourable price movements in the contract(cont.)19.2 Main features of futures transactions (cont.)Margin requirements (cont.)A contract is marked-to-market on a daily basis by the clearing housei.e. repricing of the contract daily to reflect current market valuations Subsequent margin calls may be made, requiring a contract holder to pay a maintenance margin to top up the initial margin to cover adverse price movements(cont.)19.2 Main features of futures transactions (cont.)Closing out of a contractInvolves entering into an opposite positionExample:Company S initially entered into a ‘sell one 10-year Treasury bond contract’ with company BCompany S would close out the position by entering into a ‘buy one 10-year Treasury bond contract’ for delivery on the same date, with a third party, say company RThe second contract reverses or closes out the first contract and company S would no longer have an open position in the futures market(cont.)19.2 Main features of futures transactions (cont.)Contract deliveryMost parties to a futures contract:manage a risk exposure or speculatedo not wish to actually deliver or receive the underlying commodity/instrument and close out of the contract prior to delivery dateASX Trade24 requires financial futures in existence at the close of trading in the contract month to be settled with the clearing house in one of two waysStandard delivery—delivery of the actual underlying financial securityCash settlement(cont.)19.2 Main features of futures transactions (cont.)Contract delivery (cont.)Settlement details, including the calculations of cash settlement amounts, for each contract traded on the ASX Trade24 are available on the exchange’s website at www.asx.com.auChapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.3 Futures market instrumentsFutures markets can be established for any commodity or instrument that:is freely tradedexperiences large price fluctuations at timescan be graded on a universally accepted scale in terms of its qualityis in plentiful supply, or cash settlement is possible(cont.)19.3 Futures market instruments (cont.)Examples:CommoditiesMineral—silver, gold, copper, petroleum, zincAgricultural—wool, coffee, butter, wheat and cattleFinancialCurrencies—pound sterling, euro, Swiss francInterest ratesShort-term instruments—US 90-day treasury bills, three-month eurodollar deposits, Australian 90-day bank-accepted billsLonger-term—US 10-year T-notes, Australian three-year and 10-year Commonwealth Treasury bondsShare price indices—S&P/ASX 200 Index(cont.)19.3 Futures market instruments (cont.)Chapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.4 Futures market participantsFour main categories of participants1. Hedgers2. Speculators3. Traders4. ArbitragersThese participants provide depth and liquidity to the futures market, improving its efficiency(cont.)19.4 Futures market participants (cont.)1. HedgersAttempt to reduce the price risk from exposure to changes in interest rates, exchange rates and share pricesTake the opposite position to the underlying, exposed transactionExample:An exporter has USD receivable in 90 days. To protect against falls in USD over the next three months, the exporter enters into a futures contract to sell USD(cont.)19.4 Futures market participants (cont.)2. SpeculatorsExpose themselves to risk in an attempt to make profitEnter the market with the expectation that the market price will move in a direction favourable for themExample:Speculators who expect the price of the underlying asset to rise will go long and those who expect the price to fall will go short(cont.)19.4 Futures market participants (cont.)3. TradersSpecial class of speculatorTrade on very short-term changes in the price of futures contracts (i.e. intra-day changes)Provide liquidity to the market(cont.)19.4 Futures market participants (cont.)4. ArbitragersSimultaneously buy and sell to take advantage of price differentials between marketsAttempt to make profit without taking any riskExample:Differentials between the futures contract price and the physical spot price of the underlying commodityChapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.5 Hedging: risk management using futuresFutures contracts may be used to manage identified financial risk exposures such as:Hedging the cost of funds (borrowing hedge)Hedging the yield on funds (investment hedge)Hedging a foreign currency transactionHedging the value of a share portfolioHedging the cost of funds (borrowing hedge)Hedging the yield on funds (investment hedge)Hedging a foreign currency transactionHedging the value of a share portfolioChapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.6 Risks in using futures markets for hedgingThe risks of using the futures markets for hedging include the problems of:standard contract sizemargin riskbasis riskcross-commodity hedging(cont.)19.6 Risks in using futures markets for hedging (cont.)Standard contract sizeOwing to contract size the physical market exposure may not exactly match the futures market exposure, making a perfect hedge impossibleTable 19.6(cont.)19.6 Risks in using futures markets for hedging (cont.)