Viney8e IRM ch19

Financial Institutions, Instruments and Markets
8th edition
Instructor's Resources Manual
Christopher Viney and Peter Phillips

Chapter 19
Futures contracts and forward rate agreements
Learning objective 1: Consider the nature and purpose of derivative products and the use of a
futures contract to hedge a specific risk exposure
•

A derivative is a risk management product that derives its value from an underlying commodity
or financial instrument.

•

A futures contract is a derivative product that may be used to manage risk exposures to interest
rates, exchange rates, share prices and commodity prices.

•

The risk management function of a derivatives -based strategy is to lock-in a price today that will
apply at a future date.

•

A futures contract is an agreement between two parties to buy, or sell, a specified commodity or
financial instrument at a specified date in the future, at a price that is determined today.

•

The contracts are standardised by the contract size, the underlying commodity and delivery
dates.

•

Basic futures strategy rule: conduct a transaction in the futures market today that corresponds
with the proposed physical market transaction due at a later date.

•

For example, if a risk manager intends to buy at a later date in the share market, then they would
buy a share -based futures contract today. The open position is closed-out at the maturity date.

Learning objective 2: Discuss the main features of a futures transaction, including orders and
agreement to trade, calculations, margin requirements, closing out a contract and contract
delivery
1


•

Futures contracts are standardised exchange-traded contracts available on futures exchanges such
as the Chicago Board of Trade (USA) or ASX Trade 24 (Australia).

•

Each exchange offers a set of futures contracts which are often based on underlying commodities
and financial instruments available in the local physical or spot markets.

•

Most exchanges use electronic trading, although some open -outcry exchanges still operate.

•

Buy or sell orders are placed through a broker.

•

ASX Trade 24 quotes bond and bill futures contracts at an index of 100 minus the yield; for
example, a Treasury bond futures contract yielding 7.00 per cent is quoted at 93.000.

•

Transactions are conducted through the exchange’s clearing house.

•

An initial margin payment is paid to the clearing house.

•

Contracts are marked-to-market each day. Maintenance margin calls may be required.

•

An open position is closed out by buying or selling an identical contract, but opposite to the
initial futures contract.

•

The exchange will specify if settlement is by standard delivery or by cash payment.

•

By conducting two transactions—buy and sell—the party will make either a profit or a loss on
those transactions.

•

If the intent of the hedging strategy was to protect against a rise in prices, the positive correlation
between the futures market and the physical market will ensure that if prices in the physical
market rise a profit will be made with the futures market transactions. This profit can then be
used to offset the increased cost associated with the price rise in the physical market.

Learning objective 3: Review the types of futures contracts offered through a futures exchange
•

Futures contracts develop in markets in which an underlying asset is freely traded, the asset is
easily standardised, but may experience price volatility from time to time, and the product is
readily available or cash settlement is possible.

•

Contracts tend to vary between international futures exchanges; contracts are often based on
local commodities and financial instruments.

•

Commodity futures contracts include gold, wool and frozen orange juice, and financial futures

contracts include bonds, discount securities, currencies, shares and share indices.

Learning objective 4: Identify the participants in the futures market, including hedgers,
speculators, traders and arbitrageurs, and explain why they use futures contracts
2


•

Hedgers use the futures market to manage identified risk exposures; for example, if a borrower is
exposed to an increase in interest rates, they may sell a futures contract to hedge that risk
exposure.

•

Speculators buy and sell futures contracts to try and make a profit on price movements; for
example, a speculator might anticipate a rise in a share price and take a long position in futures
to try and make a profit. Speculators increase price efficiency and liquidity in the futures market.

•

Traders conduct transactions on their own account or for clients. They tend to conduct a large
number of very short-term trades with the intention of making small margins on each trade.

•

Arbitrageurs try to make profits by conducting simultaneous transactions to take advantage of
any price differentials that might appear between markets.

Learning objective 5: Show how financial futures contracts may be used to hedge price risks,

including a borrowing hedge, an investment hedge, an FX hedge and a share portfolio hedge
•

The basis of a hedging strategy is to open a futures position today that corresponds with the
transaction to be carried out in the physical or spot market at a later date.

•

With a borrowing hedge, the risk manager will sell relevant futures contracts today. At a later
date it will close-out its futures market position by buying an identical futures contract. The
profit or loss made on the futures transactions will offset the net cost of borrowing.

•

Similarly, with an investment hedge, the hedger will buy a futures contract today, and then close
out the position at the maturity date.

•

Exposures to FX risk can also be hedged by either buying or selling a futures contract in the
required foreign currency.

•

Share portfolio risk can also be hedged by buying or selling futures contracts based on specific
listed companies, or on a range of share -market indices.

Learning objective 6: Identify risks associated with using a futures contract hedging strategy,
including standard contract size, margin payments, basis risk and cross-commodity hedging
•

While futures contracts are useful in hedging, it is important to recognise that a perfect hedge
may not be possible. Where the dollar value of a risk exposure is not perfectly matched by the
standardised dollar value of the futures contract, a small risk exposure will remain.

•

A more significant risk arises from the fact that price movements in the physical market may not
be perfectly matched by price movements in the futures market. The difference in prices between
the two markets is referred to as basis risk. Initial basis risk may occur at the implementation of
3


the futures hedging strategy, while final basis risk may occur when the futures position is closed
out and the related physical market transaction takes place.
•

Cross-commodity risk arises when, due to the limited range of futures contracts, the hedger uses
a futures contract based on an underlying financial instrument that is different from the security
associated with the risk exposure that needs to be managed. For example, a borrower may need
to use a 90-day bank-accepted bill futures contract to hedge an exposure to changes in the yield
on commercial paper in the money markets.

