Municipal bond index mbi futures

13 Financial Futures Markets

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ provide a background on financial futures contracts,

· ▪ explain how interest rate futures contracts are used to speculate or hedge based on anticipated interest rate movements,

· ▪ explain how stock index futures contracts are used to speculate or hedge based on anticipated stock price movements,

· ▪ explain how single stock futures are used to speculate on anticipated stock price movements, and

· ▪ describe the different types of risk to which traders in financial futures contracts are exposed.

In recent years, financial futures markets have received much attention because they have the potential to generate large returns to speculators and because they entail a high degree of risk. However, these markets can also be used to reduce the risk of financial institutions and other corporations. Financial futures markets facilitate the trading of financial futures contracts.

13-1 BACKGROUND ON FINANCIAL FUTURES

A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date. The buyer of a financial futures contract buys the financial instrument, and the seller of a financial futures contract delivers the instrument for the specified price.

13-1a Popular Futures Contracts

Futures contracts are traded on a wide variety of securities and indexes.

Interest Rate Futures Many of the popular financial futures contracts are on debt securities such as Treasury bills, Treasury notes, Treasury bonds, and Eurodollar CDs. These contracts are referred to as interest rate futures . For each type of contract, the settlement dates at which delivery would occur are in March, June, September, and December.

Stock Index Futures There are also financial futures contracts on stock indexes, which are referred to as stock index futures . A stock index futures contract allows for the buying and selling of a stock index for a specified price at a specified date. Various stock index futures contracts are described in Exhibit 13.1 .

13-1b Markets for Financial Futures

Markets have been established to facilitate the trading of futures contracts.

Futures Exchanges Futures exchanges provide an organized marketplace where standardized futures contracts can be traded. The exchanges clear, settle, and guarantee all transactions. They can ensure that each party's position is sufficiently backed by collateral as the market value of the position changes over time. In this way, any losses that occur are covered, so that counterparties are not adversely affected. Consequently, participants are more willing to trade financial futures contracts on an exchange.

Exhibit 13.1 Stock Index Futures Contracts

TYPE OF STOCK INDEX FUTURES CONTRACT

CONTRACT IS VALUED AS

S&P 500 index

$250 times index

Mini S&P 500 index

$50 times index

S&P Midcap 400 index

$500 times index

S&P Small Cap index

$200 times index

Nasdaq 100 index

$100 times index

Mini Nasdaq 100 index

$20 times index

Mini Nasdaq Composite index

$20 times index

Russell 2000 index

$500 times index

Most financial futures contracts in the United States are traded through the CME Group, which was formed in July 2007 by the merger of the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). The CBOT specialized in futures contracts on Treasury bonds and agricultural products, and also traded stock options (described in the next chapter). The CME specialized in futures contracts on money market securities, stock indexes, and currencies.

The CME went public in 2002, and the CBOT went public in 2005. Their merger to form the CME Group created the world's largest and most diverse derivatives exchange, which serves international markets for derivative products. As part of the restructuring to increase efficiency, the CME and CBOT trading floors were consolidated into a single trading floor (at the CBOT) and their products were consolidated on a single electronic platform, which has reduced operating and maintenance expenses.

The operations of financial futures exchanges are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC approves futures contracts before they can be listed by futures exchanges and imposes regulations to prevent unfair trading practices.

Over-the-Counter Market Some specialized futures contracts are sold “over the counter” rather than on an exchange, whereby a financial intermediary (such as a commercial bank or an investment bank) finds a counterparty or serves as the counterparty. These over-the-counter arrangements are more personalized and can be tailored to the specific preferences of the parties involved. Such tailoring is not possible for the more standardized futures contracts sold on the exchanges.

13-1c Purpose of Trading Financial Futures

WEB

www.cftc.gov

Detailed information on the CFTC.

WEB

www.nfa.futures.org

Information for investors who wish to trade futures contracts.

Financial futures are traded either to speculate on prices of securities or to hedge existing exposure to security price movements. Speculators in financial futures markets take positions to profit from expected changes in the price of futures contracts over time. They can be classified according to their methods. Day traders attempt to capitalize on price movements during a single day; normally, they close out their futures positions on the same day the positions were initiated. Position traders maintain their futures positions for longer periods of time (for weeks or months) and thus attempt to capitalize on expected price movements over a more extended time horizon.

Hedgers take positions in financial futures to reduce their exposure to future movements in interest rates or stock prices. Many hedgers who maintain large portfolios of stocks or bonds take a futures position to hedge their risk. Speculators commonly take the opposite position and therefore serve as the counterparty on many futures transactions. Thus, speculators provide liquidity to the futures market.

13-1d Institutional Trading of Futures Contracts

WEB

www.cmegroup.com

Offers details about the products offered by the CME Group and also provides price quotations of the various futures contracts.

Exhibit 13.2 summarizes how various types of financial institutions participate in futures markets. Financial institutions generally use futures contracts to reduce risk. Some commercial banks, savings institutions, bond mutual funds, pension funds, and insurance companies trade interest rate futures contracts to protect against a possible increase in interest rates, thereby insulating their long-term debt securities from interest rate risk. Some stock mutual funds, pension funds, and insurance companies trade stock index futures to partially insulate their respective stock portfolios from adverse movements in the stock market.

13-1e Trading Process

WEB

www.bloomberg.com

Today's prices of U.S. bond futures contracts and prices of currency futures contracts.

When the futures exchanges were created, they relied on commission brokers (also called floor brokers) to execute orders for their customers, which generally were brokerage firms. In addition, floor traders (also called locals ) traded futures contracts for their own account. The commission brokers and floor traders went to a specific location on the trading floor where the futures contract was traded to execute the order. Marketmakers can also execute futures contract transactions for customers. They may facilitate a buy order for one customer and a sell order for a different customer. The marketmaker earns the difference between the bid price and the ask price for such a trade, although the spread has declined significantly in recent years. Market-makers also earn profits when they use their own funds to take positions in futures contracts. Like any investors, they are subject to the risk of losses on their positions.

