Wednesday, September 2, 2009

The purposes of trading in financial futures(1)

The basic principal behind trading in financial futures is the same as in the commodity markets. A securities dealer, commercial bank, or other investor may sell future contracts on selected securities in order to protect against the risk of falling security prices (rising interest rates) and therefore a decline in the rate of return or yield from an investment. If the price of the security in question does fall, the investor can "lock in" the desired yield because a profit on the futures contracts may fully offset the capital loss incurred when selling the security itself. On the other hand, a rise in the market price of a security (fall in interest rates) may be fully offset by a loss in the futures market. Either way, the investor is able to maintain the desired holding-period yield.
Financial futures may also be used by financial institutions and other investors to reduce the risk of interest-rate fluctuations when borrowing money. For example, suppose that a commercial bank is planning to raise funds by issuing certificates of deposit (CDs) and borrowing in the Eurodollar market one year from today. However, the bank‘s economics department forecasts that interest rates are likely to rise significantly by the time the borrowing takes place. The adverse impact of these expected higher borrowing costs on the bank‘s profit position could be reduced by a sale and then a purchase of financial contracts. For example, management could sell one-year Treasury bill futures contracts now and then "zero out" this sale by purchasing a like amount of T-bills contracts when the delivery date arrives. Provided interest rates on Treasury bills, bank CDs, and Eurodollars increase by about the same magnitude, the added CD and Eurodollar borrowing costs would be offset by a profit on the futures position in T-bills. The bank could "lock in" its desired borrowing cost.

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