Risk Management

Tai Tran

1. How do Futures work?

2. Forwards vs. Futures?
3. What risks can Futures
hedge, and how to
perform the hedge?

How Futures contracts work

Forwards and Futures

Forwards
Agreement
Buy or sell
Over the counter
Customizable

Futures
Agreement
Buy or sell
Exchange-traded
Standardized

Futures
History
Developed from trade in Rice
Notes
CBOT first modern exchange,
commenced in 1850s, primarily
in agricultural commodities,
later precious metals
Financial Futures emerged in
1970s, with CBOT Ginnie Mae
contract in 1975

Characteristics
Futures contracts are
standardised:

size (face value),

deliverable asset,
expiry date
settlement terms (cash or
delivery)

Only 1-2% of open positions

settled by delivery. Most
Futures trades are closed out
before expiry.

Futures Characteristics (cont)

Delivery

Close out: entering an offsetting contract at the

new market futures price.
Open interest: total number of derivative contracts
that have not been settled.

Futures
Exchange

Buyers

Sellers

Margin
account

Clearing
House

Maintenance

Margin
account
Maintenance

Loss from intra-day

trading

Loss from intra-day

trading

When price decreases

When price increases

Questions

1. Credit risk for buyers and

sellers of Futures, compared
to Forwards?
2. Credit risk of the Futures
exchange?

Sydney Futures Exchange (SFE)

Contract Specifications
Contract

Contract

Quotes

Unit

Initial

Min Move

Point

Margin

(point move)

Value

90 Day BAB

$A1,000,000 FV BAB

100 - Yield

$650

0.01%

$24

3 Yr Bond

$A100,000 FV 3yr CGS

100 - Yield

$850

0.01%

$28

100 - Yield

$850

0.01%

$29

100 - Yield

$2,000

0.005%

$40

Cents per share

Varies $100 -

1 Cent

A$10

$2500

1.0 Index Point

$A25

$2200

1.0 Index Point

$A25

1 cent/kg

$25

with 6% Coupon
3 Yr Bond

$A100,000 FV 3yr CGS

with 12% Coupon

10 Yr Bond

$A100,000 FV 10yr CGS

with 12% Coupon

Share Futures

1000 Shares

$1750
All Ords SPI

$A25 x SPI

As for All Ords, to

one full index point

SPI 200

$A25 x ASX200

As for All Ords, to

one full index point

Wool

Equivalent of 2500 kg

Cents per kg clean

Varies $650-

clean weight fleece

weight.

$750

Close out a Futures contract

Original futures contract

New futures contract

1-Mar-2013, buy a 9-month futures contract at price

$50
F0 = $50
1-Jun-2013, see futures contracts are trading at $60.
Sell a 6-month futures contract at price $60.
Ft = $60
Profit = 60 - 50 = 10
For futures contracts, the payoff is realized immediately. We don't need to wait till maturity to realize the
payoff. There is no need to take PV of payoff.
Payoff of long futures = Ft - F0
1-Mar-2013, sell a 9-month futures contract at price
$50
F0 = $50
1-Jun-2013, see futures contracts are trading at $40.
Buy a 6-month futures contract at price $40.
Ft = $40
Profit = 50 - 40 = 10
Payoff of short futures = F0 - Ft

Payoff from a Long Futures Contract

Profit
ft-f0

Price
f0

Loss

ft

Payoff from a Short Futures Contract

Again, the payoff is determined by the relationship between
the original futures contract price (f0) and the new futures
contract price (ft).

Profit
ft - f0

Price
ft

Loss

f0

The effect of marking-to-market

Futures Contracts are marked to market at the end of every
trading day:
your position is effectively closed out at the end-of-day settlement
price
profits or losses are realised at the end of each day
A "new" position is effectively opened at the start of the next day i.e. f0
is reset every day

The value of a long futures contract, , during the trading day is:
= (ft - fo)

f0 is the market opening price and ft is the observed market price

during the trading day
The value of a short futures contract during the trading day is:
= (f0 - ft)

Immediately after marking to market, the value of a futures

contract is zero.