Electronic Trading Most futures contracts are now traded electronically. The CME Group has an electronic trading platform called Globex that complements its floor trading. Some futures contracts are traded both on the trading floor and on Globex, whereas others are traded only on Globex. Transactions can occur on Globex virtually around the clock (the platform is closed about one hour per day for maintenance) and on weekends. In 2004, the Chicago Board Options Exchange (CBOE) opened a fully electronic futures exchange.

Exhibit 13.2 Institutional Use of Futures Markets

TYPE OF FINANCIAL INSTITUTION

PARTICIPATION IN FUTURES MARKETS

Commercial banks

· • Take positions in futures contracts to hedge against interest rate risk.

Savings institutions

· • Take positions in futures contracts to hedge against interest rate risk.

Securities firms

· • Execute futures transactions for individuals and firms.

· • Take positions in futures contracts to hedge their own portfolios against stock market or interest rate movements.

Mutual funds

· • Take positions in futures contracts to speculate on future stock market or interest rate movements.

· • Take positions in futures contracts to hedge their portfolios against stock market or interest rate movements.

Pension funds

· • Take positions in futures contracts to hedge their portfolios against stock market or interest rate movements.

Insurance companies

· • Take positions in futures contracts to hedge their portfolios against stock market or interest rate movements.

13-1f Trading Requirements

WEB

www.cmegroup.com/globex

Information about how investors can engage in electronic trading of futures contracts.

Customers who desire to buy or sell futures contracts open accounts at brokerage firms that execute futures transactions. Under exchange requirements, a customer must establish a margin deposit with the broker before a transaction can be executed. This initial margin is typically between 5 and 18 percent of a futures contract's full value. Brokers commonly require margin deposits above those required by the exchanges. As the futures contract price changes on a daily basis, its value is “marked to market,” or revised to reflect the prevailing conditions. A customer whose contract values moves in an unfavorable direction may receive a margin call from the broker, requiring that additional funds be deposited in the margin account. The margin requirements reduce the risk that customers will later default on their obligations.

Type of Orders Customers can place a market order or a limit order. With a market order, the trade will automatically be executed at the prevailing price of the futures contract; with a limit order, the trade will be executed only if the price is within the limit specified by the customer. For example, a customer may place a limit order to buy a particular futures contract if it is priced no higher than a specified price. Similarly, a customer may place an order to sell a futures contract if it is priced no lower than a specified minimum price.

How Orders Are Executed Although most trading now takes place electronically, some trades are still conducted on the trading floor. In that case, the brokerage firm communicates its customers' orders to telephone stations located near the trading floor of the futures exchange. The floor brokers accommodate these orders. Each type of financial futures contract is traded in a particular location on the trading floor. The floor brokers make their offers to trade by open outcry, specifying the quantity of contracts they wish to buy or sell. Other floor brokers and traders interested in trading the particular type of futures contract can respond to the open outcry. When two traders on the trading floor reach an agreement, each trader documents the specifics of the agreement (including the price), and the information is transmitted to the customers.

USING THE WALL STREET JOURNAL: Interest Rate Futures

The Wall Street Journal provides information on interest rate futures, as shown here. Specifically, it discloses the recent open price, range (high and low), and final closing (settle) price over the previous trading day. It also discloses the number of existing contracts (open interest). Financial institutions closely monitor interest rate futures prices when considering whether to hedge their interest rate risk.

Source: Reprinted with permission of the Wall Street Journal, Copyright © 2013 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Floor brokers receive transaction fees in the form of a bid–ask spread. That is, they purchase a given futures contract for one party at a slightly lower price than the price at which they sell the contract to another party. For every buyer of a futures contract, there must be a corresponding seller.

The futures exchange facilitates the trading process but does not itself take buy or sell positions on the futures contract. Instead, the exchange acts as a clearinghouse. A clearinghouse facilitates the trading process by recording all transactions and guaranteeing timely payments. This precludes the need for a purchaser of a futures contract to check the creditworthiness of the contract seller. In fact, purchasers of contracts do not even know who the sellers are, and vice versa. The clearinghouse also supervises the delivery specified by contracts as of the settlement date.

WEB

www.cmegroup.com

Quotations for futures contracts.

Futures contracts representing debt securities such as bonds result in the delivery of those securities at the settlement date. Futures contracts that represent an index (such as a bond index or stock index) are settled in cash.

13-2 INTEREST RATE FUTURES CONTRACTS

Interest rate futures contracts specify a face value of the underlying securities (such as $1,000,000 for T-bill futures and $100,000 for Treasury bond futures), a maturity of the underlying securities, and the settlement date when delivery would occur. There is a minimum price fluctuation for each contract, such as

1

32

of a point ($1,000), or $31.25 per contract.

There are also futures contracts on bond indexes, which allow for the buying and selling of a particular bond index for a specified price at a specified date. For financial institutions that trade in municipal bonds, there are Municipal Bond Index (MBI) futures . The index is based on the Bond Buyer Index of 40 actively traded general obligation and revenue bonds. The specific characteristics of MBI futures are shown in Exhibit 13.3 .

Exhibit 13.3 Characteristics of Municipal Bond Index Futures

CHARACTERISTICS OF FUTURES CONTRACT

MUNICIPAL BOND INDEX FUTURES

Trading unit

1,000 times the Bond Buyer Municipal Bond Index. A price of 90–00 represents a contract size of $90,000.

Price quotation

In points and thirty-seconds of a point.

Minimum price fluctuation

One thirty-second (

1

32

) of a point, or $31.25 per contract.

Daily trading limits

Three points ($3,000) per contract above or below the previous day's settlement price.

Settlement months

March, June, September, December.

Settlement procedure

Municipal Bond Index futures settle in cash on the last day of trading.

13-2a Valuing Interest Rate Futures

The price of an interest rate futures contract generally reflects the expected price of the underlying security on the settlement date. Thus any factors that influence that expected price should influence the current prices of the interest futures contracts. Participants in the Treasury bond futures market closely monitor the economic indicators that affect Treasury bond prices, as shown in Exhibit 13.4 . Some of the more closely monitored indicators of economic growth include employment, gross domestic product, retail sales, industrial production, and consumer confidence. When indicators signal an increase in economic growth, participants anticipate an increase in interest rates, which places downward pressure on bond prices and therefore also on Treasury bond futures prices. Conversely, when indicators signal a decrease in economic growth, participants anticipate lower interest rates, which places upward pressure on bond prices and therefore also on Treasury bond futures.