Learning objective 7: Describe, illustrate and calculate the use of a forward rate agreement
(FRA) for hedging interest rate risk
•

A forward rate agreement (FRA) is an over-the-counter contract.

•

Unlike futures contracts, FRAs do not have a standard contract size or delivery date; nor are
margin calls a feature of the FRA market.

•

A borrower or investor can use an FRA to lock in an interest rate on a specified date, based on a
specified notional principal amount.

•

As with the futures contract, the FRA is not a product that facilitates the borrowing or investing
of funds, but rather is a risk management tool.

•

At the start of the contract, the FRA specifies a fixed FRA agreed rate that will apply on either
three-month money or six-month money at a future date.

•

The FRA agreed rate will be compared with a nominated reference rate to determine the
compensation amount payable on the settlement date, and which party will make that payment.

•

The reference rate may be LIBOR, USCP or the BBSW.

•

At the settlement date, one party to the FRA will compensate the other party for any movement
in interest rates between the FRA agreed rate and the reference rate.

•

In a borrowing hedge, the writer of the FRA will compensate the buyer if the reference rate is
higher than the agreed rate. The compensation received will offset the current higher cost of
borrowing in the physical debt market.

•

The compensation amount is calculated using the discount security formula.

Essay questions
The following suggested answers incorporate the main points that should be recognised by a student.
An instructor should advise students of the depth of analysis and discussion that is required for a
particular question. For example, an undergraduate student may only be required to briefly introduce
4


points, explain in their own words and provide an example. On the other hand, a post-graduate
student may be required to provide much greater depth of analysis and discussion.
1. An agricultural machinery supplier is exposed to a variety of risks, including the prices of
agricultural commodities such as wheat, sorghum and barley. When prices of these
commodities increase (decrease) demand for its machinery products increases (decreases).
From the perspective of a risk manager, explain how the agricultural machinery supplier can
use derivative products to hedge against adverse developments in the physical markets. (LO
19.1)
•

A derivative is a financial product that is designed essentially to manage specific risk exposures.
As a financial instrument a derivative has a price.

•

Derivative contracts are offered in the major international financial markets. Derivatives enable
the management of risks associated with interest rates, equity, commodities and foreign
currencies.

•

The trading in derivatives for the purpose of risk management allows the transfer of risk to
another party, such as an individual, corporation, financial institution or speculator, that holds a
different view on the direction, or extent, of future price changes, or faces a risk exposure that is
the opposite of the one faced by the first party.

•

In the case of an agricultural machinery supplier exposed to fluctuations in the prices of
agricultural commodities, derivatives products may be an important part of an overall risk
management strategy.

•

Primarily, the firm is exposed to the risk that physical market prices, the prices of wheat and
other commodities, will fall and, consequently, reduce the demand for its machinery products in
subsequent seasons.

•

The firm can hedge against this risk by taking positions in commodities futures markets. The
company would enter short positions.

•

If the prices in the physical markets fall because of oversupply or any other factor, the short
futures position will become more valuable. This would offset some of the losses that the
company might experience as a result of decreased demand for its products.

•

Of course, the company should be able to design a very specific risk management strategy based
on estimates of the sensitivity of demand for its machinery products and the prices of
commodities.

5


2. Define a futures contract. Describe the basic principles behind the use of futures contracts to
manage risk exposures. (LO 19.2)
•

A futures contract is a legally binding contract between two parties to buy or sell a specified
commodity or financial instrument at a specified future date at a price determined today.

•

Futures contracts are essentially designed to allow the management of certain risks attached to
commodities and financial instruments.

•

Speculators also buy and sell futures contracts to benefit from price movements. Speculators
provide liquidity in the market.

•

The price of a futures contract derives from the underlying physical market item; for example,
the price of a gold futures contract is based on the price of gold in the physical market. If the
price of gold changes then the price of the associated futures contract will also change.

•

From the risk management perspective, if the price of gold increases in the physical market, the
value of the underlying gold futures contract will fall. The two price changes offset each other
thus removing the risk of price uncertainty.

•

Futures exchanges tend to offer their own set of futures contracts. This provides an enormous
range of contracts to manage risk.

•

Within the Australian market short-term, medium-term and longer-term interest rates can be
hedged using the 90-day bank accepted bills contract, the three-year Commonwealth Treasury
bond contract, or the ten-year Commonwealth Treasury bond contract, respectively.

3. For investors and borrowers considering setting up a risk management strategy using
futures contracts, there is a basic rule that determines the timing of the various buy/sell

transactions. Specify and explain this rule, giving examples from an investor’s and a
borrower’s viewpoint. (LO 19.2)
•

The basic rule to be followed in establishing a hedging strategy is to conduct a transaction in the
futures market today that corresponds with what you intend to do in the physical market at a later
date.

•

If a borrower plans to sell its paper (for example, bills or corporate bonds) to raise funds, then it
will sell a futures contract today to cover the interest rate risk exposure when it actually issues
the paper. The hedger will close-out the open futures position by buying an identical futures
contract when it issues the paper.

•

If an investor plans to buy some shares when surplus funds become available but is concerned
the share price will rise in the meantime, the investor can buy futures contracts today. The open
6


position will be closed-out when the actual shares are bought by selling a corresponding futures
contract.
4. (a) Outline the procedure involved in buying a futures contract.
•

Futures contracts are traded on formal exchanges, such as the SFE.

