economics_of_money_banking__financial_markets

The Globalization

of Financial

Futures Markets

Explaining the

Success of

Futures Markets

C H A P T E R 1 3 Financial Derivatives 317

Because American futures exchanges were the first to develop financial futures, they dominated the trading of financial futures in the early 1980s. For example, in 1985, all of the top ten futures contracts were traded on exchanges in the United States. With the rapid growth of financial futures markets and the resulting high profits made by the American exchanges, foreign exchanges saw a profit opportunity and began to enter this business. By the 1990s, Eurodollar contracts traded on the London International Financial Futures Exchange, Japanese government bond contracts and Euroyen contracts traded on the Tokyo Stock Exchange, French government bond contracts traded on the MarchŽ ˆ Terme International de France, and Nikkei 225 contracts traded on the Osaka Securities Exchange all became among the most widely traded futures contracts in the world.

Foreign competition has also spurred knockoffs of the most popular financial futures contracts initially developed in the United States. These contracts traded on foreign exchanges are virtually identical to those traded in the United States and have the advantage that they can be traded when the American exchanges are closed. The movement to 24-hour-a-day trading in financial futures has been further stimulated by the development of the Globex electronic trading system, which allows traders throughout the world to trade futures even when the exchanges are not officially open. Financial futures trading has thus become completely internationalized, and competition between U.S. and foreign exchanges will be intense in the future.

The tremendous success of the financial futures market in Treasury bonds is evident from the fact that the total open interest of Treasury bond contracts was over 393,000 on January 30, 2003, for a total value of over $39 billion (393,000 $100,000). There are several differences between financial futures and forward contracts and in the organization of their markets that help explain why financial futures markets like those for Treasury bonds have been so successful.

Several features of futures contracts were designed to overcome the liquidity problem inherent in forward contracts. The first feature is that, in contrast to forward contracts, the quantities delivered and the delivery dates of futures contracts are standardized, making it more likely that different parties can be matched up in the futures market, thereby increasing the liquidity of the market. In the case of the Treasury bond contract, the quantity delivered is $100,000 face value of bonds, and the delivery dates are set to be the last business day of March, June, September, and December. The second feature is that after the futures contract has been bought or sold, it can be traded (bought or sold) again at any time until the delivery date. In contrast, once a forward contract is agreed on, it typically cannot be traded. The third feature is that in a futures contract, not just one specific type of Treasury bond is deliverable on the delivery date, as in a forward contract. Instead, any Treasury bond that matures in more than 15 years and is not callable for 15 years is eligible for delivery. Allowing continuous trading also increases the liquidity of the futures market, as does the ability to deliver a range of Treasury bonds rather than one specific bond.

Another reason why futures contracts specify that more than one bond is eligible for delivery is to limit the possibility that someone might corner the market and ÒsqueezeÓ traders who have sold contracts. To corner the market, someone buys up all the deliverable securities so that investors with a short position cannot obtain from anyone else the securities that they contractually must deliver on the delivery date. As

Application

Hedging Foreign Exchange Risk with Forward Contracts

Hedging Foreign Exchange Risk

As we discussed in Chapter 1, foreign exchange rates have been highly volatile in recent years. The large fluctuations in exchange rates subject financial institutions and other businesses to significant foreign exchange risk because they generate substantial gains and losses. Luckily for financial institution managers, the financial derivatives discussed in this chapterÑ forward and financial futures contractsÑcan be used to hedge foreign exchange risk.

To understand how financial institution managers manage foreign exchange risk, letÕs suppose that in January, the First National BankÕs customer Frivolous Luxuries, Inc. is due a payment of 10 million euros in two months for $10 million worth of goods it has just sold in Germany. Frivolous Luxuries is concerned that if the value of the euro falls substantially from its current value of $1, the company might suffer a large loss because the 10 million euro payment will no longer be worth $10 million. So Sam, the CEO of Frivolous Luxuries, calls up his friend Mona, the manager of the First National Bank, and asks her to hedge this foreign exchange risk for his company. LetÕs see how the bank manager does this using forward and financial futures contracts.

Forward markets in foreign exchange have been highly developed by commercial banks and investment banking operations that engage in extensive foreign exchange trading and so are widely used to hedge foreign exchange risk. Mona knows that she can use this market to hedge the foreign exchange risk for Frivolous Luxuries. Such a hedge is quite straightforward for her to execute. Because the payment of euros in two months means that at that time Sam would hold a long position in euros, Mona knows that the basic principle of hedging indicates that she should offset this long position by a short position. Thus, she just enters a forward contract that obligates her to sell 10 million euros two months from now in exchange for dollars at the current forward rate of $1 per euro.4

In two months, when her customer receives the 10 million euros, the forward contract ensures that it is exchanged for dollars at an exchange rate of $1 per euro, thus yielding $10 million. No matter what happens to future exchange rates, Frivolous Luxuries will be guaranteed $10 million for the goods it sold in Germany. Mona calls up her friend Sam to let him know that his company is now protected from any foreign exchange movements, and he thanks her for her help.

