1 futures futures markets futures and forward trading mechanism speculation versus hedging futures...
TRANSCRIPT
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Futures
Futures Markets Futures and Forward Trading Mechanism Speculation versus Hedging Futures Pricing
Foreign Exchange, stock index, and Interest Rate Futures Using Futures to manage foreign exchange rate risk Index futures Interest rate futures
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Forward - an agreement calling for a future delivery of an asset at an agreed-upon price
Futures - similar to forward but feature formalized and standardized characteristics
Key difference in futures Secondary trading - liquidity Marked to market Standardized contract units Clearinghouse warrants performance
Futures and Forwards
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Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity
Long = spot minus original futures priceShort = original futures price minus spot
Key Terms for Futures Contracts
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Futures Listings
Page 758 (with explanations on page 757). Example:
Pick up agricultural contract; let’s look at the March 2010 maturity corn contract
Each contract calls for delivery of 5,000 bushels Profit for long Profit for short
Chapter 1: Overview
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Futures vs Option
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Clearinghouse - acts as a party to all buyers and sellers. Obligated to deliver or supply delivery
Closing out positions Reversing the trade Take or make delivery Most trades are reversed and do not involve actual
delivery
Open Interest
Trading Mechanics
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Trading without and without a Clearinghouse
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Initial Margin - funds deposited to provide capital to absorb losses
Marking to Market - each day the profits or losses from the new futures price are reflected in the account.
Maintenance or variation margin - an established value below which a trader’s margin may not fall.
Margin and Trading Arrangements
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Margin call - when the maintenance margin is reached, broker will ask for additional margin funds
Convergence of Price - as maturity approaches the spot and futures price converge
Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement
Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets
Margin and Trading Arrangements
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Example: Maintenance margin
Suppose the maintenance margin is 5% while the initial margin was 10%. Still consider the March maturity Corn contract. The initial purchase price is $3.92 per bushel. How low the price of Corn future price can go before the investor receives a margin call?
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Example: Marking to Market
Page 764
Chapter 1: Overview
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Speculation - short - believe price will fall long - believe price will rise
Hedging - long hedge - protecting against a rise in price short hedge - protecting against a fall in price
Trading Strategies
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Hedging Revenues (Futures Price = $67.15)
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Basis - the difference between the futures price and the spot price over time the basis will likely change and will
eventually converge Basis Risk - the variability in the basis that will
affect profits and/or hedging performance
Basis and Basis Risk
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Spot-futures parity theorem - two ways to acquire an asset for some date in the future Purchase it now and store it Take a long position in futures
With a perfect hedge the futures payoff is certain -- there is no risk. A perfect hedge should return the riskless rate of return
Futures Pricing
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Hedge Example
Investor owns an S&P 500 fund that has a current value equal to the index of $1,300
Assume dividends of $20 will be paid on the index at the end of the year
Assume futures contract that calls for delivery in one year is available for $1,345
Assume the investor hedges by selling or shorting one contract
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Hedge Example OutcomesValue of ST 1,305 1,345 1,405
Payoff on Short
(1,345 - ST)
Dividend Income
Total 1,365 1,365 1,365
%5300,1
300,1)20345,1(
)(
0
00
S
SDF
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General Spot-Futures Parity
fRS
SDF
0
00 )(
Rearranging terms
0
000 )1()(
SDd
drSDrsSF ff
Multiple period formula: page 802 (22.2).
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Arbitrage Possibilities
If spot-futures parity is not observed, then arbitrage is possible
If the futures price is too high, short the futures and acquire the stock by borrowing the money at the riskfree rate
If the futures price is too low, go long futures, short the stock and invest the proceeds at the riskfree rate
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Theories of Futures Prices Expectations Normal Backwardation Contango
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Futures markets Chicago Mercantile (International Monetary Market) London International Financial Futures Exchange MidAmerica Commodity Exchange
Active forward market Differences between futures and forward markets Spot and forward prices in foreign exchange – page 815 Foreign exchange futures
Foreign Exchange Futures
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Interest rate parity theorem
Developed using the US Dollar and British Pound
T
UK
US
r
rEF
1
100
where
F0 is the forward price
E0 is the current exchange rate
Pricing on Foreign Exchange Futures
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Text Pricing Example
rus = 5% ruk = 6% E0 = $1.60 per pound T = 1 yr
585.1$06.1
05.160.1$
1
0
F
If the futures price varies from $1.58 per pound arbitrage opportunities will be present.
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Hedging Foreign Exchange Risk
A US firm wants to protect against a decline in profit that would result from a decline in the pound
Estimated profit loss of $200,000 if the pound declines by $.10
Short or sell pounds for future delivery to avoid the exposure
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Hedge RatioHedge Ratio in pounds
$200,000 per $.10 change in the pound/dollar exchange rate
$.10 profit per pound delivered per $.10 in exchange rate
= 2,000,000 pounds to be delivered
Hedge Ratio in contacts
Each contract is for 62,500 pounds or $6,250 per a $.10 change
$200,000 / $6,250 = 32 contracts
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Available on both domestic and international stocks
Advantages over direct stock purchase lower transaction costs better for timing or allocation strategies takes less time to acquire the portfolio
Major stock index futures – page 821
Stock Index Contracts
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Exploiting mispricing between underlying stocks and the futures index contract
Futures Price too high - short the future and buy the underlying stocks
Futures price too low - long the future and short sell the underlying stocks
Index Arbitrage
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Market Neutral Strategy
To protect against a decline in level stock prices, short the appropriate number of futures index contracts
Less costly and quicker to use the index contracts
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Example
Portfolio Beta = .8 S&P 500 = 1,000
Decrease = 2.5% S&P falls to 975
Portfolio Value = $30 million
Project loss if market declines by 2.5% = (.8) (2.5) = 2%
2% of $30 million = $600,000
Each S&P500 index contract will change $6,250 for a 2.5% change in the index
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Example -- continued
H =
=
Change in the portfolio value
Profit on one futures contract
$600,000
$6,250= 96 contracts short
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Uses of Interest Rate Hedges
Owners of fixed-income portfolios protecting against a rise in rates
Corporations planning to issue debt securities protecting against a rise in rates
Investor hedging against a decline in rates for a planned future investment
Exposure for a fixed-income portfolio is proportional to modified duration
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Example
Portfolio value = $10 million
Modified duration = 9 years
If rates rise by 10 basis points (.1%)
Change in value = ( 9 ) ( .1%) = .9% or $90,000
Present value of a basis point (PVBP) = $90,000 / 10 = $9,000
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Example -- continued
H =
=
PVBP for the portfolio
PVBP for the hedge vehicle
$9,000
$90= 100 contracts
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SWAP
A portfolio manager owns a $100 million of long-term bonds paying a coupon of 7%
He switches it to a floating rate issue based on the 6-month LIBOR rate
Page 832 shows the payoff from SWAP
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Swap Dealer
Page 831