Exhibit 13.4 Framework for Explaining Changes over Time in the Futures Prices of Treasury Bonds and Treasury Bills

Participants in the Treasury bond futures market also closely monitor indicators of inflation, such as the consumer price index and the producer price index. In general, an unexpected increase in these indexes tends to create expectations of higher interest rates and places downward pressure on bond prices and hence also on Treasury bond futures prices.

Indicators that reflect the amount of long-term financing are also monitored. For example, announcements about the government deficit or the amount of money that the Treasury hopes to borrow in a Treasury bond auction are closely monitored. Any information that implies more government borrowing than expected tends to signal upward pressure on the long-term risk-free interest rate (the Treasury bond rate), downward pressure on bond prices, and therefore downward pressure on Treasury bond futures prices.

13-2b Speculating in Interest Rate Futures

Speculators who anticipate future movements in interest rates can likewise anticipate the future direction of Treasury security values and therefore how valuations of interest rate futures will change. Speculators take positions in interest rate futures that will benefit them if their expectations prove to be correct.

EXAMPLE

In February, Jim Sanders forecasts that interest rates will decrease over the next month. If his expectation is correct, the market value of T-bills should increase. Sanders calls a broker and purchases a T-bill futures contract. Assume that the price of the contract was 94.00 (a 6 percent discount) and that the price of T-bills on the March settlement date is 94.90 (a 5.1 percent discount). Sanders can accept delivery of these T-bills and sell them for more than he paid for them. Because the T-bill futures represent $1 million of par value, the nominal profit from this speculative strategy is

In this example, Sanders benefited from his speculative strategy because interest rates declined from the time he took the futures position until the settlement date. If interest rates had risen over this period, the price of T-bills on the settlement date would have been below 94.00 (reflecting a discount above 6 percent), and Sanders would have incurred a loss.

EXAMPLE

Assume that the price of T-bills as of the March settlement date is 92.50 (representing a discount of 7.5 percent). In this case, the nominal profit from Sanders's speculative strategy is

Now suppose instead that, in February, Sanders had anticipated that interest rates would rise by March. He therefore sold a T-bill futures contract with a March settlement date, obligating him to provide T-bills to the purchaser on that delivery date. When T-bill prices declined in March, Sanders was able to obtain T-bills at a market price lower than the price at which he was obligated to sell those bills. Again, there is always the risk that interest rates (and therefore T-bill prices) will move contrary to expectations. In that case, Sanders would have paid a higher market price for the T-bills than the price at which he could sell them.

Payoffs from Speculating in Interest Rate Futures The potential payoffs from speculating in futures contracts are illustrated in Exhibit 13.5 . The left graph represents a purchaser of futures, and the right graph represents a seller of futures. The S on each graph indicates the initial price at which a futures position is created. The horizontal axis represents the market value of the securities in terms of a futures contract as of the delivery date. The maximum possible loss when purchasing futures is the amount to be paid for the securities, but this loss will occur only if the market value of the securities falls to zero. The amount of gain (or loss) to a speculator who initially purchased futures will equal the loss (or gain) to a speculator who initially sold futures on the same date, assuming zero transaction costs.

Exhibit 13.5 Potential Payoffs from Speculating in Financial Futures

Impact of Leverage Because investors commonly use a margin account to take futures positions, the return from speculating in interest rate futures should reflect the degree of financial leverage involved. This return is magnified substantially when considering the relatively small margin maintained by many investors.

EXAMPLE

In the example where Jim Sanders earned a profit of $9,000 on a futures contract, this profit represents 0.90 percent of the value of the underlying contract par value. Consider that Sanders could have taken the interest rate futures position with an initial margin of perhaps $10,000. Under these conditions, the $9,000 profit represents a return of 90 percent over the period of less than two months in which he maintained the futures position.

Just as financial leverage magnifies positive returns, it also magnifies losses. In the example where Sanders lost $15,000 on a futures contract, he would have lost 100 percent of his initial margin, and thus would have been required to add more funds to his margin account, when the value of the futures position began to decline.

Closing Out the Futures Position Most buyers or sellers of financial futures contracts do not actually make or accept delivery of the financial instrument; instead, they offset their positions by the settlement date. In the previous example, if Jim Sanders did not want to accept delivery of the T-bills at settlement date, he could have sold a T-bill futures contract with a March settlement date at any time before that date. Since his second transaction requires that he deliver T-bills at the March settlement date but his initial transaction allows him to receive T-bills at the March settlement date, his obligations net out.

When closing out a futures position, a speculator's gain (or loss) is based on the difference between the price at which a futures contract is sold and the price at which that same type of contract is purchased.

EXAMPLE

Suppose Kim Bennett purchased a futures contract on Treasury bonds at a price of 90-00 on October 2. One month later, she sells the same futures contract in order to close out the position. At this time, the futures contract specifies the price as 92-10, or 92"/32 percent of the par value. Given that the futures contract on Treasury bonds specifies a par value of $100,000, the nominal profit is

When the initial position is a sale of the futures contract, a purchase of that same type of contract will close out the position. For example, assume that Chris Harper sold Treasury bond futures on October 2 at a price of 90-00 and then took an offsetting position one month later to close out his position. Using the same numbers as before, a loss of $2,312 (ignoring transaction costs) will result from closing out his position one month later. Speculators are willing to close out a position at a loss when they expect that a larger loss will occur if the position is not closed out.

13-2c Hedging with Interest Rate Futures

Financial institutions can classify their assets and liabilities in terms of the sensitivity of their market value to interest rate movements. The difference between a financial institution's volume of rate-sensitive assets and rate sensitive liabilities represents its exposure to interest rate risk. Over the long run, an institution may attempt to restructure its assets or liabilities in order to balance its degree of rate sensitivity. However, restructuring the balance sheet takes time. In the short run, the institution may consider using financial futures to hedge its exposure to interest rate movements. A variety of financial institutions use financial futures to hedge their interest rate risk, including mortgage companies, securities dealers, commercial banks, savings institutions, pension funds, and insurance companies.