Quoting an Interest Rate Futures

In school you learn how to calculate the price of
instruments
When you trade in the market, you receive price
quotes from dealers
Interest rate futures are quoted on an Index basis
Price = 100% - yield
Yield = 100 - price

The quote: a 10 year bond futures contract, with a

nominal 6% coupon paid semi-annually is trading at
93.50
Implicit Yield in Futures Price = 100 - 93.50 = 6.50%

Hedging with Futures

The Hedge position is opposite to the

underlying instrument's position
Price

Price 

Short futures

Value 

Value

Long underlying
(spot)

Value

Value 

The loss in the underlying instrument is offset by the gain in futures

Question: How about the case when price increases? No total profit?
Answer: The benefit of this strategy is certainty of outcome. Risk is when outcome
may be different from expectation. When outcome is not different from expectation
(certain), risk is reduced.

The Hedge position is opposite to the

underlying instrument's position
Price

Price 

Long futures

Value

Value 

Short underlying
(spot)

Value 

Value

Short Hedge: protect long spot

Profit

Price Falls

(long spot loses)

Long Spot
Position

Gain on
Futures
Price
Loss on spot

Loss

Short Futures
Position (hedge)

Long Hedge: protect short spot

Profit

Price Rises

Long futures
Position

(short spot loses)

Gain on
Futures

Price
K

Loss

Loss on spot

Short spot
Position

Major Types of Futures

Interest rate
risk

Equity price
risk

Commodity
price risk

Bank bill
futures
Bond futures

Index futures

Wool futures
Wheat
futures
Corn futures
Pork futures

Foreign
exchange risk
Currency
futures

1. Hedging Interest Rate risk with Bank Bill

Futures
IR 

IR

Long futures

Borrowing

IR 

IR

Short futures

Borrowing

Risky
An Intending Borrower will undertake a Short Hedge in Bill Futures

OK

1. Hedging Interest Rate risk with Bank Bill

Futures
IR 

IR

Long futures

Lending

OK

IR 

IR

Short futures

Lending

Risky

An Intending Lender/Investor will undertake a Long Hedge in Bill Futures

Short (Borrower) Hedge

Underlying liability of Interest Rate futures is Debt.
Ways to have (long) a debt: take down a loan, issue bank bill, issue bond
In December, XYZ Co. knows it will require $9.5 million (short term) in Mar-5 of the following year. XYZ Co.
decides to sell bank bill futures to protect against an interest rate rise. XYZ goes to the futures exchange
and finds that the exchange offers BAB futures with maturity Mar-10.
Time

Cash/Physical Market

Futures Market

December

Do nothing
(while not given, it can be implied
from the futures rate that the
interest rate in Dec is close to 6.95%)

Sell
BAB Futures
Quantity: 10
Face value = 10*1m = 10m
Maturity 10-March
Quote 93.05 rate 6.95%


Get
= 9,831,517

.

Rate

March

Issue BAB
Face value 9.5m
Maturity 90 days
Rate 8.1%
Get 9,313,976

Close out futures position

Buy 10 BAB Futures
Time to expiry 90-day
Quote 91.88 8.12%
Pay 9,803,711

Profit

Interest Cost = 9.5m-9,313,976 =

186,024

Futures Profit = 9,831,517 - 9,803,711 = 27,806

June

Pay back Face value
     =  = 186,024 27,806 365 = 6.89%
9,313,976

90

The hedge is not perfect

1. Quantity mismatch: issue 9.5m BAB, but have to
use 10 BAB Futures (b/c of standardization)
2. Maturity mismatch: borrow on Mar-5, but the
futures matures on Mar-10 (b/c of standardization)
Basis risk

Long Hedge
In December, XYZ Co. knows it will have $10m surplus funds to invest
in March of the following year. XYZ Co. decides to buy bank bill
futures to protect against an interest rate fall.
Cash/Physical Market
December:
Do Nothing

March:
Buy $10mio 90 Day BABs @ 6.95%
Purchase price: $9,831,517
Interest Earnings: $168,483

Futures Market
Buy 10 March BAB Futures @ 91.88
(8.12% I.Y)
Value: $9,803,711
Close Long Position by selling 90-day
BAB Futures @ 93.05 (6.95% I.Y)
Value: $9,831,517
Futures Profit: $27,806

$196,289
365
$9,831,517 x 90 x 100 = 8.10% = Effective Return

2. Hedging Equity Price Risk with Index

Futures
The SFE offers contracts on the All Ordinaries Share
Price Index (SPI), and the SPI 200 (200 Leaders)
Index.
There are also deliverable futures contracts
available on blue chip Australian shares, including
BHP, NAB, ANZ, FBG, TE
"Fair Value" of the SPI can be defined as the
theoretical price that the SPI should be trading
based on market price and cost-of-carry
assumptions:
SPI = AOI + AOI * (CC - CR) * t
= AOI + AOI * (Interest Rate - Dividend Yield) * t

Index futures fair value

March SPI expires in 90 days, annual gross dividend
yield on the AOI is 4.5%, 90-day BBSW 5%, and AOI
is at 2625:

  
 = 2625 + 2625 5% 4.5%

= 2628.24

SPI Futures determinants:

Dividend yield of the broad market
Interest Rates
Question: can futures
Market level of AOI
level be lower than
Time to expiry

index level?

