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Trading and Capital-Markets Activities Manual

Instrument Profiles: Financial Futures
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Futures contracts are exchange-traded agreements for delivery of a specified amount and quality of a particular product at a specified price on a specified date. Futures contracts are essentially exchange-traded forward contracts with standardized terms. Futures exchanges establish standardized terms for futures contracts so that buyers and sellers only have to agree on price. 

Unlike the over-the-counter (OTC) derivative markets, futures contracts are required by U.S. law to trade on federally licensed contract markets that are regulated by the Commodity Futures Trading Commission (CFTC). Banks may invest in futures for their own account or act as a futures broker through a futures commission merchant (FCM) subsidiary. The two generic types of futures contracts are commodity futures (such as coffee, cocoa, grain, or rubber) and financial futures (that is, currencies, interest rates, and stock indexes). This section focuses on financial futures. 

CHARACTERISTICS AND FEATURES 

Terms 

All futures contracts have the following standardized terms: specific product, quality (or grade), contract size, pricing convention, and delivery date. The following is an example of the terms on a futures contract for U.S. Treasury notes traded on an exchange such as the Chicago Board of Trade (CBOT). 

Product:                         10-year Treasury notes 
Contract size:                $100,000 
Price quoted:                 32nds of 100 percent 
Delivery date:                 Any business day of delivery month (March, June,    
                                    September, or December, depending on the particular contract) 
Deliverable grade:          Any U.S. Treasury notes with maturity of 612 to 10 years 

Margin 

In addition, all exchanges require a good faith deposit or margin in order to buy or sell a futures contract. The amount of margin will vary from contract to contract and from exchange to exchange. The required margin deposit may also vary depending on the type of position held. The margin requirement is meant to ensure that adequate funds are available to cover losses in the event of adverse price changes. Margin requirements are determined and administered by the exchange's clearinghouse. 

As an example of how margin requirements operate, consider a deutschemark (DM) 125,000 futures contract against the dollar with a price of $.68/DM. One trader takes a long DM position, meaning that it will receive DM 125,000 and pay $85,000 in December. Another trader takes a short DM position, such that it will pay the DM 125,000 in return for $85,000. Each trader puts up an initial margin of $4,250, which is invested in U.S. Treasuries in margin accounts held at each trader's broker. Time passes and the $/DM rate increases (the DM decreases in value) so that the trader with the long DM position must post additional margin. When the spot rate subsequently reaches $.61/DM, the long trader decides to cut his losses and close out his position. Ignoring the limited effect of prior fluctuations in margin, the long trader's cumulative loss measures $8,750 ($.68/DM - $.61/DM) -  DM 125,000). 

Exchanges 

Futures contracts are traded on organized exchanges around the world. Exchanges for the major futures contracts in currencies, interest rates, and stock indexes are discussed below. 

Currency Futures 

In the United States, futures contracts trade in the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME) in the major currencies, including the deutschemark, Japanese yen, British pound, Canadian dollar, and Swiss franc. Overseas, the most active currency futures exchanges are the London International Financial Futures Exchange (LIFFE) and the Singapore International Monetary Exchange (SIMEX). 

Interest-Rate Futures 

The IMM and the CBOT list most of the fixed-income futures in the United States. Contracts on longer-term instruments, such as Treasury notes (2-, 5-, and 10-year) and Treasury bonds (30-year), are listed on the CBOT. Futures on short-term instruments such as Eurodollar deposits and Treasury bills trade on the IMM. There are also futures on bond indexes such as those for municipal bonds, corporate bonds, Japanese government bonds, and British gilts. As with currencies, the most active overseas exchanges are in London and Singapore. 

Stock-Index Futures 

In the United States, stock-index futures are available for the S&P 500 (CME), Major Market Index (CME), New York Stock Exchange Composite Index (New York Futures Exchange), and Nikkei 225 Index (CME). Overseas, there are futures on many of the major equity markets, including the Nikkei (Osaka and Singapore Futures Exchanges), DAX (LIFFE), and FTSE 100 (LIFFE). 