•

A market order will be placed with a broker to buy or sell a particular contract.

•

Transactions are conducted by open outcry on the exchange floor (for example, CBOT) or on the
exchange’s electronic trading platform (for example, SFE).

•

The majority of exchanges now use electronic trading systems, however the largest exchanges
(CBOT and CME) use open outcry.

•

The electronic trading system automatically matches buy and sell orders.

•

Details of the transaction are recorded by the SFE clearing-house.

•

The clearing-house guarantees transactions through processes of novation and margin calls.

•

Novation—an agreement to replace one party to a contract with another party.

•

The full futures contract price is not paid; rather an initial margin is deposited with the clearinghouse.

•

The margin is sufficient to cover immediate adverse movements in contract prices in case it is
necessary for the clearing-house to close-out a position for a client.

•

The clearing-house will mark-to-market the contract daily.

•

Maintenance margin calls may be made by the clearing-house requiring the broker to top-up the
initial margin. This is required when the contract price has moved against the client and the
initial margin is no longer adequate.

(b) Indicate the implications of being long in a futures contract.
•

The trader who is long in a futures contract will be exposed to losses and margin calls if the price
of the underlying asset falls.

(c) Indicate the implications of being short in a futures contract.
•

The trader who is short in a futures contract will be exposed to losses and margin calls if the
price of the underlying asset increases.

(d) What are the procedures for closing-out these positions prior to delivery? (LO 19.2)

7


•

The vast majority of open futures positions are closed-out by the client before
expiry date by taking an opposite contract

•

A long position occurs when the underlying asset has been bought forward,
that is, a buy futures contract. A party to a long position will close-out that
open position by selling another futures contract with the same commodity
and expiry date.

•

A short position occurs when the underlying asset has been sold forward. The
short position can be closed out by going long a futures contract with same
commodity and expiry date.

5. On ASX Trade 24 the quotation of the three year Treasury bond futures contract is such that
traders can easily follow a ‘buy low sell high’ rule. Construct an example that shows how this
works. (LO 19.2)
•

Futures contracts are quoted at 100 minus the yield; therefore a Commonwealth Treasury bond
futures contract quoted at 93.75 has a yield of 6.25% per annum.

•

Futures contracts are quoted at an index figure of 100 minus the yield so that a dealer can follow
the basic principle of buy low and sell high; for example, if the above contract is priced based on
a 6.25% yield were to be sold at a later date at a yield of 7.00%, then it at first seems that a profit
would be made because the contract was bought at 6.25% and sold at 7.00%. However, if we
calculate the actual prices of the two contracts we find that a loss would be made.

•

By adopting the index quote convention, if the dealer buys at 93.75 and sells at 93.00 it is
apparent that a loss has been made.

6. ‘In 2012, the average daily turnover in the Australian bond futures markets was 172 000
contracts for the 3-year and 72 000 for the 10-year. This indicates an undesirably high level of
speculation in the bond futures markets in Australia.’ Discuss the validity of this statement.
(LO 19.2)
•

The daily turnover in the bonds futures markets in Australia indicates the substantial size and
importance of the markets.

•

Futures and other derivative contracts can be used for both hedging and speculation. The
turnover figures themselves do not tell us which of these forces is dominating.

•

As we have seen, speculation is a critical component of the futures markets and their risk
management function. Individuals and firms with exposure to various physical market risks can
8


enter positions in the futures markets designed to manage, minimise or offset those risks.
Individuals with the opposite exposures may take the other side of the contract but often it is a
speculator with no physical market exposure who takes the opposite side of the contract.
•

The speculator operates on the basis of an expectation about the future prices that will prevail in
the physical markets. Whereas a farmer may wish to lock in a price for his wheat and protect
himself against a fall in the wheat price, a speculator may believe that wheat prices have a good
chance of increasing over the short or medium term. The farmer goes short, the speculator goes
long.

•

The statement is not a valid one because (1) we cannot tell how many speculative trades are
included in the daily turnover figures, and (2) speculation is an essential component of wellfunctioning derivative markets, providing much needed depth and liquidity for hedgers seeking
to transfer risk.

7. Distinguish between hedgers and speculators. Show how a hedger could use the 90-day
bank-accepted bill futures contracts to hedge interest rate uncertainty. Show how a speculator
may use the same futures contract in an attempt to make a profit. (LO 19.4)
•

A hedger uses the futures market to manage an interest rate risk inherent in their business
dealings.

•

A hedger may use 90-day bank accepted bills futures contracts to manage a short-term interest
rate risk exposure; for example, a borrower can lock-in the cost of borrowing by selling futures
contracts to obtain protection against the risk of rising interest rates. Alternatively, an investor
can lock-in the value of an investment, and protect against the effects of falling interest rates, by
buying futures contracts.

•

Speculators attempt to make a profit by purposely taking risks. Speculators enter the market in
the expectation that the market price will move in a favourable direction for them.

•

Futures contract transactions of speculators are not supported by an underlying commercial
transaction; for example, a speculator may sell bills future contacts simply based on its
expectation that bank bill prices are going to fall (yields rise); that is, sell contracts at say 93.50
and subsequently buy opposite contracts at say 92.00

•

Speculators who expect prices to rise would buy the contract now (go long); those who expect
prices to fall would sell the contract now (go short).