(cont.)19.6 Risks in using futures markets for hedging (cont.)Margin paymentsInitial margin required when entering into a futures contractFurther cash required if prices move adversely (i.e. margin calls)Opportunity costs associated with margin requirements(cont.)19.6 Risks in using futures markets for hedging (cont.)Basis riskTwo types of basis riskInitial basisThe difference between the price in the physical market and the futures market at commencement of a hedging strategyFinal basisThe difference between the price in the physical market and the futures market at completion of a hedging strategyA perfect hedge requires zero initial and final basis risk(cont.)19.6 Risks in using futures markets for hedging (cont.)Cross-commodity hedgingUse of a commodity or financial instrument to hedge a risk associated with another commodity or financial instrumentOften necessary as futures contracts are available for few commodities or instrumentsSelection of a futures contract that has price movements that are highly correlated with the price of the commodity or instrument to be hedgedChapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.7 Forward rate agreements (FRAs)The nature of the FRAAn FRA is an over-the-counter product enabling the management of an interest rate risk exposureIt is an agreement between two parties on an interest rate level that will apply at a specified future dateAllows the lender and borrower to lock in interest ratesUnlike a loan, no exchange of principal occursPayment between the parties involves the difference between the agreed interest rate and the actual interest rate at settlement(cont.)19.7 Forward rate agreements (FRAs) (cont.)The nature of the FRA (cont.)Disadvantages of FRAs include:risk of non-settlement, i.e. credit riskno formal market existsThe FRA specifies:FRA agreed date, fixed at start of FRAnotional principal amount of the interest coverFRA settlement date when compensation is paidcontract period on which the FRA interest rate cover is based (end date)reference rate to be applied at settlement date(cont.)19.7 Forward rate agreements (FRAs) (cont.)(cont.)19.7 Forward rate agreements (FRAs) (cont.)Settlement amount = FRA settlement rate - FRA agreed ratewhereis = reference rate at the FRA settlement rate, expressed as a decimalic = the fixed FRA agreed rate, expressed as a decimalD = the number of days in the contract periodP = the FRA notional principal amount(cont.)Using an FRA for a borrowing hedge Example: On 19 September this year a company wishes to lock in the interest rate on a prospective borrowing of $5 000 000 for a six-month period from 19 April next year to 19 October of the same year. An FRA dealer quotes ‘7Mv13M (19) 13.25 to 20’. On 19 April the BBSW on 190-day money is 13.95% per annum. where is = 0.1395 (on 19 April) ic = 0.1395 (on 19 September) D = 183 days (from 19 April to 19 October) P = $5 000 000(cont.)19.7 Forward rate agreements (FRAs) (cont.) Using an FRA for a borrowing hedge (cont.)As interest rates have risen over the period, the settlement of $15 379.19 is paid by the FRA dealer to the company(cont.)19.7 Forward rate agreements (FRAs) (cont.)19.7 Forward rate agreements (FRAs) (cont.)(cont.)19.7 Forward rate agreements (FRAs) (cont.)Main advantages of FRAsTailor-made, over-the-counter contract, providing great flexibility with respect to contract period and the amount of each contractUnlike a futures contract, an FRA does not have margin paymentsMain disadvantages of FRAsRisk of non-settlement (credit risk)No formal market exists and concern about difficulty closing out FRA position is overcome by entering into another FRA opposite to the original agreementChapter organisation19.1 Hedging using futures contracts19.2 Main features of a futures transaction19.3 Futures market instruments19.4 Futures market participants19.5 Hedging: risk management using futures19.6 Risks in using futures markets for hedging19.7 Forward rate agreements (FRAs)19.8 Summary19.8 SummaryA futures contractAn agreement between two parties to buy or sell a specified commodity or instrument at a specified date in the future, at a price specified todayMay be used as a hedging strategy by opening a position today that requires a closing transaction that is the reverse of the exposed transaction in the physical marketLimitations include margin calls, imperfect hedging owing to basis risk, and availability(cont.)19.8 Summary (cont.)FRAsOver-the-counter contracts specifying an agreed interest rate to apply at a future dateAdvantages include:flexibility—they are tailor-madeno margin callsDisadvantages include:non-settlement or credit risklack of formal market