Using Interest Rate Futures to Create a Short Hedge Financial institutions commonly take a position in interest rate futures to create a short hedge, which represents the sale of a futures contract on debt securities or an index that is similar to its assets. The “short” position from the futures contract is taken to hedge the institution's “long” position (in its own assets).

Consider a commercial bank that currently holds a large amount of corporate bonds. Its primary source of funds is short-term deposits. The bank will be adversely affected if interest rates rise in the near future because its liabilities are more rate-sensitive than its assets. Although the bank believes that its bonds are a reasonable long-term investment, it anticipates that interest rates will rise temporarily. Therefore, it hedges against the interest rate risk by selling futures on securities that have characteristics similar to the securities it is holding, so that the futures prices will change in tandem with these securities. One strategy is to sell Treasury bond futures, since the price movements of Treasury bonds are highly correlated with movements in corporate bond prices.

If interest rates rise as expected, the market value of existing corporate bonds held by the bank will decline. Yet this decline could be offset by the favorable impact of the futures position. The bank locked in the price at which it could sell Treasury bonds. It can purchase Treasury bonds at a lower price just prior to settlement of the futures contract (because the value of bonds will have decreased) and profit after fulfilling its futures contract obligation. Alternatively, it could offset its short position by purchasing futures contracts similar to the type that it sold earlier.

EXAMPLE

Assume that Charlotte Insurance Company plans to satisfy cash needs in six months by selling its Treasury bond holdings for $5 million at that time. It is concerned that interest rates might increase over the next three months, which would reduce the market value of the bonds by the time they are sold. To hedge against this possibility, Charlotte plans to sell Treasury bond futures. It sells 50 Treasury bond futures contracts with a par value of $5 million ($100,000 per contract) for 98-16 (i.e., 98"/32 percent of par value).

Suppose that the actual price of the futures contract declines to 94-16 because of an increase in interest rates. Charlotte can close out its short futures position by purchasing contracts identical to those it has sold. If it purchases 50 Treasury bond futures contracts at the prevailing price of 94-16, its profit per futures contract will be

Charlotte had a position in 50 futures contracts, so its total profit from that position will be $200,000 ($4,000 per contract x 50 contracts). This gain on the futures contract position will help offset the reduced market value of Charlotte's bond holdings. Charlotte could also have earned a gain on its position by purchasing an identical futures contract just before the settlement date.

If interest rates rise by a greater degree over the six-month period, the market value of Charlotte's Treasury bond holdings will decrease further. However, the price of Treasury bond futures contracts will also decrease by a greater degree, creating a larger gain from the short position in Treasury bond futures. If interest rates decrease, the futures prices will rise, causing a loss on Charlotte's futures position. But that will be offset by a gain in the market value of Charlotte's bond holdings. In this case, the firm would have experienced better overall performance without the hedge. Firms cannot know whether a hedge of interest rate risk will be beneficial in a future period because they cannot always predict the direction of future interest rates.

Cross-Hedging The preceding example presumes that the basis, or the difference between the price of a security and the price of a futures contract, remains the same. In reality, the price of the security may fluctuate more or less than the futures contract used to hedge it. If so, a perfect offset will not result when a given face value amount of securities is hedged with the same face value amount of futures contracts.

The use of a futures contract on one financial instrument to hedge a position in a different financial instrument is known as cross-hedging. The effectiveness of a cross-hedge depends on the degree of correlation between the market values of the two financial instruments. If the price of the underlying security of the futures contract moves nearly in tandem with the security being hedged, the futures contract can provide an effective hedge.

Even when the futures contract is highly correlated with the portfolio being hedged, the value of the futures contract may change by a higher or lower percentage than the portfolio's market value. If the futures contract value is less volatile than the portfolio value, hedging will require a greater amount of principal represented by the futures contracts. For example, assume that the value of the portfolio moves by 1.25 percent for every percentage point movement in the price of the futures contract. In this case, the value of futures contracts needed to fully hedge the portfolio would be 1.25 times the principal of the portfolio.

Trade-off from Using a Short Hedge When considering the rising and the declining interest rate scenarios, the advantages and disadvantages of interest rate futures are obvious. Interest rate futures can hedge against both adverse and favorable events. Exhibit 13.6 compares two probability distributions of returns generated by a financial institution whose liabilities are more rate-sensitive than its assets. If the institution hedges its exposure to interest rate risk, its probability distribution of returns is narrower than if it does not hedge. The return when hedging would have been higher than the return without hedging if interest rates increased (left side of the graph) but lower if interest rates decreased (right side).

Exhibit 13.6 Comparison of Probability Distributions of Returns; Hedged versus Unhedged Positions

WEB

www.cmegroup.com

Go to the section on Market Data where quotes are provided in order to review quotes on interest rate futures.

A financial institution that hedges with interest rate futures is less sensitive to economic events. Thus, financial institutions that frequently use interest rate futures may be able to reduce the variability of their earnings over time, which reflects a lower degree of risk. However, it is virtually impossible to perfectly hedge the sensitivity of all cash flows to interest rate movements.

Using Interest Rate Futures to Create a Long Hedge Some financial institutions use a long hedge to reduce exposure to the possibility of declining interest rates. Consider government securities dealers who plan to purchase long-term bonds in a few months. If the dealers are concerned that prices of these securities will rise before the time of their purchases, they may purchase Treasury bond futures contracts. These contracts lock in the price at which Treasury bonds can be purchased, regardless of what happens to market rates prior to actual purchase of the bonds.

Hedging Net Exposure Because interest rate futures contracts entail transaction costs, they should be used only to hedge net exposure , which is the difference between asset and liability positions. Consider a bank that has $300 million in long-term assets and $220 million worth of long-term, fixed-rate liabilities. If interest rates rise, the market value of the long-term assets will decline but the bank will benefit from the fixed rate on the $220 million in long-term liabilities. Thus, the bank's net exposure is only $80 million (assuming that the long-term assets and liabilities are similarly affected by rising interest rates). This financial institution should therefore focus on hedging its net exposure of $80 million by creating a short hedge.