•

Speculators may construct straddle or spread positions. In a straddle the speculator may
simultaneously buy a contract for delivery in a particular month, and sell an identical contract
9

with a later month delivery date. This strategy is motivated by an expectation of a change in the
price differential between the two contracts.
•

A spread position is similar to the straddle, but involves the simultaneous buying and selling of
related contracts (rather than identical contracts) in the anticipation of a change in the price
differential, or spread, between the two contracts. An example would be the buying of 90-day
bank accepted bill contracts and the simultaneous selling of 3-year treasury bond contracts. The
speculator is anticipating a change in the yield curve.

•

Speculators take on much of the risk that hedgers seek to avoid. Speculators support trading
volumes and liquidity in the market.

8. A business plans to borrow approximately $40 million in short-term funding through the
issue of commercial paper in three months’ time. The business does not have a view on what is
likely to happen to interest rates over the next three months, but it would be very satisfied if it
could obtain its funding at the current yield.
(a) Using the following data, show how 90-day bank-accepted bills futures contracts can be
used to hedge the interest rate risk to which the business is exposed. Show the calculation and
timing of all transactions and cash flows (ignore transaction costs and margin requirements).
Today’s data:
(i)

current commercial paper yields 6.00 per cent per annum

(ii)

90-day bank-accepted bills futures contract 93.75.

Data in three months:
(iii)

commercial paper yields 7.00 per cent per annum

(iv)

90-day bank-accepted bills futures contract 93.25

Cash or Physical Market
Today:

Futures Market
Today:

The company expects to borrow $40

Sell 40 90-day bank accepted bills

million in three months; it notes that

futures contracts at 93.75 (yield 6.25%)

current yields are 6.00%, but is

Use discount securities formula

exposed if yields rise before the

P = 365 x $40 million

commercial paper is issued

365 + (0.0625 x 90)
= $39 392 917.37

Three months time:

pay initial margin
Three months time:
10


Sell commercial paper with a face

buy 40 contracts at 93.25

value of $40 million – yield 7.00%

P = $39 345 145.86

P = $39 321 303.53
Hedge outcome:

•

•

cost of borrowing increased over
three-month period by $95 543.12

•
•

profit received from the futures

profit

received

from

transactions is $47 771.51
•

the profit is used to offset the

futures

additional cost of borrowing in the

transactions is $47 771.51

physical market when the company

borrower was not able to perfectly

issues commercial paper

hedge risk because of initial and
final basis risk

(b) What is the effective cost of funds achieved with this hedging strategy? What would the
cost of funds have been had the hedge not been put in place? Explain your answer, showing
your calculations. (LO 19.5)
net cost of funds

 365
x
Effective cost of funds = 
 total amount of fund available  90

 cost of bills - futures profit  365
= 
x
 amount borrowed + futures profit  90

 $678,696.47 - $47,771.51  365
=
x
 $39,321,303.53 + 47,771.51  90
= 6.49% per annum
•

If the hedging strategy had not been put in place then the cost of issuing the commercial paper
would have been 7.00 per cent per annum.

9. A funds manager forecasts that it will need to invest $100 million in approximately 90 days.
The manager wishes to receive a return as close as possible to the medium-term interest rates
currently available, but expects that rates will have fallen by the time the funds are available
for investment.

11


(a) Outline what the manager would do today in the financial futures market in order to secure
a return that is close to current medium-term market rates.
•

The funds manager will investigate different strategies available to hedge the interest rate risk
exposure. Assume the manager decides to implement a strategy using futures contracts. The
manager is interested in medium-term yields and therefore will use a three-year Commonwealth
Treasury bond futures contracts. Since the funds manager will buy investments in three months,
the initial transaction in the futures strategy is to buy futures contracts.

(b) Calculate the price of a three-year Treasury bond futures contract quoted at 96.50
•

To calculate the price of the three-year Commonwealth treasury bond futures contract the
formula is:

 1 - (1 + i ) −n 

−n
(
)
P = C 

+
A
1
+
i


i
 


•

where:
i = the nominal interest rate per period expressed as a decimal
n = the number of coupon periods
C = periodic coupon payments
A = the face value of the bond

•

A Commonwealth Treasury bond futures contract is based on a 6.00% per annum fixed interest
bond with a face value of $100 million and paying half-yearly coupons.

•

Therefore:
i = 3.50% per annum / 2 = 1.75 = 0.0175
n = 3 year bond x half-yearly coupons = 6
C = 6.00% per annum bond; half-yearly coupons

= $100 million x 0.03 = $3 000 000
A = $100 000 000



1 - (1 + 0.0175) −6 
−6
P = $3,000,000 
 + $100,000,000(1 + 0.0175) 
0.0175




= $16,946,992.85 + $90,114,254.17
= $107,061,247.00

12


(c) Outline how the funds manager would close out the futures market position.
•

The funds manager will close-out the position by selling a three-year Commonwealth Treasury
bond contract. The net margin plus (minus) any profit (loss) made on the two transactions will be
returned by the clearing house. The profit (loss) will be offset against the return received when
investing the funds for the client.

(d) Outline and explain the factors that will determine how successful this strategy will be in
securing an effective return that is close to today’s market rates. (LO 19.5)

•

The funds manager will need to charge the cost of the futures strategy against the client; that is,
the opportunity cost of the margin calls. This will lower the net yield received.

•

The hedging strategy will be exposed to initial basis risk and final basis risk. This risk may
impact the effectiveness of the strategy, but will usually make it impossible to achieve a perfect
hedge.

•

When the funds are eventually invested the funds manager will probably not invest them in
treasury bonds, but rather will choose some other investment alternative. Therefore an element of
cross-commodity risk will be evident.

