Financial Futures Markets: Hedging and Speculating with Futures Contracts
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 Series: Chapter 13 Review
Futures contracts are basically agreements to buy or sell something at a specific price on a specific date in the future. Chapter 13 focuses on financial futures, which cover Treasury bills, Treasury bonds, stock indexes, and individual stocks. Two types of people use them: hedgers who want to reduce risk, and speculators who want to bet on price movements.
How Financial Futures Work
A financial futures contract is a standardized agreement. It specifies the amount of the financial instrument, the price, and the settlement date. Settlement dates are typically in March, June, September, and December.
Most futures in the U.S. trade through the CME Group, formed in 2007 when the Chicago Board of Trade merged with the Chicago Mercantile Exchange. The exchange acts as a clearinghouse. It guarantees every transaction, so you do not need to worry about whether the person on the other side of your trade can actually pay up.
To trade futures, you deposit a margin (typically 5-18% of the contract’s value) with your broker. As prices move daily, your position is “marked to market.” If the value moves against you, you get a margin call and have to put up more cash.
Most traders never take actual delivery of anything. They close out their positions before the settlement date by taking an offsetting trade. Your gain or loss is the difference between the price when you opened the position and the price when you closed it.
Interest Rate Futures
Interest rate futures are contracts on debt securities like T-bills and Treasury bonds. Their prices move inversely with interest rates. When rates go up, bond prices go down, and so do the prices of bond futures contracts.
Speculating
If you think interest rates will fall, you buy Treasury bond futures. When rates drop, bond prices rise, and your futures contract becomes more valuable. If you think rates will rise, you sell futures.
The returns can be dramatic because of leverage. A speculator might put down $10,000 in margin on a contract worth $1 million. A gain of $9,000 on the underlying contract value represents a 90% return on the margin deposit. But a $15,000 loss would wipe out the margin entirely and then some.
Hedging
Financial institutions use interest rate futures to protect themselves against rate movements.
A short hedge means selling futures to protect against rising rates. If a bank holds corporate bonds and rates rise, the bonds lose value. But the bank can profit from its short futures position (since bond futures prices also fell), offsetting the loss.
A long hedge means buying futures to protect against falling rates. A bank that earns floating-rate income but pays fixed-rate interest on deposits would buy futures. If rates fall, the gain on the futures position offsets the reduced income.
Madura illustrates this with Charlotte Insurance Company. They hold $5 million in Treasury bonds and worry about rates rising. They sell 50 Treasury bond futures contracts at 98-16. When rates rise and futures drop to 94-16, they buy back the contracts and pocket $200,000, which helps offset the decline in their bond portfolio.
The key insight: hedging narrows the range of possible outcomes. You give up some upside to reduce your downside. A hedged institution has a narrower probability distribution of returns compared to an unhedged one.
Cross-hedging happens when you hedge one instrument using a futures contract on a different but correlated instrument. It works well if the two instruments move in tandem, but imperfect correlation means the hedge will not be exact.
Stock Index Futures
These let you buy or sell an entire stock index at a future date. The S&P 500 futures contract is valued at $250 times the index. At an index level of 1600, one contract is worth $400,000. Mini contracts are also available at $50 times the index.
Unlike bond futures, stock index futures settle in cash. No one delivers 500 stocks to your doorstep. On settlement day, your gain or loss is calculated and the cash changes hands.
Speculating with Stock Index Futures
If you expect the market to go up, buy index futures. If you expect it to go down, sell them. Boulder Insurance Company, in Madura’s example, expected a big market jump. They bought S&P 500 futures at 1500. The index rose to 1600 at settlement, and they made $25,000 per contract.
Hedging Stock Portfolios
This is where stock index futures really shine for institutional investors. If a mutual fund expects a temporary market decline but does not want to sell its stocks (too many transaction costs), it can sell index futures instead.
If the portfolio is similar to the S&P 500, a decline of 5% (say, a $20,000 loss on a $400,000 portfolio) would be offset by a roughly $20,000 gain on the short futures position. The hedge is more effective when the portfolio closely tracks the index.
You do not have to hedge everything. A portfolio manager with a $1.2 million portfolio could sell one contract to hedge a third, two contracts for two-thirds, or three for full coverage. More hedging means more protection but also less upside.
Dynamic Asset Allocation
Portfolio managers increasingly use futures to shift between aggressive and defensive positions without actually buying or selling stocks. When they are bullish, they buy futures to amplify exposure. When they are bearish, they sell futures to dampen it. This avoids the transaction costs of restructuring a portfolio.
Single Stock Futures
These are contracts to buy or sell 100 shares of a specific stock at a future date. They trade on OneChicago, a joint venture between the CBOE and CME Group.
Buying single stock futures is similar to buying the stock itself but with much less capital required (just the margin). Selling them is like shorting a stock, except you do not need to borrow shares first.
Settlement dates are quarterly, and contracts are available for over 2,200 stocks.
The Risks
Madura identifies six types of risk in futures trading.
Market risk is the big one. If your expectations are wrong, you lose money. Hedgers worry less about this because losses on futures should be offset by gains on the positions they are hedging.
Basis risk occurs when the futures contract does not move in perfect tandem with the position you are hedging. This is especially relevant for cross-hedges.
Liquidity risk means you might not find someone willing to take the other side of your trade when you want to close out. Stick to widely traded contracts to minimize this.
Credit risk matters for over-the-counter trades where there is no exchange guarantee. The counterparty might default. Exchange-traded futures largely eliminate this because the clearinghouse guarantees performance.
Prepayment risk is specific. If you hedge a portfolio of bonds and those bonds get called early, your hedge is suddenly on a position you no longer hold. If rates then move against you, you take the loss without the offsetting gain.
Operational risk is about human failure. MF Global Holdings lost big on speculative positions in 2011 and raided customer accounts to cover losses. Peregrine Financial Group had a cash balance $100 million less than reported and went bankrupt in 2012. Both cases showed how lack of oversight can destroy a firm.
Systemic Risk
The 2008 crisis proved that interconnected derivative positions can spread problems across the entire financial system. If one big player defaults on OTC futures, their counterparties lose out and might default on their own obligations, creating a chain reaction. The Financial Reform Act of 2010 created the Financial Stability Oversight Council to monitor this kind of systemic risk.
My Take
The leverage in futures is both the attraction and the danger. A 5-18% margin means you are controlling assets worth 5 to 20 times your actual investment. That is incredible upside and terrifying downside.
The MF Global and Peregrine stories are cautionary tales. These were not rogue traders at giant banks. These were entire firms that either speculated recklessly or committed fraud. If you trade futures through a broker, you are relying on that broker to not steal your money. That is a level of trust most retail investors do not think about.
The hedging examples are the most practical part of the chapter. For institutional investors, futures provide an efficient way to manage risk without overhauling their portfolios. But Madura is honest: you cannot know in advance whether a hedge will help or hurt. You are trading certainty of returns for a narrower range of outcomes. Whether that trade-off is worth it depends entirely on your situation and your expectations.
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