13-3 STOCK INDEX FUTURES

A futures contract on a stock index is an agreement to purchase or sell an index at a specified price and date. For example, the purchase of an S&P 500 (which represents a composite of 500 large corporations) futures contract obligates the purchaser to purchase the S&P 500 index at a specified settlement date for a specified amount.

The S&P 500 index futures contract is valued as the index times $250 (see Exhibit 13.1), so if the index is valued at 1600, the contract is valued at 1600 × $250 = $400,000. Mini S&P 500 index futures contracts are available for small investors. These contracts are valued at $50 times the index, so if the index is valued at 1600, the contract is valued at 1600 × $50 = $80,000.

Stock index futures contracts have settlement dates on the third Friday in March, June, September, and December. The securities underlying the stock index futures contracts are not actually deliverable, so settlement occurs through a cash payment. On the settlement date, the futures contract is valued according to the quoted stock index. The net gain or loss on the stock index futures contract is the difference between the futures price when the initial position was created and the value of the contract as of the settlement date.

Like other financial futures contracts, stock index futures can be closed out before the settlement date by taking an offsetting position. For example, if an S&P 500 futures contract with a December settlement date is purchased in September, this position can be closed out in November by selling an S&P 500 futures contract with the same December settlement date. When a position is closed out prior to the settlement date, the net gain or loss on the stock index futures contract is the difference between the futures price when the position was created and the futures price when the position is closed out.

Recently, sector index futures have also been created so that investors can buy or sell an index that reflects a particular sector. These contracts are distinguished from stock index futures because they represent a component of a stock index. Investors who are optimistic about the stock market in general might be more interested in stock index futures, while investors who are especially optimistic about one particular sector may be more interested in sector index futures. Sector index futures contracts are available for many different sectors, including consumer goods, energy, financial services, health care, industrial, materials, technology, and utilities.

13-3a Valuing Stock Index Futures

The value of a stock index futures contract is highly correlated with the value of the underlying stock index. However, the value of the stock index futures contract commonly differs from the price of the underlying asset because of some unique features of the stock index futures contract.

EXAMPLE

Consider that an investor can buy either a stock index or a futures contract on the stock index with a settlement date of six months from now. On the one hand, the buyer of the index receives dividends whereas the buyer of the index futures does not. On the other hand, the buyer of the index must use funds to buy the index whereas the buyer of index futures can engage in the futures contract simply by establishing a margin deposit with a relatively small amount of assets (such as Treasury securities), which may generate interest while being used to satisfy margin requirements.

Assume that the index will pay dividends equal to 3 percent over the next six months. Also assume that the purchaser of the index will borrow funds to purchase the index at an interest rate of 2 percent over the six-month period. In this example, the advantage of holding the index (a 3 percent dividend yield) relative to holding a futures contract on the index more than offsets the 2 percent cost of financing the purchase of the index. The net financing cost (also called “cost of carry”) to the purchaser of the underlying assets (the index) is the 2 percent cost of financing minus the 3 percent yield earned on the assets, or −1 percent. A negative cost of carry indicates that the cost of financing is less than the yield earned from dividends. Therefore, the stock index futures contract should be valued about 1 percent above the underlying stock index so that it is no less desirable to investors than is the stock index itself.

In general, the underlying security (or index) tends to change by a much greater degree than the cost of carry, so changes in financial futures prices are primarily attributed to changes in the values of the underlying securities (or indexes).

In some cases, numerous institutional investors may buy or sell index futures instead of selling stocks to prepare for a change in market conditions, and their actions can cause the movement in the index futures price to deviate from the underlying value of the actual stocks that make up the index. The futures can be purchased immediately with a small, up-front payment. Purchasing actual stocks may take longer because of the time needed to select specific stocks, and a larger up-front investment is necessary. Thus, stock index futures may be more responsive to investor expectations about the market than are values of the underlying stock prices.

Indicators of Stock Index Futures Prices Because stock index futures prices are primarily driven by movements in the corresponding stock indexes, participants in stock index futures monitor indicators that may signal movements in the stock indexes. The economic indicators that signal changes in bond futures prices can also affect stock futures prices, but not necessarily in the same manner. Whereas economic conditions that cause expectations of higher interest rates adversely affect prices of Treasury bonds (and therefore Treasury bond futures), the impact of such expectations on a stock index (and therefore on stock index futures) is not as clear.

13-3b 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.

EXAMPLE

Boulder Insurance Company plans to purchase a variety of stocks for its stock portfolio in December, once cash inflows are received. Although the company does not have cash to purchase the stocks immediately, it is anticipating a large jump in stock market prices before December. Given this situation, it decides to purchase S&P 500 index futures. The futures price on the S&P 500 index with a December settlement date is 1500. The value of an S&P 500 futures contract is $250 times the index. Because the S&P 500 futures price should move with the stock market, it will rise over time if the company's expectations are correct. Assume that the S&P 500 index rises to 1600 on the settlement date.

In this example, the nominal profit on the S&P 500 index futures is

USING THE WALL STREET JOURNAL: Index Futures

The Wall Street Journal provides information on stock index futures, as shown here. Specifically, it discloses the recent open price, range (high and low), and final closing (settle) price over the previous trading day In addition, it discloses the number of existing contracts (open interest) Financial institutions closely monitor interest rate futures prices when considering whether to hedge their market risk.

Source: Reprinted with permission of the Wall Street Journal, Copyright © 2013 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

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.

13-3c Hedging with Stock Index Futures

Stock index futures are also commonly used to hedge the market risk of an existing stock portfolio.

EXAMPLE

Glacier Stock Mutual Fund expects the stock market to decline temporarily, causing a temporary decline in its stock portfolio. The fund could sell its stocks with the intent to repurchase them in the near future, but this would incur excessive transaction costs. A more efficient solution is to sell stock index futures. If the fund's stock portfolio is similar to the S&P 500 index, Glacier can sell futures contracts on that index. If the stock market declines as expected, Glacier will generate a gain when closing out the stock index futures position, which will somewhat offset the loss on its stock portfolio.