10. A funds manager currently manages a diversified Australian share portfolio valued at $250
million. The manager decides to use the S&P/ASX 200 Index futures contract to manage an
exposure to a forecast decline in share prices. The S&P/ASX 200 Index is currently at 5500. In
three months’ time the S&P/ASX 200 is at 5150.
(a) Today: set up a hedging strategy to manage the risk exposure.
•

The price of the futures contract equals the S&P/ASX200 Index multiplied by $25

•

To establish the hedging strategy, the funds manager can sell 1800 S&P/ASX200 futures
contracts

•

Value

= 1800 x 5500 x $25
= $247 500 000

•

Note: the manager wishes to protect a selling position in the future so will sell futures contracts
today

•

Pay initial margin.

(b) In three months’ time: close out the open position.
•

To close an open position, take opposite contracts
13


•

Buy 1800 S&P/ASX200 futures contracts

•

Receive return of margin payments and futures strategy profits.

(c) Show the net valuation effect of the hedging strategy. (LO 19.5)
•

Buy 1800 S&P/ASX200 futures contracts

•

Value

= 1800 x 5150 x $25
= $231 750 000

•

Net profit = $15 750 000

•

Net profit will be used to offset the fall in value of the share portfolio in the stock market.

11. An energy company located in Russia has entered into a contract to export natural gas into
Europe with delivery in three months. The contract is denominated in EUR and is valued at
EUR100 million. The spot exchange rate is EUR/RUB49.2820. Assume that the spot rate in
three months’ time is EUR/RUB46.6060 and that there is no basis risk between the futures
market and the spot FX markets. Set up a hedging strategy using the futures market. Show
your calculations. Explain the outcomes of the strategy. Assume that EUR futures have a face
value of EUR100 000 per contract. (LO 19.5)
Cash or Physical Market

Today:
•

Russian exporter sells gas for EUR100

• sell 1000 EUR futures contracts

million

with face value EUR100 000
• rate: EUR/RUB49.282
• value = EUR100 million x 49.2820
= 4 928 200 000
• pay initial margin

•

current spot rate is EUR/RUB49.2820

•

the notional contract value today is

RUB4 928 200 000
Three months time:
•

Futures Market
Today:

Three months time:
•
•
•

receive payment of EUR100 million
for gas exported

•

spot rate EUR/RUB46.6060

• converts to RUB4 660 600 000
Hedge outcome:
•

= 4 660 600 000
•

the exporter wished to sell the base
currency in the future so needed to sell

buy 1000 EUR futures contracts
rate: EUR/RUB46.6060
value = EUR100 million x 46.6060

Profit on the futures contract =
RUB267 600 000

•

14


EUR futures contracts
•

The strategy was effective. Although
the EUR depreciated against the RUB,
the futures position profits offset the
loss that would have been made.

12. While financial futures contracts may be used to hedge the risk of fluctuations in the prices
of the underlying securities, the use of futures contracts often entails some risk. What are the
sources of risk arising from the use of futures contracts in risk management? List, explain and
demonstrate the implications of each type of risk. (LO 19.6)
Important risks associated with using futures contract are standard contract sizes, margin risk, basis
risk and cross-commodity hedging.
Standard contract size:
•

Financial and commodity futures contracts are traded on a formal exchange and therefore
contract terms and conditions are standardised; for example, the short-term interest rate futures
contract is only based on the 90-day bank accepted bill, each contract has a face value of $1
million and must be settled on specified contract dates.

•

Similarly, the main share index futures contract is based on the S&P/ASX200 Index multiplied
by 25, expressed in dollars. Also, the individual listed share contracts are based on an underlying

1000 shares.

•

In order to exactly match the dollar amount of an interest rate risk exposure, the exposure would
need to be for $1 million (1 contract), $2 million (2 contracts) etc.

•

It is to be expected that the majority of risks will be for amounts lesser or greater than the
standard contract sizes, especially for smaller businesses.

Margin risk:
•

The futures exchange clearing-house requires buyers and sellers of contracts to pay an initial
margin, or deposit. If the price of the contract moves against contract holders, they will be
required to make maintenance margin calls to top-up the margin held by the clearing-house.

•

If a margin call is not made the clearing-house will automatically close-out the position.

•

The funds held in the margin account will be used to offset any futures contract losses.

15

•

There is a need to assess the opportunity costs and liquidity risks associated with making margin
calls.

Basis risk:
•

Basis risk is a situation where pricing differentials between markets are evident.

•

The price of a futures contract is derived from the underlying physical market commodity or
financial instrument.

•

Price differentials are often evident between the futures market contract price and the physical
market price. The longer the term to maturity of a futures contract, the greater is the potential
price differential.

•

Differentials appear because futures contract pricing include a component relating to forecast
price movements. For example, current bill yields may be 5.80%, but the market expects they
will rise; the futures contract will incorporate the expected rise in the yield.

•

Initial basis risk occurs at the commencement of a futures hedging strategy.

•

Final basis risk may be evident when closing out an open position.

Cross-commodity hedging:
•

Using a futures contract based on one commodity or financial instrument to hedge a risk
associated with a different commodity or financial instrument.

•

Contract specification on futures contracts are standardised; for example, to hedge a short-term
interest rate exposure, using futures contracts, it is necessary to use the 90-day bank accepted bill
contract. The hedger may in fact be exposed to changes in yields at the roll-over dates of
promissory notes (commercial paper).

•

Another example is of a share market investor using share index futures contracts to manage the
exposure of an investment portfolio. The futures contract is based on the S&P/ASX200 Index;
however, the investor may well hold a portfolio of only a small number of shares

•

While price correlation will exist in the above example, they may not be constant.