SPI and Commodity Basis Risk

Our equity portfolio is vastly different from the
Index most of the time.
Using a futures contract on the Index to hedge our
portfolio gives rise to Commodity Basis Risk
Commodity Basis Risk arises when we use a
contract on A to hedge B (because there is no
contract on B)
Solution to CBR: using portfolio Beta

Calculate portfolio Beta

Share

Share

JLH

0.8

100,000 5

500,000

SIDS

0.7

200,000 3.8

760,000

UB

0.72

NM

1.35

Number of
shares in the
portfolio

Market price

75,000 11.25
150,000 4.2

Market value
(#shares x
market price)

843,750
630,000
2,733,750

 

= 



500,000
760,000
843,750
630,000
+ 0.7
+ 0.72
+ 1.35
= 0.8742
= 0.8
2,733,750
2,733,750
2,733,750
2,733,750

How many index futures contracts?

Portfolio
Value
2,733,750
= 0.8742
= 35.87 
2665 25
Futures
level

Point
value

Underhedge or Overhedge?
1. Step 1: calculate beta
2. Step 2: forecast the
movement of the market
which is proxied by a
stock index
3. Step 3: forecast the
movement of the
portfolio using (1) and
(2)
4. Step 4
1. Expect the portfolio
value to increase:
underhedge
2. Expect the portfolio
value to decrease:
overhedge

Index
Beta < -1
Beta = -1
-1 < Beta < 0
0 < Beta < 1
Beta = 1
Beta > 1

Buy or Sell?
>0

M

M

Long futures

Long portfolio

Risky

M

M

Short futures

Long portfolio

OK

Buy or Sell?
<0

M

M

Long futures

Long portfolio

OK

M

M

Short futures

Long portfolio

Risky

June index: 2650. June futures: 2665. Bearish on the market.

September index: 2500. September futures: 2525.
Equity Market

Futures Market

June

Portfolio value $2,733,750

Expect the market to fall, positive beta so

expect portfolio to fall, so overhedge
Sell 36 SPI Futures @ 2665, expiration Sep
Get 2665*25*36= 2,398,500

September

Index changes from 2650 to 2500

2500/2650-1=-6%, index falls by 6%

Close out short position

Buy 36 SPI Futures @ 2525, expiration Sep
Pay 2,272,500

Beta = 0.8742 portfolio falls by

(0.8742 * 6%)
Portfolio value =
2,733,750*(1 - 6%*0.8742) =
2,598,476
Profit

Portfolio loss = 2,733,750 - 2,598,476

= 135,274

Net

135,274 - 126,000 = 9,274

Futures profit = 2,398,500 - 2,272,500 =

126,000

We make a loss on the portfolio, but the loss is partially offset by the gain in futures.
Without futures: loss 135,274 || With futures: loss 9,274

Summary of index futures

Get index level
Calculate futures level
Get individual Betas and market prices
Calculate portfolio Beta
Calculate hedge ratio (number of contracts)
Underhedge or overhedge?
Buy or sell futures?
Construct hedge strategy

3. Hedging Commodity Price risk with

Commodity Futures
A manufacturer wants to buy 20,000 kg of grade-A wool 3 months
later. The wool will be used to produce clothes.
Today price of grade-A wool: 760 cents / kg
The manufacturer already signed a contract to sell clothes at an
agreed price. They cannot increase the price of clothes they sell.
So they need to fix the cost of wool they will buy later.
The firm is exposed to the risk that price of grade-A wool may
increase 3 months later (higher than 760c/kg).
To hedge the price risk, the manufacturer goes to SFE, and finds
that SFE offers the following futures contract:
One contract is for 2,500 kg wool
Grade B wool
Futures price 650 cents / kg

The firm has to use the contract even when it does not perfectly
match their need.