4The forward exchange rate will probably differ slightly from the current spot rate of $1 per euro because the interest rates in Germany and the United States may not be equal. In that case, as we will see in Equation 2 in Chapter 19, the future expected exchange rate will not equal the current spot rate and neither will the forward rate. However, since interest differentials have typically been less than 6% at an annual rate (1% bimonthly), the expected appreciation or depreciation of the euro over a two-month period has always been less than 1%. Thus the forward rate is always close to the current spot rate, and so our assumption in the example that the forward rate and the spot rate are the same is a reasonable one.

320 P A R T I I I

Hedging Foreign Exchange Risk with Futures Contracts

Financial Institutions

As an alternative, Mona could have used the currency futures market to hedge the foreign exchange risk. In this case, she would see that the Chicago Mercantile Exchange has a euro contract with a contract amount of 125,000 euros and a price of $1 per euro. To do the hedge, Mona must sell euros as with the forward contract, to the tune of 10 million euros of the March futures. How many of the Chicago Mercantile Exchange March euro contracts must Mona sell in order to hedge the 10 million euro payment due in March?

Using Equation 1 with VA 10 million euros and VC 125,000 euros:

NC 10 million/125,000 40

Following the Financial News

Futures Options

The prices for financial futures options are published daily. In the Wall Street Journal, they are found in the section ÒFutures Options PricesÓ under the ÒInterest RateÓ heading. An excerpt from this listing is reproduced here.

INTEREST RATE

Est vol 78,455;

Wd vol 51,578 calls 17,896 puts

Op int Wed 252,705 calls 282,711 puts

Information for each contract is reported in columns, as follows. (The Chicago Board of TradeÕs option on its Treasury bonds futures contract is used as an example.)

Source: Wall Street Journal, February 14, 2003, p. C10.

Strike Price: Strike (exercise) price of each contract, which runs from 111 to 116

Calls-Settle: Premium (price) at settlement for call options on the Treasury bond futures expiring in the month listed, with each full point representing $1,000 and 64ths of a point listed to the right of the hyphen; at a strike price of 112, the March call optionÕs premium is 1 45/64, or $1,703.10 per contract

Puts-Settle: Premium (price) at settlement for put options on the Treasury bond futures expiring in the month listed, with each full point representing $1,000 and 64ths of a point listed to the right of the hyphen; at a strike price of 112, the March put optionÕs premium is 19/64, or $296.90 per contract

Profits and Losses on Option and Futures Contracts

To understand option contracts more fully, letÕs first examine the option on the same June Treasury bond futures contract that we looked at earlier in the chapter. Recall that if you buy this futures contract at a price of 115 (that is, $115,000), you have agreed to pay $115,000 for $100,000 face value of long-term Treasury bonds when they are delivered to you at the end of June. If you sold this futures contract at a price of 115, you agreed, in exchange for $115,000, to deliver $100,000 face value of the long-term Treasury bonds at the end of June. An option contract on the Treasury bond futures contract has several key features: (1) It has the same expiration date as the underlying futures contract, (2) it is an American option and so can be exercised at any time before the expiration date, and (3) the premium (price) of the option is quoted in points that are the same as in the futures contract, so each point corresponds to $1,000. If, for a premium of $2,000, you buy one call option contract on the June Treasury bond contract with an exercise price of 115, you have purchased the right to buy (call in) the June Treasury bond futures contract for a price of 115 ($115,000 per contract) at any time through the expiration date of this contract at the end of June. Similarly, when for $2,000 you buy a put option on the June Treasury bond contract with an exercise price of 115, you have the right to sell (put up) the June Treasury bond futures contract for a price of 115 ($115,000 per contract) at any time until the end of June.

Futures option contracts are somewhat complicated, so to explore how they work and how they can be used to hedge risk, letÕs first examine how profits and losses on the call option on the June Treasury bond futures contract occur. In February, our old friend Irving the Investor buys, for a $2,000 premium, a call option on the $100,000 June Treasury bond futures contract with a strike price of 115. (We assume that if Irving exercises the option, it is on the expiration date at the end of June and not before.) On the expiration date at the end of June, suppose that the underlying Treasury bond for the futures contract has a price of 110. Recall that on the expiration date, arbitrage forces the price of the futures contract to be the same as the price of the underlying bond, so it too has a price of 110 on the expiration date at the end of June. If Irving exercises the call option and buys the futures contract at an exercise price of 115, he will lose money by buying at 115 and selling at the lower market price of 110. Because Irving is smart, he will not exercise the option, but he will be out the $2,000 premium he paid. In such a situation, in which the price of the underlying financial instrument is below the exercise price, a call option is said to be Òout of the money.Ó At the price of 110 (less than the exercise price), Irving thus suffers a

(a)Profit or loss for buyer of call option and buyer of futures

(b)Profit or loss for buyer of put option and seller of futures