Clearinghouses 

Clearinghouses provide centralized, multilateral netting of an exchange's futures contracts. Centralized clearing, margin requirements, and daily settlement of futures contracts substantially reduce counterparty credit risk. A futures exchange operates in tandem with a clearinghouse that interposes itself between a contract's counterparties and, thus, guarantees payment to each. 

In addition, customers in futures markets post collateral, known as initial margin, to guarantee their performance on the obligation. At the end of each day, the futures position is marked to market with gains paid to or losses deducted from (variation margin payments) the margin account. The balance in a margin account cannot fall below a minimum level (known as maintenance margin). If the position falls below the maintenance margin, the counterparty must put up additional collateral. 

Under some circumstances, traders that have positions in a variety of futures and options on futures can have their margin determined on a portfolio basis. This process takes into account the natural offsets from combinations of positions which may reduce the total margin required of a market participant. The industry has developed a scenario-based portfolio margining system called SPARTM which stands for the Standard Portfolio Analysis of Risk. 

Many futures contracts specify settlement in cash, rather than by physical delivery, upon expiration of the contract. Cash settlement has the advantage of eliminating the transaction costs of purchasing and delivering the underlying instruments. Examples of cash-settled contracts are futures on Eurodollars, municipal bond indexes, and equity indexes. 

USES 

Market participants use futures to (1) hedge market risks, (2) arbitrage price discrepancies within and between markets, (3) take positions on future market movements, and (4) profit by acting as market makers (forwards) or brokers (futures). Financial institutions, money managers, corporations, and traders use these instruments for managing interest-rate, currency, commodity, and equity risks. While most large financial institutions are active in the interest-rate and foreign-exchange markets, only a handful of financial institutions have exposures in commodities or equities. 

Hedging 

Futures are used to hedge the market risk of an underlying instrument. For example, financial institutions often face interest-rate risk from borrowing short-term and lending long-term. If rates rise, the institution's spread will decrease or even become negative. The institution can hedge this risk by shorting a futures contract on a fixed-income instrument (such as a Treasury security) maEagle Tradersg at the same time as the asset. If rates rise, the futures position will increase in value, providing profit to offset the decrease in net interest spread on the cash position. If rates fall, however, the value of the futures contract will fall, offsetting the increase in the institution's interest-rate spread. 

Arbitrage 

Risk-free arbitrage opportunities in which a trader can exploit mis-pricing across related markets to lock in a profit are rare. For brief periods of time, pricing in the futures market may be inconsistent with pricing in the cash market. For example, if DM futures are overpriced relative to the rates implied by interest-rate parity relationships, a trader could borrow dollars, sell them against spot DM, purchase a DM deposit, and sell the DM future. This arrangement would lock in a risk-free return. 

Positioning 

Traders and investors can use futures for speculating on price movements in various markets. Futures have the advantage of lower transactions costs and greater leverage than many cash-market positions. Speculators may make bets on changes in futures prices by having uncovered long or short positions, combinations of long and short positions, combinations of various maturities, or cash and futures positions. Speculators may profit from uneven shifts in the yield curve, fluctuations in exchange rates, or changes in interest-rate differentials. 

For example, a speculator expecting stock prices to increase buys 10 contracts on the S&P 500 index for March delivery at a price of $420. Each contract covers 500 times the price of the index, thereby giving the speculator immediate control of over $2.1 million (420 - 500 - 10) of stock. By February, the index increases to 440, giving the speculator an unrealized profit of $100,000 ((440 - 420) - 500 - 10). The market is still bullish, so the speculator decides to hold the contract for several more weeks, anticipating more profits. Instead, negative economic news drives the index down to 405 and induces the speculator to close out his position, leaving a loss of $75,000. 

