Chapter 19 – future contracts and forward rate agreement

Learning objectives

 Consider the nature and purpose of derivative products
 Outline features of a futures transaction
 Review the types of futures contracts available through a futures exchange
 Identify why participants use derivative markets and how futures are used to hedge price risk
 Identify risks associated with using a futures contract hedging strategy
 Explain and illustrate the use of an FRA for hedging interest rate risk

19.1 Derivative contracts- futures and FRA

• Future contracts and forward rate agreement (FRAs) are called derivatives because they derive their price form an underlying physical market product
• A futures contract is the right to buy or sell a specific item at a specified future date at a price determined today
• The risk management function of a derivative-based strategy is to lock-in price today that will apply at a future date.
• Two main types of derivative contracts
1. commodity (e.g. gold, wheat and cattle)
2. Financial (e.g. shares, government securities and money market instruments)

Hedging using futures contracts

• Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party
• The change in the market price of a commodity or security is offset by a profit or loss on the futures contract
• Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes in interest rates, exchange rates and share prices
• 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.

***Example: A farmer wants to sell wheat in a couple of months, but is concerned that the price is going to fall in the mean time. How can the farmer hedge