In the previous discussion, commodity contracts meant futures contracts for physical goods. However, there are also financial and currency futures. Financial futures are contracts for the future delivery of securities such as stocks, Treasury bills, and bonds.
Currency futures are contracts for the future delivery of currency such as the British pound or the European euro. The markets for these contracts, like the market for com- modity futures, have two participants: the speculators and the hedgers. It is the interac- tion of these two parties (i.e., the demand and supply of each contract) that determines the futures price.
The next sections present an introduction to financial futures and currency futures.
Initially stock index futures are covered, which includes a discussion of stock index
financial futures Contracts for the future delivery of a financial asset.
currency futures Contracts for the future delivery of for- eign exchange.
arbitrage and programmed trading. Stock index arbitrage is important because it links the futures markets and the equity markets. If the futures price for stocks rises, arbitrage assures that the prices of stocks also rise. The process also works in reverse. If the futures price for equities declines, arbitrage assures that the decline is transferred to the stock market. A description of futures for debt instruments follows index arbitrage. The last section on futures covers currency futures.
Stock Market Futures
Stock index futures are futures contracts based on an index of the stock market (e.g., the Standard & Poor’s 500 stock index or the New York Stock Exchange Composite Index). These contracts offer speculators and hedgers opportunities for profit or risk reduction that are not possible through the purchase of individual securities. For exam- ple, the S&P 500 stock index futures contracts have a value that is 250 times the value of the index. Thus, if the S&P 500 stock index is 1,000, the contract is worth $250,000.
By purchasing this contract (i.e., by establishing a long position), the holder profits if the market rises. If the index were to rise to 1,100, the value of the contract would in- crease to $275,000. The investor would then earn a profit of $25,000. Of course, if the S&P 500 Index should decline, the buyer would experience a loss. (“Mini” contracts that are worth 50 times the S&P 500 stock index are also available.)
The sellers of these contracts also participate in the fluctuations of the market.
However, their positions are the opposite of the buyers’ positions (i.e., they are short).
If the value of the S&P 500 stock index were to fall from 1,000 to 900, the value of the contract would decline from $250,000 to $225,000, and the short seller would earn a
$25,000 profit. Of course, if the market were to rise, the short seller would suffer a loss.
Obviously, if the individual anticipates a rising market, that investor should buy the futures contract. Conversely, if the investor expects the market to fall, that individual should sell the contract.
S&P 500 stock index futures contracts are similar to other futures contracts. The buyers and sellers must make good-faith deposits (i.e., margin payments). As with other futures contracts, the amount of this margin (approximately 7 percent of the value of the contract) is modest relative to the value of the contract. Thus, these contracts offer con- siderable leverage. If stock prices move against the investor and his or her equity in the position declines, the individual will have to place additional funds in the account to sup- port the contract. Since there is an active market in the contracts, the investor may close a position at any time by taking the opposite position. Thus, if the investor had purchased a contract, that long position would be closed by selling a contract. If the investor had sold a contract, that short position would be closed by buying a futures contract.
There is one important difference between stock market index futures and com- modity futures contracts. Settlement at the expiration or maturity of the contract oc- curs in cash. There is no physical delivery of securities as could occur with a futures contract to buy or sell wheat or corn. Instead, gains and losses are totaled and are added to or subtracted from the participants’ accounts. The long and short positions are then closed.
One reason for the development of commodity futures markets was the need by producers and users of commodities to hedge their positions against price fluctuations.
Stock index futures (and other financial and currency futures) developed in part for
stock index futures A contract based on an index of security prices.
the same reason. Portfolio managers buy and sell stock index futures in order to hedge against adverse price movements. For example, suppose a portfolio manager has a well-diversified portfolio of stocks. If the market rises, the value of this portfolio rises.
However, there is risk of loss if the market were to decline. The portfolio manager can reduce the risk of loss by selling an NYSE Composite Index futures contract. If the market declines, the losses experienced by the portfolio will be at least partially offset by the appreciation in the value of the short position in the futures contract.
To execute such a hedge, the portfolio manager uses a futures contract that matches the composition of the portfolio. The NYSE Composite Index contract is suitable for a well-diversified stock portfolio but would not be appropriate for a specialized portfo- lio. Instead, the portfolio manager who is responsible for a portfolio of smaller compa- nies would more likely use futures on the S&P Midcap index, which gives more weight to smaller companies.
To hedge using stock index futures, the portfolio manager divides the value of the portfolio by the value of the contract to determine the number of contracts to sell.
For example, if the value of the portfolio is $1,000,000 and the futures contracts are worth $85,000, the individual would sell 11 to 12 contracts ($1,000,000/$85,000 5 11.76). It may not be possible to exactly hedge the portfolio, since the futures contracts may be unavailable in the desired units. In this example, the portfolio manager would not be able to sell 11.76 futures contracts, but would have to sell either 11 or 12 con- tracts. This question of units is less of a problem for managers of large portfolios. If the portfolio’s value had been $100,000,000, the number of contracts would be 1,176 ($100,000,000/$85,000 5 1,176.47), and the difference between 1,176 and 1,177 is immaterial. The problem facing this portfolio manager will be the market’s ability to absorb such a large number of contracts. Is there sufficient demand at current prices to absorb $100,000,000 worth of futures contracts? If the answer is no, then prices will change (which changes the required number of contracts) or the portfolio manager will not be able to completely hedge the long position in the stocks.