This hedge is more effective when the investor's portfolio, like the S&P 500 index, is diversified. The value of a less diversified stock portfolio will correlate less with the S&P 500 index, in which case a gain from selling index futures may not completely offset the loss in the portfolio during a market downturn.

Assuming that the stock portfolio moves in tandem with the S&P 500, a full hedge would involve the sale of the amount of futures contracts whose combined underlying value is equal to the market value of the stock portfolio being hedged.

EXAMPLE

Suppose that a portfolio manager has a stock portfolio valued at $400,000. In addition, assume the SB:P 500 index futures contracts are available for a settlement date one month from now at a level of 1600, which is about equal to today's index value. The manager could sell SB:P 500 futures contracts to hedge the stock portfolio. Since the futures contract is valued at $250 times the index level, the contract will result in a payment of $400,000 at settlement date. One index futures contract can be used to match the existing value of the stock portfolio. Assuming that the stock index moves in tandem with the manager's stock portfolio, any loss on the portfolio should be offset by a corresponding gain on the futures contract. For example, if the stock portfolio declines by about 5 percent over one month, this reflects a loss of $20,000 (0.05 × $400,000 = $20,000). Yet the SB:P 500 index should also have declined by 5 percent (to a level of 1520). Therefore, the SB:P 500 index futures contract that was sold by the manager should result in a gain of $20,000 [(1600 − 1520) × $250], which offsets the loss on the stock portfolio.

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.

Most investors who had hedged their stock portfolios with index futures benefited from the hedge when the credit crisis began in 2008. In particular, hedging during the second half of the year was especially beneficial because many stocks declined by more than 30 percent during that period.

Test of Suitability of Stock Index Futures The suitability of using stock index futures to hedge can be assessed by measuring the sensitivity of the portfolio's performance to market movements over a period prior to taking a hedge position. The sensitivity of a hypothetical position in futures to those same market movements in that period could also be assessed. A general test of suitability is to determine whether the hypothetical derivative position would have offset adverse market effects on the portfolio's performance. Although it may be extremely difficult to perfectly hedge all of a portfolio's exposure to market risk, for a hedge to be suitable there should be some evidence that such a hypothetical hedge would have been moderately effective for that firm. That is, if the position in financial derivatives would not have provided an effective hedge of market risk over a recent period, a firm should not expect that it will provide an effective hedge in the future. This test of suitability uses only data that were available at the time the hedge was to be enacted.

Determining the Proportion of the Portfolio to Hedge Portfolio managers do not necessarily hedge their entire stock portfolio, because they may wish to be partially exposed in the event that stock prices rise. For instance, if the portfolio in the preceding example were valued at $1.2 million, the portfolio manager could have hedged one-third of the stock portfolio by selling one stock index futures contract. The short position in one index futures contract would reflect one-third of the stock portfolio's value. Alternatively, the manager could have hedged two-thirds of the stock portfolio by selling two stock index futures contracts. The higher the proportion of the portfolio that is hedged, the more insulated the manager's performance is from market conditions, whether those conditions are favorable or unfavorable.

Exhibit 13.7 illustrates the net gain (including the gain on the futures and the gain on the stock portfolio) to the portfolio manager under five possible scenarios for the market return (shown in the first column). If the stock market declines, any degree of hedging is beneficial, but the benefits are greater if a higher proportion of the portfolio is hedged. If the stock market performs well, any degree of hedging reduces the net gain, but the reduction is greater if a higher proportion of the portfolio is hedged. In essence, hedging with stock index futures reduces the sensitivity to both unfavorable and favorable market conditions.

Exhibit 13.7 Net Gain (on Stock Portfolio and Short Position in Stock Index Futures) for Different Degrees of Hedging

PROPORTION OF STOCK PORTFOLIO HEDGED

SCENARIO FOR MARKET RETURN

0%

33%

67%

100%

−20%

−20%

−13.4%

−6.7%

0%

−10

−10

−6.7

−3.3

0

13-3d Dynamic Asset Allocation with Stock Index Futures

Institutional investors are increasingly using dynamic asset allocation, in which they switch between risky and low-risk investment positions over time in response to changing expectations. This strategy allows managers to increase the exposure of their portfolios when they expect favorable market conditions and to reduce their exposure when they expect unfavorable conditions. When they anticipate favorable market movements, stock portfolio managers can purchase stock index futures, which intensify the effects of market conditions. Conversely, when they anticipate unfavorable market movements, they can sell stock index futures to reduce the effects that market conditions will have on their stock portfolios. Because expectations change frequently, it is not uncommon for portfolio managers to alter their degree of exposure. Stock index futures allow portfolio managers to alter their risk–return position without restructuring their existing stock portfolios. Using dynamic asset allocation in this way avoids the substantial transaction costs that would be associated with restructuring the stock portfolios.

13-3e Arbitrage with Stock Index Futures

The New York Stock Exchange narrowly defines program trading as the simultaneous buying and selling of at least 15 different stocks that, in aggregate, are valued at more than $1 million. Program trading is commonly used in conjunction with the trading of stock index futures contracts in a strategy known as index arbitrage . Securities firms act as arbitrageurs by capitalizing on discrepancies between prices of index futures and stocks. Index arbitrage involves the buying or selling of stock index futures with a simultaneous opposite position in the stocks that the index comprises. The index arbitrage is instigated when prices of stock index futures differ significantly from the stocks represented by the index. For example, if the index futures contract is priced high relative to the stocks representing the index, an arbitrageur may consider purchasing the stocks and simultaneously selling stock index futures. Conversely, if the index futures are priced low relative to the stocks representing the index, an arbitrageur may purchase index futures and simultaneously sell stocks. An arbitrage profit is attainable if the price differential exceeds the costs incurred from trading in both markets.

Index arbitrage does not cause the price discrepancy between the two markets but instead responds to it. The arbitrageur's ability to detect price discrepancies between the stock and futures markets is enhanced by computers. Roughly half of all program trading activity is for the purpose of index arbitrage.

