Tài chính doanh nghiệp - Chapter 18: Futures contracts and forward rate agreements

Chapter 18Futures Contracts andForward RateAgreementsWebsite:  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonLearning ObjectivesOutline features of futures contractsIdentify futures market instruments and participantsUnderstand the different types of risks that can be hedged using futuresOverview of forward rate agreementsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation18.1 Introduction18.2 General Principles of Hedging Using Futures18.3 Main Features of Futures Transactions18.4 Futures Market Instruments18.5 Futures Market ParticipantsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)18.6 Hedging: Risk Management Using Futures18.7 Risks in Using Futures Markets for Hedging18.8 Forward Rate Agreements (FRAs)18.9 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.1 IntroductionFutures contracts and FRAs are called derivatives because they derive their price from an underlying physical market productTwo main types of derivative contractsCommodity (e.g. gold, wheat and cattle)Financial (e.g. shares, government securities and money market instruments)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.1 Introduction (cont.)Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes in interest rates, exchange rates and share pricesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation18.1 Introduction18.2 General Principles of Hedging Using Futures18.3 Main Features of Futures Transactions18.4 Futures Market Instruments18.5 Futures Market ParticipantsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.2 General Principles of Hedging Using FuturesHedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another partyA futures contract is the right to buy or sell a specific item at a specified future date at a price determined todayCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.2 General Principles of Hedging Using Futures (cont.)The change in the market price of a commodity or security is offset by a profit or loss on the futures contractExample: a farmer wants to sell wheat in a couple of months. He is concerned that the price is going to fall in the meantime. How can he hedge this price risk?Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.2 General Principles of Hedging Using Futures (cont.)SolutionEnter into a wheat futures contract to sellIf wheat prices fall, the futures contract will rise in value, offsetting the loss in the physical market from the fall in the wheat priceIf wheat prices rise, the futures contract will fall in value, offsetting the gain in the physical market from a rise in the wheat priceCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation18.1 Introduction18.2 General Principles of Hedging Using Futures18.3 Main Features of Futures Transactions18.4 Futures Market Instruments18.5 Futures Market ParticipantsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures TransactionsOrders and agreement to tradeFutures contracts are highly standardised and an order normally specifiesWhether it is a buy or sell orderThe type of contract (varies between exchanges)Delivery month (expiration)Price restrictions (if any) e.g. limit order Time limits on the order (if any)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures Transactions (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures Transactions (cont.)Margin requirementsBoth the buyer (long position) and the seller (short position) pay an initial margin, held by the clearing house, rather than the full price of the contractMargins are imposed to ensure traders are able to pay for any losses they incur due to unfavourable price movements in the contractCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures Transactions (cont.)Margin requirements (cont.)A contract is marked-to-market on a daily basis by the clearing houseI.e. repricing of the contract daily to reflect current market valuations Subsequent margin calls may be made, requiring a contract holder to pay a maintenance margin to top-up the initial margin to cover adverse price movementsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures Transactions (cont.)Closing out of a contractInvolves entering into an opposite positionExample: if company S initially entered into a ‘sell one ten-year treasury bond contract’, it would close out the position by entering into a ‘buy one ten-year treasury bond contract’ as illustrated in Table 18.2Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures Transactions (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures Transactions (cont.)Contract deliveryMost parties to a futures contractManage a risk exposure or speculateDo not wish to actually deliver or receive the underlying commodity/instrument and close out of the contract prior to delivery dateCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.3 Main Features of Futures Transactions (cont.)Contract delivery (cont.)SFE (Sydney Futures Exchange) requires financial futures in existence at the close of trading in the contract month to be settled with the clearing house by standard delivery or cash settlementCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation18.1 Introduction18.2 General Principles of Hedging Using Futures18.3 Main Features of Futures Transactions18.4 Futures Market Instruments18.5 Futures Market ParticipantsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.4 Futures Market InstrumentsFutures markets can be established for any commodity or instrument thatIs freely tradedExperiences large price fluctuations at timesCan can be graded on a universally accepted scale in terms of its qualityIs in plentiful supply, or cash settlement is possibleCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.4 Futures Market Instruments (cont.)ExampleCommoditiesMineral (e.g. silver, gold, copper, petroleum and zinc)Agricultural (e.g. wool, coffee, butter, wheat and cattle)FinancialCurrencies (e.g. pound sterling and euro)Interest rates (e.g. US 90-day bills, 3-month euro deposits)Share price indices (e.g. All Ordinaries)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation18.1 Introduction18.2 General Principles of Hedging Using Futures18.3 Main Features of Futures Transactions18.4 Futures Market Instruments18.5 Futures Market ParticipantsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.5 Futures Market ParticipantsFour main categories of participantsHedgersSpeculatorsTradersArbitragersThese participants provide depth and liquidity to the futures market; thus, improving its efficiencyCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonFour main categories of