In addition to the number of contracts, the portfolio manager must consider the volatility of the portfolio relative to the market. The preceding illustration implicitly assumes that the value of the portfolio exactly follows the index on which the futures contract is based. In effect, the example assumes that the portfolio’s beta equals 1.0.
If the beta is greater than 1.0, more contracts must be sold to hedge against a price decline, since the value of the contracts sold short will decline less than the value of the portfolio. If the portfolio’s beta is less than 1.0, fewer contracts must be sold, since the value of the market will decline more than the value of the portfolio.
The entire process of hedging is illustrated in Exhibit 19.1, in which two portfolio managers want to hedge $2,000,000 portfolios against a price decline. Portfolio A has a beta of 1.25, while portfolio B has a beta of 0.75. Since the portfolio betas differ, portfolio A requires that nine contracts be sold, while portfolio B requires the selling of only five. The market subsequently declines by 10 percent from 1,100 to 990. Each portfolio sustains a loss, but the short positions in the futures contracts generate profits that offset the losses. Except for the problem of units, each investor has successfully hedged against the price decline but has also forgone the opportunity for a gain. If the market had risen, the increase in the value of the contracts would offset the gain in the stocks. Hedging with stock index futures works in both directions but is the most ap- propriate strategy when the portfolio manager expects a price decline and is unwilling
ExhIBIT 19.1
Using Stock Index Futures to Hedge $2,000,000 Portfolios
Portfolio A Portfolio B
Value of portfolio: $2,000,000 $2,000,000
Beta: 1.25 0.75
Value of S&P 500 stock $250 3 1,100 5 $275,000 $250 3 1,100 5 $275,000 index contract:
Number of contracts
necessary to hedge: ($2,000,000/$275,000)(1.25) 5 9.09 ($2,000,000/$275,000)(0.75) 5 5.45
Number of contracts sold: 9 5
Gain on futures contracts sold short after market declines by
10 percent to 990: $275,000 3 9 2 990($250)9 5 $247,500 $275,000 3 5 2 990($250)5 5 $137,500 Loss on portfolio: [$2,000,000(1 2 0.1) 2 $2,000,000]
(1.25) 5 2$250,000
[$2,000,000(1 2 0.1) 2 $2,000,000](0.75) 5 2$150,000
Net gain (loss) $247,500 2 $250,000 5 ($2,500) $137,500 2 ($150,00) 5 ($12,500)
to sell the portfolio. For example, the portfolio manager may wish to hedge during a period of greater uncertainty but does not want to sell the securities and generate tax- able capital gains.
Besides selling the index futures contract (establishing a short position in futures), the portfolio manager could have hedged by writing an index call option (establishing a covered call position) or by purchasing an index put option (establishing a protective put position). Each of these strategies is designed to protect against a decline in the market as a whole. Each offers potential advantages and has disadvantages, so there is no clear argument to use one exclusively. Selling a futures contract is an easy position to establish and tends to have low transaction costs. If, however, the market were to rise, the loss on the futures contract will offset the gain on the market. Selling the futures eradicates the upside potential.
Selling the call generates income from the sale but the downside protection is lim- ited. If the market were to decline sufficiently to offset the proceeds of the sale of the call, the portfolio will sustain a loss. In addition, if the market rises, the value of the call will increase, which offsets the gain in the portfolio. The protective put does not limit the upside potential. If the market were to rise, the increase in the value of the portfolio is not offset by an equal decrease in the value of the put. But buying the put requires a cash outlay, and the process must be repeated (and cash outlays increased) if the port- folio manager wants to retain the protection from a market decline.
Programmed Trading and Index Arbitrage
Programmed trading arose after the creation of stock index futures and has become a major link between the stock market and the futures market. Through programmed trading and index arbitrage, price changes in one market are transferred to the other
and vice versa as the participants move funds between the markets to take advantage of price differentials.
The term programmed trading refers to the coordinated purchases or sales of an entire portfolio of securities. The managers of mutual funds or financial institutions cannot physically place individual orders to buy and sell large quantities of stocks. In- stead, large orders are placed through computers that are programmed (hence the name programmed trading) to enter the trades if certain specifications are met.
As explained earlier in this text, arbitrage refers to the simultaneous establishment of long and short positions to take advantage of price differentials between two mar- kets. If, for example, the price of the British pound were $2.46 in Paris and $2.50 in Bonn, the arbitrageur would buy pounds in Paris and simultaneously sell them in Bonn.
The pounds bought in Paris could be delivered in Bonn; hence, the individual is assured of a $0.04 profit on the transaction. This riskless arbitrage position ensures that the price of the pound will be approximately the same in Paris and Bonn with minute dif- ferentials being explained by transactions costs.
Conceptually, index arbitrage is no different, except the arbitrageur is buying or selling index futures and securities instead of pounds. The principle is the same. If prices deviate in different markets, an opportunity for arbitrage is created. Arbitrageurs will seek to take advantage of the price differentials, and through their actions the differ- entials are erased. This type of arbitrage is frequently done by mutual funds with large holdings of securities that duplicate the various indexes of stock prices. These funds shuffle money between stocks and futures to take advantage of price differentials.
Programmed trading index arbitrage combines the two concepts: Computers are programmed to enter orders to sell or buy blocks of securities designed to take advan- tage of arbitrage opportunities that exist in the securities and futures markets. If stock index futures prices rise, the arbitrageurs will short the futures and buy the stocks in the index. If futures prices decline, the arbitrageurs do the opposite. They go long in the futures contracts and short the stocks in the index.