Money managers use financial futures as an asset-allocation tool. Futures allow managers to shift the fixed-income, currency, and equity portions of their portfolios without having to incur the costs of transacting in the cash market. A fixed-income manager may use bond futures to readjust the composition of a fixed-income portfolio in response to a particular outlook on interest rates. For example, a manager anticipating an increase in interest rates can shorten portfolio duration to reduce the risk of loss by selling Treasury bond or bill futures. Currency futures could be used to reduce or increase currency risk in an international portfolio. Equity index futures can be used to adjust a portfolio's exposure to the stock market.

Market Making or Brokering 

A financial institution can also attempt to profit by holding itself out as a market maker or broker, providing two-way prices (bid and offer) to the market. While earning the bid offer spread, the institution will either hedge the resulting positions or choose to hold the position to speculate on expected price movements. 

DESCRIPTION OF MARKETPLACE 

The combination of contract standardization, centralized clearing, and limited credit risk promotes trading of futures on exchanges such as the CBOT, CME, and LIFFE. In the United States, futures exchanges traditionally use the open outcry's method of trading, whereby traders and floor brokers, standing in pits on the trading floor, shout out or use hand signals to indicate their buy and sell orders and prices. Technological innovation and the desire for after-hours trading have fostered the development of electronic trading systems. These systems have become quite popular overseas, especially on newer exchanges. For example, GLOBEX is an electronic trading system that currently provides after-hours trading of contracts listed on the CME and the MATIF (Marche a Terme International de France) in Paris. The LIFFE after-hours trade-matching system is called APT, and the CBOT system is called Project A. In addition to these electronic trading systems, several exchanges have extended trading hours through exchange linkages. The oldest and most well-known linkage is the mutual offset system between the CME and the SIMEX for Eurodollar futures contracts. SIMEX has similar arrangements with the International Petroleum Exchange (IPE). LIFFE has announced plans for futures linkages with the CBOT and the CME. 

Customers submit their buy or sell orders through registered commodity brokers known as FCMs. Several large domestic and foreign banks and bank holding companies have established their own FCM subsidiaries. Most of these subsidiaries are also clearing members of the major commodity exchange clearinghouses and have an established floor staff working on the clearinghouse's associated futures exchange. Institutional customers often place their orders directly with the FCM's phone clerks on the exchange floor. The clerk signals the order to a pit broker (usually an independent contractor of the FCM). The pit broker completes the transaction with another member of the exchange and then signals a confirmation back to the phone clerk who verbally relates the trade information back to the customer. The trade is then processed by the FCM for trade matching, clearing, and settlement. An FCM's back-office clerks usually recap the customer's transactions at the end of day with the customer's back-office staff. Paper confirmation is mailed out the following day; however, on-line confirmation capability is becoming increasingly common. 

PRICING 

As with forward rates, futures prices are derived from arbitrage-free relationships with spot prices, taking into account carrying costs for corresponding cash-market goods. With commodities, carrying costs include storage, insurance, transportation, and financing costs. The cost-of-carry for financial instruments consists mostly of financing costs, though it may also include some fixed costs such as custody fees. The cost-of-carry concept when referred to in the context of futures contracts is known as the basis (that is, the difference between the cash price for a commodity or instrument and its corresponding futures price). 

In the case of fixed-income, interest-rate futures, the cost-of-carry represents the difference between the risk-free, short-term interest rate and the yield on the underlying instrument. The price of a fixed-income future can be expressed by the formula: 

F = P + [P  x  (r - y)], 

where F is the futures price, P is the cash price of the deliverable security, r is the short-term collateralized borrowing rate (or repo rate), and y is any coupon interest paid on the security divided by P. To understand the relationship between spot and futures prices, imagine an investor who borrows at the repo rate, takes a long position in the underlying bond, and sells a bond future. At the maturity of the futures contract, the investor can deliver the bond to satisfy the futures contact and use the cash proceeds from the short futures position to repay the borrowing. In competitive markets, the futures price will be such that the transaction does not produce arbitrage profits. 

For foreign-exchange futures, the cost-of-carry can be derived from the differential between the interest rates of the domestic and foreign currencies. When foreign interest rates exceed domestic rates, the cost-of-carry is negative. The spread that could be earned on the difference between a short domestic position and a long foreign position would subsidize the combined positions. For the no-arbitrage condition to hold, therefore, a comparable futures position (domestic per foreign) must cost less than the cash (spot) position. 