participantsHedgersAttempt to reduce the price risk from exposure to changes in interest rates, exchange rates and share pricesTake the opposite position to the underlying, exposed transactionExample: exporter has USD receivable in 90 days. To protect against fall in USD over next 3 months, exporter enters into a futures contract to sell USDCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonFour main categories of participants (cont.)SpeculatorsExpose themselves to risk in the attempt to make profitEnter the market in the expectation that the market price will move in a favourable direction for themExample: speculators who expect the price of the underlying asset to rise will go long and those that expect the price to fall will go shortCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonFour main categories of participants (cont.)TradersSpecial class of speculatorTrade on very short-term changes in the price of futures contracts (i.e. intra-day changes)Provide liquidity to the marketCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonFour main categories of participants (cont.)ArbitragersSimultaneously buy and sell to take advantage of price differentials between marketsAttempt to make profit without taking any riskExample: differentials between the futures contract price and the physical spot price of the underlying commodityCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)18.6 Hedging: Risk Management Using Futures18.7 Risks in Using Futures Markets for Hedging18.8 Forward Rate Agreements (FRAs)18.9 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.6 Hedging: Risk Management Using FuturesFutures contracts may be used to manage identified financial risk exposures such asHedging the cost of fundsHedging the value of a money market investmentHedging a foreign currency payableHedging the value of a share portfolioCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.6 Hedging: Risk Management Using Futures (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.6 Hedging: Risk Management Using Futures (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.6 Hedging: Risk Management Using Futures (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.6 Hedging: Risk Management Using Futures (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)18.6 Hedging: Risk Management Using Futures18.7 Risks in Using Futures Markets for Hedging18.8 Forward Rate Agreements (FRAs)18.9 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.7 Risks in Using Futures Markets for HedgingThe risks of using the futures markets for hedging include the problems ofStandard contract sizeMargin riskBasis riskCross-commodity hedgingCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.7 Risks in Using Futures Markets for Hedging (cont.)Standard contract sizeExample90-day bank bill—$1,000,000 face value3-year T-bond—$100,000 face valueListed company share—1000 sharesA perfect hedge may not be possible i.e. due to contract size, the physical market exposure may not exactly match the futures market exposureCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.7 Risks in Using Futures Markets for Hedging (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.7 Risks in Using Futures Markets for Hedging (cont.)Margin riskInitial margin required when entering into a futures contractFurther cash required if prices move adversely (i.e. margin calls)Opportunity costs associated with margin requirementsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.7 Risks in Using Futures Markets for Hedging (cont.)Basis riskTwo types of basis riskInitial basisThe difference between the price in the physical market and the futures market at start dateFinal basisThe difference between the price in the physical market and the futures market at end dateA perfect hedge requires zero initial and final basis riskCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.7 Risks in Using Futures Markets for Hedging (cont.)Cross-commodity hedgingUse of a commodity or financial instrument to hedge a risk associated with another commodity or financial instrumentOften necessary as futures contracts are available for few commodities or instrumentsSelect a futures contract that has price movements that are highly correlated with the price of the commodity or instrument to be hedgedCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)18.6 Hedging: Risk Management Using Futures18.7 Risks in Using Futures Markets for Hedging18.8 Forward Rate Agreements (FRAs)18.9 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.8 Forward Rate Agreements (FRAs)The nature of the FRAA FRA is an over-the-counter product enabling the management of an interest rate risk exposureIt is an agreement between two parties on an interest rate level that will apply at a specified future dateAllows the lender and borrower to lock-in interest ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.8 Forward Rate Agreements (FRAs) (cont.)The nature of the FRA (cont.)Unlike a loan, no exchange of principal occursPayment between the parties involves the difference between the agreed interest rate and the actual interest rate at settlementDisadvantages of FRAs includeRisk of non-settlement i.e. credit riskNo formal market existsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.8 Forward Rate Agreements (FRAs) (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.8 Forward Rate Agreements (FRAs) (cont.)Settlement amount = FRA settlement rate - FRA agreed rate(18.2)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.8 Forward Rate Agreements (FRAs) (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.8 Forward Rate Agreements (FRAs) (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.8 Forward Rate Agreements (FRAs) (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)18.6 Hedging: Risk Management Using Futures18.7 Risks in Using Futures Markets for Hedging18.8 Forward Rate Agreements (FRAs)18.9 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.9 Summary (cont.)Limitations include margin calls, imperfect hedging due to basis risk, and availabilityFRAs are over-the-counter contracts specifying an agreed interest rate to apply at a future dateCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson18.9 Summary (cont.)A futures contract is an agreement between two parties to buy or sell a specified commodity or instrument at a specified date in the future, at a price specified todayFutures may be used as a hedging strategy by opening a position today that requires a closing transaction that is the reverse of the exposed transaction in the physical marketCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson