Book title: Understanding
Financial Markets & Instruments
A future is a derivative that is used to transfer the price risk of the underlying instrument from one party to another. A future is thus a contract between two parties whereby the one party (the buyer) agrees to buy an underlying asset from the other party to the contract on a specific future date, and at a price determined at the close of the contract.
The underlying asset can be a financial asset such as a bond, a currency such as US dollars, a commodity, etc. Because most futures are cash settled (which will be explained later in the text), almost anything with a determinable value can be used as an underlying asset to a futures contract.
A future is normally classified according to the underlying instrument. Where, for instance, two parties agree to buy and sell a specific quantity of rice (of a certain quality) at a certain price on a future date, the contract will be a commodity futures contract. Where two parties agree to buy and sell bonds, this will be known as a financial futures contract, and where two parties agree to buy and sell a certain amount of foreign currency, this is a currency futures contract.
A futures contract is thus
6.2 Futures contracts v. forward contracts
Futures contracts and forward contracts are similar in that they are both contracts to buy and sell an underlying instrument at a predetermined price on a future date. Future contracts between parties are closed with a futures exchange acting as intermediary, and are standardised in terms of the type and quality of the underlying asset, the terms of the contract and the delivery date, method of settlement and price determination.
Forward contracts, on the other hand, are closed between two parties independently from an exchange (OTC), and the terms are structured to suit the specific needs of the two parties.
The following is a comparison of some of the characteristics of forward contracts and futures contracts:
6.3 The working and trading of a futures contract
In a futures contract, both parties have an obligation,
Both the buyer and the seller can make a profit or suffer a loss, due to the fact that the contract price (at which the underlying instrument is bought and sold) is determined at closing of the contract. If the market price at the delivery date is lower than the futures contract price, the buyer suffers a loss because he could have bought the instrument in the market at a lower price. He is now obliged, according to the contract, to buy the underlying instrument at the higher price specified in the contract. the opposite applies when the market value of the underlying instrument is above the futures contract price. The buyer can now buy the underlying instrument at the lower contract price, and sell the instrument immediately at the higher market price, thus making an immediate profit.
6.3.1 An example of the working of a futures contract
Mr Kriek is a farmer in Northern Natal, and one of his specialities is potatoes. Mr Kriek has planted potatoes and he knows that they will be ready for sale and delivery in three months' time. Due to the good rains during the season, Mr Kriek expects to harvest three tons of potatoes. He also knows that the harvest countrywide will be a good one and is worried that he won't be able to sell all his potatoes, or that he will be forced to sell them at a discounted price and suffer a loss.
The Lion Food Company in Johannesburg produces potato chips. The company expects an influx of tourists to South Africa due to a reduction in the currency and the sporting events taking place during the summer. The company has budgeted a huge increase in production in three months' time, and is scared that there will not be sufficient potatoes available in the market, or that the demand would increase, thus pushing up prices.
Mr Kriek and the Lion Food Company close a contract whereby Mr Kriek undertakes to supply the company with three tons of potatoes in three months' time. The Lion Food company undertakes to buy three tons of potatoes from Mr Kriek at R1 000 per ton on delivery of the potatoes. The market price of potatoes at the closing of the contract is R950 per ton.
6.3.2 The effect of the contract and the market price
The market price of potatoes at the closing of the contract has no direct effect on the contract except that it acts as a guideline to the determination of the contract price (R1000).
At the date of delivery determined in the contract (called the close-out date), Mr Kriek has an obligation to supply three tons of potatoes and the Lion Food Company has an obligation to take delivery of the potatoes and pay Mr Kriek R3000 (R1 000 x 3).
If the market price of potatoes on the day of delivery (the close-out day of the contract) is R1050, the effect for the two parties will be as follows:
If Mr Kriek did not close the contract, he could have sold his potatoes in the market at R1 050 (assuming the demand is high enough). The effect of the contract is thus:
6.3.3 Settlement and delivery of a futures contract
Due to the fact that Mr Kriek lives in Northern Natal, and the Lion Food Company is in Johannesburg, there are further costs and the risks of transporting the potatoes to Johannesburg. Instead of physical delivery taking place, the parties agree to the following:
Mr Kriek will sell his potatoes in the market at the market price (saving him the hassle of delivery to Johannesburg), and will pay to (or receive from) the Lion Food Company the difference between the market value and the contract price.
The Lion Food company will buy potatoes at the market in Johannesburg, and will receive from Mr Kriek the difference between the market value and the contract price. The effect for the two parties is as follows:
This process is called cash settlement and has the same effect as physical delivery. Most of the futures in South Africa are cash settled.
A contract can thus be honoured by cash settlement, which would be the difference between the market value on close-out date and the contract price. This would also be the profit/loss to the buyer/seller. Because physical delivery does not take place, a futures contract can be entered (as seen previously) on almost anything with a determinable value, such as an index of prices.
6.3.4 Security measures of a futures contract
As seen in the above example, both the buyer and the seller can suffer a loss and be obliged to pay to the other party the cash settlement amount. The risk is thus that the party in a loss position cannot pay the amount owed to the other party at close-out of the contract. To ensure that both parties can honour payments at close-out, they agree to put an amount on deposit (in the case of futures, at an exchange) from which the settlement can be made at close-out, if necessary. This initial security deposit, in the case of South African futures, is determined by the South African Futures Exchange (SAFEX), paid to them by both parties at the closing of the contract, and is called an initial margin.
There is, however, the risk that the initial margin does not fully cover the loss suffered by one party, because of an adverse movement in market prices. To cover this risk, the futures contract further stipulates that the daily movement in market prices will be settled between the two parties (through an exchange), as if the contract has expired (closed out) every day. This process is called marking to market, which gives the effect of marking (valuing) the futures contract to its market value at the end of each day.
The example used in 3.1 is used here, with the following detail relating to the contract:
The initial margin placed with SAFEX on 1 February is R500 per contract. The cash flow effect of this contract would thus be as follows:
Both parties would place an initial margin of R1 500 (R500 x 3) with the exchange. The difference between the market price (R950) and the contract price (R1 000) must be settled between the two parties as if the contract was closed out at the end of the day (marking to market). The Lion Food Company thus pays Mr Kriek R150 ((R1 000 - R950) x 3).
The market price has now moved slightly in favour of the Lion Food Company compared to the previous day. If the contract was closed out today, the loss to the Lion Food Company would only have been R90 ((R1 000 - R970) x 3). Mr Kriek must thus pay back R60 (R150 - R90) to the Lion Food Company. This payment is equal to the movement in the market value times the amount of contracts ((R950 - R970) x 3) = 60.
The Lion Food Company pays Mr Kriek R120 ((R970 - R930) x 3).
The farmer pays the Lion Food company R240 ((R930 - R1 010) x 3).
This is the date of close-out. Two payments take place; the marking to market payment as for the previous days, and the initial margins to be paid back by the exchange. The marking to market payment will result in Mr Kriek paying R120 ((R1 010 - R1 050) x 3) to the Lion Food Company.
Each party will also receive back R1 500 initial margin from the exchange.
After these payments have taken place, the contract will be closed out.
In practice, each party will receive a statement in the morning from SAFEX of the previous days' movements in market values and the margins to be paid in or paid back (see appendix 11 for an example). This statement has to be settled immediately with SAFEX, who then receives money from one party and pays it over to the other party.
If we take the above scenario and work out the net cash flow of Mr Kriek, it will appear as follows:
The net cash flow for Mr Kriek is thus the same as if cash flow would have taken place on close-out date only as in 6.3.3.
The same cash flow table can be drawn up for the Lion Food Company, from which it can be seen that they would have made a profit of R150.
The following are examples of underlying instruments on which futures contracts are available on SAFEX (see appendix 10 for contract details):
Trading on SAFEX is totally electronic and on-line via the ATS system, and no telephone conversations have to take place. Electronic funds transfer procedures are used for settlement and no physical contracts are issued. A statement of positions and cash flows is supplied daily to each member.
6.3.5 The gearing effect
Only a small initial margin is required relative to the value of the underlying instrument. In the case where an investor invests in an all-share index futures contract, the initial margin that has to be lodged with SAFEX is R3 250 (February 1996). The exposure of one contract is equal to the index times R10. Thus, if the index is 6 400 (November 1997), the exposure of one contract is R64 000. Contracts are traded in multiples of 10 contracts. The investor investing in 10 contracts would thus pay an initial margin of R32 500, and have an exposure equal to a physical investment of R640 000 on the JSE in the shares representing the all-share index.
6.3.6 The pricing of futures contracts
Theoretically, the trading price of a futures contract should be equal to the current market value of the underlying instrument plus interest on this value for the period up to close-out of the contract. For instance, there is a future available on 10 ounces of gold on 1 January and the following relates:
The market price of 10 ounces of gold on 1 January is R1 000.
The futures contract price on 10 ounces of gold, with a close-out of 31 December (thus one year to settlement) is R1160.
The following would be applicable:
If the short-term borrowing rate was 15%, an arbitrageur (a trader who makes money out of differences in separate markets) could borrow R1 000 at 15% for one year. He would then buy the gold immediately at R1 000 and sell a futures contract at R1 160.
On 31 December, he would deliver the gold (as seller in the futures contract) he has bought and will receive R1 160 for the gold according to the futures contract. (Cash settlement would result in the same situation, as can be seen in 6.3.3, assuming that he can sell the gold in the market at market value.) He would then have to pay back his loan, and in total he would have to pay back R1 150 (R1000 + 15% interest for a year). Without taking risks, the arbitrageur would have made a profit of R10 on his transactions.
Theoretically, the value of a futures contract should thus be equal to the following:
FV = SP + (SP x i x d/365) (for simple interest as in above example)
FV = SP(1 + 1)^(d/365) (for compound interest)
FV = theoretical value of the futures contract expiring in d days
SP = current spot value of the underlying instrument
i = short-term borrowing rate
d = number of days left to close-out of the contract.
In the above example with a simple interest rate of 15% the theoretical value should be:
FV = 1 000 + (1 000 x 15% x 365/365)
FV = R1 150.
Where income is received on the underlying instrument, such as interest on a bond or dividends on shares, the future value of the income stream must be subtracted from the above calculation to arrive at the theoretical fair value. This is because the income stream can be invested and applied to repay the interest on the amount loaned to purchase the underlying instrument.
This calculation of the fair value of futures contracts is, however, a theoretical exercise to determine, among other things, the possibility of arbitrage opportunities. The actual market price is determined by supply and demand as is the case with other market products. The differences in carrying costs are the main determinants that lead to differences in fair values and market prices of futures.
The bid price by buyers and the offer price by sellers determine the final price at which futures are bought and sold.