13. (a) Define the forms of basis risk and explain why it is important for a hedger to
understand this risk prior to dealing in derivative products. Use examples to explain your

responses.
•

One of the basic principles of risk management hold that in managing one risk exposure, you
may in fact be creating another risk exposure. It is therefore essential for a risk manager to
16


understand completely the risk management products and strategies that are available, and the
implications of using these.
•

Within the context of the futures market, basis risk describes the difference between the price of
a commodity or financial security in the physical market, and the price of the related futures
contract.

Initial basis risk:
•

Occurs when pricing differentials appear between the physical market and the futures market at
the commencement of a hedging strategy

•

Initial basis will be evident where the market generally has adopted the view that prices in the
physical market will change; for example, if a company with a loan facility that is due to be
rolled over in three months is concerned that interest rates may rise in that time, then in all
probability other market participants have also come to the same view. The forecast rise in
interest rates will be reflected in a rise in yields in the futures market. It is then a question of how
far yields are expected to change that will be reflected in the futures contract pricing. In this

situation the interest rates quoted in the physical market will be the current rates, whereas the
rates quoted in the futures market will reflect the forecast change in rates, thus creating initial
basis risk.

Final basis risk:
•

Occurs when pricing differentials between the physical market and the futures market appear at
the completion of a hedging strategy; for example, while a company may use a 90-day bankaccepted bills futures contract to hedge a borrowing exposure. Final basis risk will occur where
the company is unable to discount its bills in the physical market at exactly the same yield used
to price the futures contract. One reason that there will be a difference between the actual cost of
borrowing in the physical market and the price of the futures contracts will be the level of risk
attributed to the borrower. The discounter will add a margin for the borrower’s credit risk and
this will result in final basis risk between the prices quoted in the futures market and the physical
market.

•

Typically, initial and final basis risk will be evident between the markets and this means that it is
generally not possible to set up a perfect hedging strategy.

17


(b) When hedging risk, what is cross-commodity risk? In your answer provide examples to
explain cross-commodity risk within the context of interest rate risk and share price risk. (LO
19.6)
•

Cross-commodity hedging refers to the use of a futures contract based on one commodity or

financial instrument to hedge a risk associated with another commodity or financial instrument.

•

The necessity for cross-commodity hedging arises because futures contracts are available for
only a relatively small number of commodities and financial instruments.

•

The cross-commodity hedge will use a futures contract that exhibit price movements that are
highly correlated with the price of the risk exposure to be hedged; for example, a borrower that
has issued securities into the money or capital markets is exposed to interest rate movements. If
the borrower intends to use futures contracts to hedge that interest rate risk exposure it must
decide which type of futures contract to use. For example, within the Australian markets the
surrogate short-term interest futures contract is the 90-day bank accepted bills contract; the
medium-term contract is the 3-year Commonwealth Treasury bond contract and the longer-term
contract is the 10-year Commonwealth Treasury bond contract. Therefore, a borrower may need
to:
o use the 90-day bank-accepted bill futures contract to hedge a commercial paper issue
o use the 3-year Commonwealth Treasury bond futures contract to hedge a loan facility that
could range from say 1 year to 5 years to maturity
o use the 10-year Commonwealth Treasury bond futures contracts to hedge a longer-term
debenture or unsecured note issue.

•

While the prices of each of these pairings may be reasonably highly correlated, the spread, or
difference in prices, may not be constant through time. As a result of changes in the spread,
cross-commodity hedge risk is introduced. The combination of basis risk and cross-commodity
hedge risk means that a perfect hedge can seldom be expected using futures contracts.

14. (a) What is a forward rate agreement?
•

The FRA is a contractual agreement, between two parties, relating to an interest rate level that
will apply at a specified future date. A borrower that needs to borrow funds in seven months can
lock-in an interest rate today that will apply in seven months.

•

The FRA effectively allows the parties to the agreement to lock-in a rate of interest that will
apply at the specified future date based on a notional principal amount.

18


(b) What are the main features of an FRA? Explain how a corporation that needs to borrow
funds in seven months can use an FRA to fix the cost of funds today.
•

The agreement relates to the interest rate; no exchange of principal takes place.

•

The final settlement between the parties to the agreement is the value of the difference between
the FRA agreed interest rate and the reference interest rate that exists on the settlement date.

•

An FRA can usually be entered into for periods of up to two years.

•

An FRA is a compensation agreement; one party will compensate the other party, based on the
notional principal amount, for any adverse movement in the FRA settlement rate relative to the
FRA agreed rate.

The FRA will specify:
•

the FRA agreed rate; fixed at the start of the FRA

•

the notional principal amount of the interest cover

•

the FRA settlement date when compensation is paid

•

the contract period on which the FRA interest rate cover is based (end date)

•

the reference rate to be applied at settlement date.

(c) What are the main differences between an FRA and a futures contract? (LO 19.7)
•

The FRA is an over-the-counter product.

•

A futures contract is an exchange traded contract. Futures contracts are standardised.

•

An FRA can be negotiated to meet a risk manager’s specific needs in relation to amount and
contract period

•

Futures contracts require margin payments; the FRA does not

•

Futures contracts are guaranteed by the clearing-house; with the FRA counterparty risk is evident

15. You know that in seven months’ time your company is going to borrow $5 million for six
months. You obtain the following quotes from an FRA dealer:
6Mv7M (23) 10.35 to 25
7Mv13M (23) 10.50 to 20
You enter into an FRA with the dealer:
(a) What will be the FRA agreed rate?