Some critics suggest that the index arbitrage activity of purchasing index futures while selling stocks adversely affects stock prices. However, if index futures did not exist, institutional investors could not use portfolio insurance. In this case, a general expectation of a temporary market decline would be more likely to encourage sales of stocks to prepare for the decline, which would actually accelerate the drop in prices.

13-3f Circuit Breakers on Stock Index Futures

As mentioned in Chapter 12 , circuit breakers are trading restrictions imposed on specific stocks or stock indexes. The CME Group imposes circuit breakers on several stock index futures, including the S&P 500 futures contract.

By prohibiting trading for short time periods when prices decline to specific threshold levels, circuit breakers may allow investors to determine whether circulating rumors are true and to work out credit arrangements if they have received a margin call. If prices are still perceived to be too high when the markets reopen, the prices will decline further. Thus circuit breakers do not guarantee that prices will turn upward. Nevertheless, they may be able to prevent large declines in prices that would be due to panic selling rather than to fundamental forces.

13-4 SINGLE STOCK FUTURES

A single stock futures contract is an agreement to buy or sell a specified number of shares of a specified stock on a specified future date. Such contracts have been traded on futures exchanges in Australia and Europe since the 1990s. The Chicago Board Options Exchange and the CME Group recently engaged in a joint venture called OneChicago, where single stock futures contracts of U.S. stocks are traded. The size of a contract is 100 shares. Investors can buy or sell singles stock futures contracts through their broker, and they can be purchased on margin. The orders to buy and sell a specific single stock futures contract are matched electronically. Single stock futures have become increasingly popular, and today are available on more than 2,200 stocks. They are regulated by the Commodity Futures Trading Commission and the Securities and Exchange Commission.

Settlement dates are on the third Friday of the delivery month on a quarterly basis (March, June, September, and December) for the next five quarters as well as for the nearest two months. For example, on January 3, an investor could purchase a stock futures contract for the third Friday in the next two months (January or February) or over the next five quarters (March, June, September, December, and March of the following year).

Investors who expect a particular stock's price to rise over time may consider buying futures on that stock. To obtain a contract to buy March futures on 100 shares of Zyco stock for $5,000 ($50 per share), an investor must submit the $5,000 payment to the clearinghouse on the third Friday in March and will receive shares of Zyco stock on the settlement date. If Zyco stock is valued at $53 at the time of settlement, the investor can sell the stock in the stock market for a gain of $3 per share or $300 for the contract (ignoring commissions). This gain would likely reflect a substantial return on the investment, since the investor had to invest only a small margin (perhaps 20 percent of the contract price) to take a position in futures. If Zyco stock is valued at $46 at the time of settlement, the investor would incur a loss of $4 share, which would reflect a substantial percentage loss on the investment. Thus, single stock futures offer potential high returns but also high risk.

Investors who expect a particular stock's price to decline over time can sell futures contracts on that stock. This activity is similar to selling a stock short, except that single stock futures can be sold without borrowing the underlying stock from a broker (as short-sellers must do). To obtain a contract to sell March futures of Zyco stock, an investor must deliver Zyco stock to the clearinghouse on the third Friday in March and will receive the payment specified in the futures contract.

Investors can close out their position at any time by taking the opposite position. Suppose that, shortly after the investor purchased futures on Zyco stock with a March delivery at $50 per share, the stock price declines. Rather than incur the risk that the price could continue to decline, the investor could sell a Zyco futures contract with a March delivery. If this contract specifies a price of $48 per share, the investor's gain will be the difference between the selling price and the buying price, which is $2 per share or $200 for the contract.

Recently, futures contracts for exchange-traded funds (ETFs) have also been introduced. These allow an investor to buy or sell a particular ETF at a specified price. More information about ETFs is provided in Chapter 23 .

13-5 RISK OF TRADING FUTURES CONTRACTS

Users of futures contracts must recognize the various types of risk exhibited by such contracts and other derivative instruments.

13-5a Market Risk

Market risk refers to fluctuations in the value of the instrument as a result of market conditions. Firms that use futures contracts to speculate should be concerned about market risk. If their expectations about future 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.

13-5b Basis Risk

A second type of risk is basis risk, or the risk that the position being hedged by the futures contracts is not affected in the same manner as the instrument underlying the futures contract. This type of risk applies only to those firms or individuals who are using futures contracts to hedge. The change in the value of the futures contract position may not move in perfect tandem with the change in value of the portfolio that is being hedged, so the hedge might not perfectly hedge the risk of the portfolio.

13-5c Liquidity Risk

A third type of risk is liquidity risk, which refers to potential price distortions due to a lack of liquidity. For example, 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.

13-5d Credit Risk

A fourth type of risk is credit risk , which is the 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.

The credit risk of counterparties is not a concern when trading futures and other derivatives on exchanges, because the exchanges normally guarantee that the provisions of the contract will be honored. The financial intermediaries that make the arrangements in the over-the-counter market can also take some steps to reduce this type of risk. First, the financial intermediary can require that each party provide some form of collateral to back up its position. Second, the financial intermediary can serve (for a fee) as a guarantor in the event that the counterparty does not fulfill its obligation.

13-5e Prepayment Risk

Prepayment risk refers to the possibility that the assets to be hedged may be prepaid earlier than their designated maturity. 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 without a corresponding gain from its bond position (because the bonds were called earlier).

As a second example, consider a savings and loan association with large holdings of long-term, fixed-rate mortgages that are mostly financed by short-term funds. It sells Treasury bond futures to hedge against the possibility of rising interest rates; then, after the futures position is established, interest rates decline and many of the existing mortgages are prepaid by homeowners. The savings and loan association will incur a loss from its futures position without a corresponding gain from its fixed-rate mortgage position (because the mortgages were prepaid).

13-5f Operational Risk

A sixth type of risk is 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 conditions. Furthermore, those employees may take more speculative positions than the firms desire if the firms do not have adequate controls to monitor them.

EXAMPLE

The case of MF Global Holdings serves as a good example of operational risk. During 2011, it experienced major losses from its speculative positions, and it pulled funds from its customer accounts to cover its losses. It ultimately experienced liquidity problems and went bankrupt in October 2011. The funds that it pulled from customer accounts were not repaid. A few months later, another brokerage firm for futures traders (Peregine Financial Group) also experienced liquidity problems, as its actual bank cash balance was more than $100 million less than what it had reported. It ultimately filed for bankruptcy in July 2012. These events triggered concerns about the exposure of traders to financial fraud in the futures markets.