HEDGING 

Hedge Ratio 

The hedge ratio is used to calculate the number of contracts required to offset the interest-rate risk of an underlying instrument. The hedge ratio is normally constructed by determining the price sensitivity of the hedged item and the price sensitivity of the futures contract. A ratio of these price sensitivities is then formulated to determine the number of futures contracts needed to match the price sensitivity of the underlying instrument.

Interest-Rate Exposure 

Financial institutions use futures to manage the risk of their assets and liabilities, as well as off-balance-sheet exposures. Asset/liability management may involve the use of futures to lock in spreads between borrowing and lending rates. For example, a financial institution may sell Eurodollar futures in advance of an anticipated funding to lock in the cost of funds. If LIBOR subsequently increases, the short futures position will increase in value, offsetting the higher spot interest cost that the financial institution will have to pay on its funding. 

These contracts may be used to hedge investment portfolios against yield-curve shifts. Financial institutions can hedge mortgage portfolios by selling futures contracts (or GNMA forwards), and government bond dealers may sell Treasury futures to hedge their inventory. Pension and other types of benefits managers may hedge a fixed future liability by selling futures, or they may hedge an expected receipt by buying futures. 

Interest-rate swap dealers use futures (or forwards) to hedge their exposures because directly offsetting swaps with the necessary terms cannot be found easily. The dealers rely on Eurodollar futures, Treasury futures, and floating-rate agreements (a type of interest-rate forward) to hedge their unmatched commitments. For example, a dealer obligated to pay LIBOR may sell Eurodollar futures to protect itself against an increase in interest rates. 

Foreign-Exchange Exposure 

Corporations engaged in international trade may use foreign-currency contracts to hedge payments and receipts denominated in foreign currencies. For example, a U.S. corporation that exports to Germany and expects payment in DM could sell DM futures (or forwards) to eliminate the risk of lower DM spot rates at the time that the payment arrives. A corporation may also use foreign-exchange contracts to hedge the translation of its foreign earnings for presentation in its financial statements. 

Financial institutions use foreign-exchange futures (or forwards) to hedge positions arising from their businesses dealing in foreign exchange. An institution that incurs foreign-exchange exposure from assisting its customers with currency risk management can use offsetting contracts to reduce its own exposure. A financial institution can also use futures (or forwards) to cover unmatched currency swaps. For example, a dealer obligated to make a series of DM payments could buy a series of DM futures (or forwards) to reduce its exposure to changes in the DM/$ exchange rate. 

RISKS 

Users and brokers of futures face various risks, which must be well understood and carefully managed. The risk-management methods applied to futures (or forwards) may be similar to those used for other derivative products. 

Credit Risk 

Unlike OTC derivative contracts, the credit risk associated with a futures contract is minimal. The credit risk in futures is less because the clearinghouse acts as the counterparty to all transactions on a given exchange. An exchange's clearinghouse may be a division of the exchange, as in the case of the CME, or may be a separately owned and operated entity, such as the Chicago Board of Trade Clearing Corporation (BOTCC) or the London Clearing House (LCH). 

In addition to the credit protection a futures clearinghouse receives from prospective (initial) margin and the daily contract revaluations and settlement (marking to market), a clearinghouse is usually supported by loss sharing arrangements with its clearing member firms. These loss-sharing provisions may take the form of limited liability guarantees ("pass the-hat rules" (BOTCC, LCH)) or unlimited liability guarantees ("good-to-the-last-drop rules" (CME, NYMEX, SIMEX)). Because of these safeguards, no customer has lost money due to default on a U.S. futures exchange. In addition, customer-account segregation significantly reduces the risk a customer faces with regard to excess margin funds on deposit with its FCM. Segregation is required for U.S. futures brokers but is less common overseas. However, even with customer-account segregation, FCM customers are exposed to the performance of the FCM's other customers. Unlike a U.S. broker-dealer securities account, the futures industry does not have a customer insurance scheme such as the Securities Investor Protection Corporation (SIPC). The exchanges and their clearinghouses often maintain small customer-guarantee funds, but disbursement from these funds is discretionary. 