19

•

The FRA quote 7Mv13M states that the dealer is quoting seven months forward on 6-month
money (therefore disregard first quote). Also the FRA quote of 10.50 - 20 means that the dealer
is prepared to buy (lend) at 10.50% per annum and sell (borrow) at 10.20% per annum.

•

In this case, the company is the borrower and therefore will accept the buy rate from the dealer
(10.50%).

•

Note: the contract will be settled on the 23rd of the specified month. We have not been advised of
the FRA settlement reference rate; for example, it may be BBSW or LIBOR.

(b) If the reference rate on the settlement date is 9.75 per cent per annum, what is the
compensation amount?
FRA settlement rate minus the FRA agreed rate
365 × P
365 × P
−
365 + (D × i s ) 365 + (D × i c )

where:
is = 0.0.975
ic = 0.1050
D = assume 182 days (reasonable to assume 180 or 183 days also)
P = $5 000 000
365 × 5 000 000

365 × 5 000 000
−
365 + (182 × 0.0975) 365 + (182 × 0.1050)
= $4 768 187.70 − $4 751 243.13
= $16 944.57

settlement =

•

The FRA compensation amount, or settlement amount, is $16 944.57

(c) Which party to the FRA will make the compensation payment? (LO 19.7)
•

Company is a borrower and wished to hedge the cost of funds

•

The company locked in a rate of 10.50% per annum in the FRA contract

•

At settlement date rates have fallen to 9.75% per annum

•

The company will be able to borrow at the lower rate in the physical market

20

•

Therefore, the company will pay the compensation amount of $16 944.57 to the writer of the
FRA, the bank.

FINANCIAL NEWS CASE STUDY
In 2013, the ASX introduced the S&P/ASX 200 Volatility Index, or VIX, and an associated
futures contract, S&P/ASX 200 VIX Futures. Standard & Poor’s (2013) released the following
announcement:

Sydney, 21 October, 2013 – ASX today commenced trading of S&P/ASX 200 VIX futures, a
new exchange-traded product that allows users to trade, hedge and arbitrage anticipated
volatility in the Australian equity market.

The new S&P/ASX 200 VIX futures will allow market participants to trade anticipated changes
in volatility in a single transaction and in a manner independent of the factors that normally
complicate volatility strategies, such as expiring options and price movements in the
underlying market.

The S&P/ASX 200 VIX index (A-VIX), Australia’s equity market volatility benchmark and
gauge of the near-term volatility in the Australian equity market over the next 30 days, will be
the underlying index for the new futures contract. S&P/ASX 200 VIX futures will allow users to
isolate local equity market volatility and avoid the timing, currency and matching risk incurred
when using volatility products based on offshore indices.

The Volatility Index is constructed on the basis of volatilities implied by prices on index
options. As we shall see in the following chapter, volatility is a core component of the standard
options pricing models. A trader can attempt to estimate volatility and input that value into the

options pricing formula to determine a price or if a trader observes the market price and solves
the formula for volatility he or she can figure out what volatility is implied by the current
market price for the option.

21


Because the options price implies a volatility for the underlying security, market expectations
about volatility can be extracted from the options prices. By applying a particular
‘methodology’ to the ‘near’ and ‘next’ term index options on the S&P/ASX 200, the Volatility
Index or VIX can be constructed. Its value will go up and down as the expectations of market
participants and their trading behaviour changes.

One of the most interesting features of the VIX is its interpretation by traders as a ‘fear’ or
‘sentiment’ index. Because options can be used to hedge portfolios against large swings in the
prices of shares, the prices of options tend to reflect how risk averse people are feeling by how
much they are willing to pay to ‘insure’ their portfolios. When share prices fall and risk
aversion increases, index options should become more expensive. They will also imply higher
volatility. When markets become calm and risk aversion decreases, index options should
become less expensive and imply lower volatility. These changes in volatility are encompassed
in the VIX.

One way to interpret the VIX, apart from the basic ‘higher = more fear’ interpretation, is that a
VIX value of 50, which is quite high, implies that the options markets are pricing in a strong
chance of a one monthly change in the value of the S&P/ASX 200 Index of plus or minus 14
per cent (50 multiplied by the square-root of 1/12). By contrast, a lower VIX value of 10
implies a strong chance of a one monthly change in the value of the S&P/ASX 200 of plus or
minus just 2.88 per cent (www.asx.com.au/products/sp-asx200-vix-index.htm).

The ASX has introduced a futures contract on the VIX that allows traders to speculate on and

hedge against future movements in volatility. Some of the features of the S&P/ASX 200 VIX
Future contract are as follows:
•

The underlying index is the S&P/ASX 200 VIX.

•

The contract price is $1000 multiplied by the VIX value.

•

Contracts are available on the next two months.

The VIX futures contract can be used for hedging and speculating. Two examples are:
•

Because implied volatility is asymmetric (it goes up by more when share prices fall than
when they rise), there is an inverse relationship between share prices and the VIX value.
22


As such, a fund manager may use the VIX futures contract to protect the portfolio from
volatility and, in particular, price declines. The fund manager would take a long position
in VIX futures.
•

Because the VIX reflects market sentiment, contrarian speculators or those who believe
that markets will soon become calm may speculate on this by taking a short position in
VIX futures at times when the market appears to be unjustifiably nervous.

‘Shorting volatility’ can be a sound trade. Historically, we know that markets do calm down as
whatever crisis is troubling market participants subsides. The trouble is that this may happen
more slowly than expected and there is nothing to say that markets might not become more
volatile in the meantime. The trader who is short the volatility will normally be right.
Unfortunately, by the time he or she is proven correct, he or she might also be insolvent.
SOURCE: Extract from Standard and Poor’s (2013), ASX Launches Futures Product for Trading Equity Market Volatility, 21 October 2013.

