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Unformatted text preview: 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 Futures contracts are standardised exchange-traded contracts available on futures exchanges such as the Chicago Board of Trade (USA) or the Sydney Futures Exchange (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. The SFE 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 exchanges 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 transactionsbuy and sellthe party will make either a profit or a loss on those transactions....
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