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.