What is a future?
An agreement to buy/sell a standard quantity of a specified asset on a fixed future date, at a price agreed today.
Key features:
- Exchange-traded.
- Standardised contracts.
- High liquidity.
- Clearing and settlement systems in place (no counter party risk).
- Low initial costs - but margin requirements exist.
What is a ‘long-future’?
The buyer of the future enters into an obligation to buy on a future date.
What is a ‘short-future’?
The seller of the future is under obligation to sell on a future date.
How are ETFs traded on the futures market?
They are traded in standardised parcels known as contracts.
What is a forward?
A future but OTC traded.
Key features:
- OTC traded.
- Contract negotiable.
- Possibility of limited liquidity.
- Counter party/default risks.
- Costs high - but margin requirements rarely required.
What are the three types of investors that would use futures?
Speculator: Risk-takers seeking large profits.
Hedger: Someone seeking to reduce their risk.
Arbitrageur: Someone seeking risk-free profits by exploiting market inefficiencies.
Why would a speculator buy a future (‘go-long’)?
Buying an underlying asset for a pre-determined price at a future date, with the expectation of the underlying asset’s value rising in this time.
Why would a speculator sell a future (‘go-short’)?
Selling an underlying asset for a pre-determined price at a future date, with the expectation of the underlying asset’s value falling in this time.
How would a hedger protect against a fall in price of a particular asset?
Short-hedge (‘going-short’): using a future to reduce the risk of existing cash positions.
e.g. If an oil producer fears the price of oil will fall in the future, they may wish to sell futures of his desire price to remove this uncertainty.
How would a hedger protect against a rise in price of a particular asset?
Long hedge (‘going-long’): using a future to protect against a rise in price.
e.g. If a company relied on oil for their business, but feared the oil prices were set to rise, they may enter the futures market and buy oil at a later date at a fixed price.
What does tick size refer to?
The smallest permitted quote on one contract e.g. one percentage point, £10 etc.
What does tick value refer to?
The monetary change in the value of one contract if there is one-tick change in the quote.
How do you calculate the fund manager’s profit/loss of a futures contract?
Profit/loss = No. of ticks the price has changed by x Tick Value x No. of contracts
What is index arbitrage?
Trading price anomalies between index pricing and futures contracts on the index.
An index arbitrageur trades in the cash and futures markets when the differences between the theoretical futures price and the actual futures price are sufficiently large to create arbitrage profits: a trader will sell the futures index if it is expensive and buy the underlying stock, or buy the futures contract when it is cheap and sell short underlying stocks. Hence, index arbitrage plays an important role in linking futures prices and cash prices.
FTSE 100 Index Future (equity based index):
- Fixes the price at which the underlying index may be bought or sold at a specific future date.
- Contract size: Index Value x £10.
- Cash-settled.
- Quote given in index points.
- Tick Size: 0.5 index points
- Tick Value: £5 (0.5 x £10)
3-Month Sterling Future (interest-rate based index):
- Provides a means to gain/hedge interest-rate exposure for a period of 3-months from a given future date.
- Contract size: £500,000 (this amount does not change hands, only the interest effect).
- Cash-settled (the difference in value between the interest bill for 3 months at the rate agreed and the actual rate that arises.
- Quote: 100 - Rate of Interest (IR↑, futures prices ↓)
- Tick Size: 0.01% (0.0001).
- Tick Value: £12.50 (£500,000 x 0.01% x 3/12).
Long (10 year) Gilt Future:
- Provides a means to gain/hedge exposure to UK Gilts. It effectively represents a bond index contract.
- Contract size: £100,000 nominal of notional 4% gilt.
- Physically-settled (the seller of the future must deliver gilts and the buyer must pay the pre-agreed price).
- Quote: Per £100 NV.
- Tick Size: 0.01% (1 basis point).
- Tick Value: £10
What does beta (β) refer to?
The volatility of the portfolio relative to the index.
(β of market = 1).
- A portfolio with a beta of 1.00 has the same volatility as the market.
- A portfolio with a beta of 1.20 is 20% more volatile than the market.
- A portfolio with a beta of 0.80 is 20% less volatile than the market.
To hedge a portfolio fully, how can a portfolio manager calculate the number of futures contracts (N) to sell?
N = (Portfolio Value / Futures Value) x β
always round up
How do you calculate the Futures Value?
Futures Value = Futures Quote x £10
What is the ‘basis’ of a futures contract?
The numerical difference between a cash price and a futures price.
Basis = Spot Price - Futures Price
When is the market in ‘contango’?
When the future prices are higher than the current cash (spot) prices. The market is at a ‘premium’.
This is considered normal as the FP = cash price + cost of carry.
When is the market in ‘backwardation’?
When the future prices are lower than the current cash (spot) prices. The market is at a ‘discount’.
This is considered a ‘supply squeeze’ in which S↓ and P↑ in the SR and S↑ and P↓ in the LR.
What does the convenience yield refer to?
The benefit associated with holding an underlying asset, rather than the contract or derivative product.