Finally, clearinghouses maintain their margin funds in their accounts at their respective settlement banks. These accounts are not unique and carry the same credit risks as other demand deposit accounts at the bank. For this reason, the European Capital Adequacy Directive assigns futures and options margins a 20 percent risk-based capital treatment. 

Market Risk 

Because futures are often used to offset the market risk of other positions, the risk of these contracts should be evaluated by their effect on the market risk of the overall portfolio. Institutions that leave positions in the portfolio un-hedged may be more exposed to market risk than institutions that run a matched book.  A financial institution may choose to leave a portion of its exposure uncovered to benefit from expected price changes in the market. If the market moves against the institution's prediction, the institution would incur losses. 

Basis Risk 

Basis risk is the potential for loss from changes in the price or yield differential between instruments in two markets. Although risk from changes in the basis tends to be less than that arising from absolute price movements, it can sometimes represent a substantial source of risk. 

With futures, basis may be defined as the price difference between the cash market and a futures contract. As a contract matures, the basis fluctuates and gradually decreases until the delivery date, when it equals zero as the futures price and the cash price converge. Basis on interest-rate futures can vary due to changes in the shape of the yield curve, which affects the financing rate for holding the deliverable security before delivery. In foreign currency, basis risk arises from changes in the differential between interest rates of two currencies. 

Investors may set up hedges with futures, which leave them vulnerable to changes in basis between the hedge and the hedged instrument. For example, Treasury note futures could be sold short to hedge the value of a medium-term fixed-rate corporate loan. If market forces cause credit spreads to increase, the change in value of the hedge may not fully offset the change in value of the corporate bond. 

Yield-curve risk may also arise by holding long and short positions with equal durations but different maturities. Although such arrangements may protect against a parallel yield-curve shift, they may leave investors exposed to the risk of a nonparallel shift causing uneven price changes. 

Liquidity Risk 

Because of the multilateral netting ability of a futures clearinghouse, futures markets are generally more liquid than their equivalent OTC derivative contracts. However, experience varies with each product and market. In the futures markets, most liquidity is found in near-term contracts and can be rather thin in the more distant contracts. 

Clearing and Settlement Risk 

In OTC markets, clearing and settlement occurs on a bilateral basis, exposing counterparties to intraday and overnight credit risks. To reduce these risks as well as transactions costs, many financial institutions have bilateral netting arrangements with their major counterparties. Position netting allows counterparties to net their payments on a given day, but does not discharge their original legal obligations for the gross amounts. Netting by novation replaces obligations under individual contracts with a single new obligation. 

ACCOUNTING TREATMENT 

The accounting treatment for foreign-currency futures contracts is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivatives and Hedging Activities." (See section 2120.1, "Accounting," for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

The credit-equivalent amount of a financial futures contract is calculated by summing -
 
 1. the mark-to-market value (positive values only) of the contract and 
 2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are below.

                                               Credit-Conversion  
Remaining Maturity                        Factor 
One year or less                              0.00% 
Five years or less                            0.50% 
Greater than five years                     1.50% 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, "Capital Adequacy.") 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

Banks may invest in any futures contract. However, in taking delivery of non-financial products, the bank may need to place the physical commodity in other real estate owned (OREO). In addition, the bank may not engage in the buying and selling of physical commodities or hold itself out as a dealer or merchant in physical commodities. 

REFERENCES 

Fabozzi, Frank, and Dessa. The Handbook of Fixed Income Securities. 4th ed. Irwin Professional Publishing, 1995. 
Kolb, Robert. Inside the Futures Markets. Kolb Publishing Co. 1991. 
Stigum, Marcia. The Money Market. 3rd ed. Dow Jones-Irwin, 1990.  

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