DISCUSSION POINTS
• Explain why a volatility index such as the S&P/ASX 200 VIX may be interpreted as a
‘sentiment’ index.
Simply, the index is computed on the basis of volatilities implied by index options. Because
investors use index options to hedge their portfolios and because they are more likely to do
so when they are fearful of losses, there is a link between index options prices, implied
volatility and risk aversion.
• A fund manager currently holds a well-diversified portfolio of Australian shares valued
at $250 000 000. The global political context is unstable and the fund manager
anticipates a period of unusually high market volatility. The S&P/ASX 200 VIX
currently stands at 22. The S&P/ASX 200 Index stands at 5500. Explain how the
manager can use VIX futures to hedge exposure to the anticipated volatility. Determine
the net valuation of the strategy if the position is closed out when the S&P/ASX 200
Index stands at 4700 and the corresponding VIX stands at 38.
Assuming the losses on the ASX200 are matched by the fund manager’s portfolio, the fund
will suffer a loss of 14.54 per cent. That is, after the market index declines to 4700, the
portfolio will be valued at $213 650 000.
To hedge a $250 000 000 portfolio, the fund manager could take a long position in VIX
23


futures. A general rule of thumb is to enter into one contract for each $100 000 of market

exposure, or 2500 contracts. The position is initially worth 2500 x $1000 x 22 =
$55 000 000. When the VIX increases to 38, the position is worth $95 000 000. The futures
profit of $40 000 000 partially offsets the loss suffered by the physical portfolio.
• A speculator believes, contrary to the fund manager, that markets are likely to remain
calm. The speculator enters a short position on the VIX futures contract at 22. The
speculator goes short on 1000 contracts. Determine the value of the trade if the
speculator is forced to close out the position when the VIX stands at 31.
The initial position is valued at 22 x $1000 x 1000 = $22 000 000. At VIX of 31, it is valued
at $31 000 000. Because the trader has entered a short position, he or she has suffered a loss
of $9 000 000.
• What is the anticipated one monthly movement in the S&P/ASX 200 Index indicated by
VIX values of 5, 15, 25, 35 and 45, respectively? What is the probability associated with
each anticipated movement?
A VIX value of 5 represents an annualised expected change of 5 per cent over the next
month (30 days). Therefore, to find the anticipated monthly movement, multiply the VIX
value by the square-root of 1/12 = 0.288. The one monthly movement implied by a VIX of 5
is +/–1.44%. Since this represents one standard deviation, there is a 68 per cent likelihood
that the market will move up or down by 1.44 per cent over the next 30 days. The same logic
applies to each VIX value. For example, a VIX of 35 represents a one-month anticipated
movement of 10.10 per cent. As before, there is a 68 per cent chance of the market moving
up or down by 10.10 per cent over the next 30 days.

True/False questions
1.

F Derivatives products cannot be used to hedge risks associated with interest rate

movements.
2.

T A forward contract is a derivative product that is traded over-the-counter with a financial

institution.
3.

T A financial futures contract allows a hedger to create a situation where any change in the

physical market price of a financial instrument is mostly offset by a profit, or loss, derived from the
futures market transactions.
4.

T A limit order is one in which a client instructs the broker to buy a specific contract only up

to a specified price or to sell a specified contract down to a specified price.
24


5.

F An opening position in the futures market does not require an initial margin to be lodged

with the futures exchange clearing-house.
6.

F Margin calls are only made in the last few days before a contract is due to expire.

7.

T A client with a long position in a 90-day bank-accepted bill futures contract would

experience a reduction in the balance of their margin account if the price of the contract fell from
92.50 to 91.50.
8.

F If an investor has a long position in three-year Treasury bond futures contracts, on the

delivery date the investor must deliver the specified Treasury bonds to ASX Trade 24.
9.

T A borrower with a short position in an interest rate futures contract can close-out the

futures position by establishing a long position in the same contract with the same delivery date as
the original contract.
10.

F The main participants in the futures markets are parties that hedge a risk exposure

associated with an underlying physical market product. As such, speculators do not participate in the
futures market.
11.

F A business that intends to obtain funds through the sale of bank-accepted bills at a known

future date can hedge the risk that yields will change between now and the issue date by buying the
appropriate number of futures contracts now.
12.

F If a short bank-accepted bills futures position is opened at 92.50, and is closed out at 91.50,

a loss would be made through the futures market transactions.

13.

T A share portfolio manager is to use futures contracts to hedge the value of a diversified

share portfolio against a fall in share prices. The manager will sell the appropriate number of related
share price index futures contracts now.
14.

T It would be impossible to obtain a perfect interest rate hedge on bank bills currently

yielding 7.25 per cent per annum in the physical market if the bank bill futures contracts are
currently priced at 92.40.
15.

F Basis risk is the difference between the initial price of a futures contract and the final price

of the same contract.
16.

T Cross-commodity hedging risk occurs because futures contracts are not available on all

financial assets, and so the hedger may need to use a futures contract that approximates the physical
market asset that is at risk.
17.

T A portfolio manager may use either the S&P/ASX 200 VIX futures contract or the futures

contract on the S&P/ASX 200 Index to hedge a portfolio of shares.
18.

F FRA transactions can be used to lock in a future cost of funds; they also guarantee the

availability of funds for a borrower at a specified future date.
25