13-5g 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).

EXAMPLE

Nexus, Inc., requests several transactions in derivative securities that involve buying futures on Treasury bonds in an over-the-counter market. Bangor Bank accommodates Nexus by taking the opposite side of the transactions. The bank's positions in these contracts also serve as a hedge against its existing exposure to interest rate risk. As time passes, Nexus experiences financial problems. As interest rates rise and the value of a Treasury bond futures contract declines, Nexus will take a major loss on the futures transactions. It files for bankruptcy, since it is unable to fulfill its obligation to buy the Treasury bonds from Bangor Bank at the settlement date. Bangor Bank was relying on this payment to hedge its exposure to interest rate risk. Consequently, Bangor Bank experiences financial problems and cannot make the payments on other over-the-counter derivatives contracts that it has with three other financial institutions. These financial institutions were relying on those funds to cover their own obligations on derivative contracts with several other firms. These firms may then be unable to honor their payment obligations resulting from the derivative contract agreements, causing the adverse effects to spread further.

The credit crisis in 2008 and 2009 demonstrated that some financial institutions had high exposure to risk because their derivative security positions were intended to enhance profits rather than to hedge portfolio risk. Since then, regulators have become more aware of the potential systemic risk.

The Financial Reform Act in 2010 resulted in the creation of the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the United States and making regulatory recommendations that could reduce any risks to the financial system. The council consists of ten members who head regulatory agencies overseeing key components of the financial system (including the CFTC, which regulates financial futures trading).

13-6 GLOBALIZATION OF FUTURES MARKETS

The trading of financial futures also requires the assessment of international financial market conditions. The flow of foreign funds into and out of the United States can affect interest rates and therefore the market value of Treasury bonds, corporate bonds, mortgages, and other long-term debt securities. Portfolio managers assess international flows of funds to forecast changes in interest rate movements, which in turn affect the value of their respective portfolios. Even speculators assess international flows of funds to forecast interest rates so that they can determine whether to take short or long futures positions.

13-6a Non-U.S. Participation in U.S. Futures Contracts

Financial futures contracts on U.S. securities are commonly traded by non-U.S. financial institutions that maintain holdings of U.S. securities. These institutions use financial futures to reduce their exposure to movements in the U.S. stock market or interest rates.

13-6b Foreign Stock Index Futures

Foreign stock index futures have been created both for speculating on and hedging against potential movements in foreign stock markets. Expectations of a strong foreign stock market encourage the purchase of futures contracts on the representative index. Conversely, if firms expect a decline in the foreign market, they will consider selling futures on the representative index. Financial institutions with substantial investments in a particular foreign stock market can hedge against a temporary decline in that market by selling foreign stock index futures.

Some of the more popular foreign stock index futures contracts are identified in Exhibit 13.8 . Numerous other foreign stock index futures contracts have been created. In fact, futures exchanges have been established in Ireland, France, Spain, and Italy. Financial institutions around the world can use futures contracts to hedge against temporary declines in their asset portfolios. Speculators can take long or short positions to speculate on a particular market with a relatively small initial investment. Financial futures on debt instruments (such as futures on German government bonds) are also offered by numerous exchanges in non-U.S. markets, including the London International Financial Futures Exchange (LIFFE), Singapore International Monetary Exchange (SIMEX), and Sydney Futures Exchange (SFE). In 2001, the LIFFE was acquired by Euronext, an alliance of European stock exchanges.

Exhibit 13.8 Popular Foreign Stock Index Futures Contracts

NAME OF STOCK FUTURES INDEX

DESCRIPTION

Nikkei 225

225 Japanese stocks

Toronto 35

35 stocks on Toronto stock exchange

Financial Times Stock Exchange 100

100 stocks on London stock exchange

Barclays share price

40 stocks on New Zealand stock exchange

Hang Seng

33 stocks on Hong Kong stock exchange

Osaka

50 Japanese stocks

All Ordinaries share price

307 Australian stocks

Electronic trading of futures contracts is creating an internationally integrated futures market. As mentioned previously, the CME Group has instituted Globex, a round-the-world electronic trading network. It allows financial futures contracts to be traded even when the trading floor is closed.

13-6c Currency Futures Contracts

A currency futures contract is a standardized agreement to deliver or receive a specified amount of a specified foreign currency at a specified price (exchange rate) and date. The settlement months are March, June, September, and December. Some companies act as hedgers in the currency futures market by purchasing futures on currencies that they will need in the future to cover payables or by selling futures on currencies that they will receive in the future. Speculators in the currency futures market may purchase futures on a foreign currency that they expect to strengthen against the U.S. dollar or sell futures on currencies that they expect to weaken against the U.S. dollar.

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. If they close out their long position, their gain or loss is determined by the difference between the futures price when they created the position and the futures price at the time the position was closed out. Sellers of currency futures contracts either deliver the foreign currency at the settlement date or close out their position by purchasing an identical type and number of contracts prior to the settlement date.

SUMMARY

· ▪ A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date. Financial institutions such as commercial banks, savings institutions, bond mutual funds, pension funds, and insurance companies trade interest rate futures contracts to hedge their exposure to interest rate risk. Some stock mutual funds, pension funds, and insurance companies trade stock index futures to hedge their exposure to adverse stock market movements.

· ▪ An interest rate futures contract locks in the price to be paid for a specified debt instrument. Speculators who expect interest rates to decline can purchase interest rate futures contracts, because the market value of the underlying debt instrument should rise. Speculators who expect interest rates to rise can sell interest rate futures contracts, because the market value of the underlying debt instrument should decrease.

· ▪ Financial institutions (or other firms) that desire to hedge against rising interest rates can sell interest rate futures contracts. Financial institutions that desire to hedge against declining interest rates can purchase these contracts. If interest rates move in the anticipated direction, the financial institutions will gain from their futures position, which can partially offset any adverse effects of the interest rate movements on their normal operations.