3. Hedging Commodity Price risk with

Commodity Futures
Time

Cash/Physical Market

Futures Market

August

Do nothing
Grade-A Wool price 760 cents per kg
(20,000 kg = $152,000)

Buy 8 grade-B Wool Futures at 650 cents

per kg, expiration November
Value = 8 * 2500 * 650c = $130,000

November

Grade-A Wool price increases to 950

cents / kg.
Buy 20,000 kg Grade-A Wool at 950
cents.
Purchase price $190,000

Grade-B Wool futures price increases to

759 cents / kg.
Close long position by selling 8 grade-B
Wool Futures at 750 cents, expiration
November
Value $150,000

Outcome

Increased Cost = 190,000 - 152,000 =

$38,000

Futures Profit $20,000

Commodity Basis Risk arises: the firm has to use grade-B

wool futures to hedge their position of grade-A wool.
Risks: grade-A wool and grade-B wool futures may change
their prices differently. The hedge is not perfect.

Forwards vs. Futures

Forwards

Futures

Over
the counter
Forwards

Exchange-traded
Futures

Customizable

Standardized

Flexible

Less flexible

Lower basis risk

Higher basis risk

Usually not transferrable

Usually transferrable

Lower liquidity

Higher liquidity

Higher credit risk for buyers and sellers

Lower credit risk for buyers and sellers

Less regulation

More regulation

Lower price visibility

Higher price visibility (more people trade,

so it's easier to arrive at the "fair price")

No marking to market

Daily marking to market

Higher transaction cost

Cost of finding counter-party
Bid-ask spread from dealers

Lower transaction cost

Futures Advantages & Disadvantages

Advantages
Liquid
Lower credit risk
High price visibility
Low transaction cost

Disadvantages
Standardisation, less flexible
Maturity, quantity and grade
mismatches are common
Short-term hedge only
Margin Calls: introduce
uncertainty of cash flow and
potential higher transaction
costs

Appendix

Forwards and Futures price

Forward and futures prices are usually assumed to
be the same. When interest rates are uncertain they
are, in theory, slightly different:
A strong positive correlation between interest rates
and the asset price implies the futures price is
slightly higher than the forward price
A strong negative correlation implies the reverse

Bond Futures
We want to establish a hedge position in futures,
which matches the sensitivity of our physical bonds
Interest-sensitivity of Bonds means we must modify
the naive hedge ratio to hedge more accurately,
using:
Duration-modified hedge ratio

 
 .   

=

 
 .   

Volatility-modified hedge ratio

EXAMPLE:
At 1st of April, 1998:
CGS 10% 15.10.04
June 98 10Y Futures

Price
107.001
112.749

D*(approx)
4.982
8.95

How many contracts would a lender need to sell in order to hedge

$10,000,000 of the Oct 04?

107.001 4.98
=
= 0.528
112.749 8.95

Therefore we sell:

10
0.528
= 52.8 53 

100,000
(Note: we could substitute DVBP or convexity for Duration using this
approach.)

Currency Futures
An alternative to forward contracts
Exchange traded like all other futures contracts
Standardised wrt:
size
maturity
currency (terms currency always USD)

Long position in commodity currency also a short position

in terms currency

Currency Futures
Contract
AUD/USD
AUD/USD
AUD/USD
DEM/USD
JPY/USD
GBP/USD

Exchange
CME
IMM
SFE
SGX
SGX
SGX

Contract size
AUD 100,000
AUD 100,000
AUD 100,000
DEM 125,000
JPY 12,500,000
GBP 62,500

Currency Futures
Australian company expects to receive $1mio USD in three
months:
prevailing exchange rate AUD/USD 0.7000
AUD futures on CME trading at 0.6928
Brokerage $50 (USD) per contract

Expected AUD receipt $1,428,571 (@0.70)

Concerned that AUD will appreciate
Buy 14 AUD futures on CME @ 0.6928

Currency Futures
Cash Market

Futures Market

Now

Expected receipt of USD 1

million
Do nothing

Buy 14 March AUD/USD contracts at

market price of 0.6928
Cost = USD 969,920
Brokerage fee USD 700 (AUD 1000)

3 months

Receive USD 1 million

Convert at AUD/USD 0.8
Yielding AUD 1,250,000

Sell 14 March futures at 0.8005 = USD

1,127,000
Less purchase cost of USD 969,920
Profit USD 157,080
Convert at 0.8 to AUD196,350
Brokerage fee USD700 (AUD875)

Proceed

AUD 1,250,000

Futures profit AUD $196,350

Outcome: AUD 1,250,000 + 196,350 - 1,875 = AUD 1,444,475