Futures markets(Chapter 13)

ECO 322Nov 25, 2013Dr. Watson

Fable of the cattleman

Cattleman wants less price volatility so he can plan for the future

Meatpacker wants less price volatility so he can plan for the future

Cattleman promise to sell you 100 cattle 6 months from now - $1.70/pound

Innovation 1

Trader showed up and thought, “That’s a really low price. … There was a drought in another province and all their cattle died. The price is going up… Say, meatpacker, can I buy your contract?” Trader will pay the farmer $1.70 for the cattle

6 months from now The meatpacker earns some profit.

Innovation #2

Another trader shows up, who thinks the price will be even higher.

He will buy the contract from the first trader. The first trader makes money off of cattle he

never owned. Suppose there was news – trade

restrictions on cattle had been dropped, so we can get all the cattle we want from another country

What about death? That’s called the ultimate default risk

Some definitions

Long – bought Short – sold Hedge – Offset risk by buying another asset

that will move differently Offset a long position with a short position in the

same area. Airline – lose money when price of oil goes up,

so they buy oil stocks. Micro hedge – hedge on one asset Macro hedge – hedge entire portfolio Counterparty – whoever you’re trading with

Example

I own $5million in T-bills If the interest rate goes up, what happens to

the value of my T-bills? I’m going to sell some futures contracts

How much does it cost? $100,000 N = value of the asset / value of the contract

5 million / 100,000 = 50.

Suppose the i was 6%, goes up 8% My 5 goes down to 4.1 Value of the sale makes up the loss.

Real world: Forward and Futures In a forward contract, I am selling a very

specific asset In a futures contract, I am selling

something that looks like this Your bonds will expire in 15 years or more The Treasury cannot call on them $5 million

Forward markets are going to be less liquid, more default risk; lower transaction costs

Real world: I don’t actually trade with you In a futures market, the seller is selling to

a clearinghouse. The buyer is buying from the clearinghouse.

Where does the clearinghouse get its money?

The buyer and seller are both going to make a deposit: margin requirement

If the price of your asset changes, you need to change your margin. Mark to market Margin call

We have a futures market in: Foreign exchange You buy $5 million at N155/$ one year

from now You turn around and sell $5million at

N165 Profit = N50million

Price of a futures contract today depends on everyone’s expectations

Forward contract - $1million Futures contract - $125,000

Investing vs. Hedging vs. Gambling Time – Investment takes time, gambling

is today? Risk – Hedging is there to reduce your

risk; gambling is about increasing your risk

When you invest, you own something With gambling, you are not creating

anything

Is arbitrage is gambling? Moving across distance – a diaper in my

house vs a diaper in another country Moving across time

Options

One way to pay your CEO – stock options You can buy X shares at today’s price … in the

future American option – exercise anytime European option – exercise only when

expires

Call option – option to buy Put option – option to sell

Options pt 2

Futures often more liquid than the original asset

“in the money” – you could earn profits“out of the money” – the option is not profitable

Lower the “strike price” – higher premium Longer time period (term) – higher

premium More volatility – higher premium

Credit derivatives

Credit option – put (sell) bonds at the current price

Total global GDP: $50 trillion Total value of credit derivative contracts:

$1200 trillion