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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. Futures and Forwards. - PowerPoint PPT Presentation
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11Ch22&23 – MBA 567
Futures
Futures MarketsFutures and ForwardTrading MechanismSpeculation versus HedgingFutures Pricing
Foreign Exchange, stock index, and Interest Rate Futures
Using Futures to manage foreign exchange rate riskIndex futuresInterest rate futures
22Ch22&23 – MBA 567
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 futuresSecondary trading - liquidity
Marked to market
Standardized contract units
Clearinghouse warrants performance
Futures and Forwards
33Ch22&23 – MBA 567
Futures price - agreed-upon price at maturityLong position - agree to purchaseShort position - agree to sellProfits on positions at maturityLong = spot minus original futures priceShort = original futures price minus spot
CBOT futures contract – page 788Different types of futures contracts – page 789
Key Terms for Futures Contracts
44Ch22&23 – MBA 567
Futures vs Option
55Ch22&23 – MBA 567
Clearinghouse - acts as a party to all buyers and sellers.
Obligated to deliver or supply delivery
Closing out positionsReversing the trade
Take or make delivery
Most trades are reversed and do not involve actual delivery
Open Interest
Trading Mechanics
66Ch22&23 – MBA 567
Trading without and without a Clearinghouse
77Ch22&23 – MBA 567
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
88Ch22&23 – MBA 567
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
99Ch22&23 – MBA 567
Example
Related to marking to market
Maintenance margin – page 793-794
1010Ch22&23 – MBA 567
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
1111Ch22&23 – MBA 567
Hedging Revenues (Futures Price = $67.15)
1212Ch22&23 – MBA 567
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
1313Ch22&23 – MBA 567
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
1414Ch22&23 – MBA 567
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
1515Ch22&23 – MBA 567
Hedge Example Outcomes
Value 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
1616Ch22&23 – MBA 567
General Spot-Futures Parity
fRS
SDF
0
00 )(
Rearranging terms
0
000 )1()(
SDd
drSDrsSF ff
Multiple period formula: page 802 (22.2).
1717Ch22&23 – MBA 567
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
1818Ch22&23 – MBA 567
Theories of Futures Prices
Expectations
Normal Backwardation
Contango
1919Ch22&23 – MBA 567
2020Ch22&23 – MBA 567
Futures marketsChicago Mercantile (International Monetary Market)London International Financial Futures ExchangeMidAmerica Commodity Exchange
Active forward marketDifferences between futures and forward marketsSpot and forward prices in foreign exchange – page 815Foreign exchange futures
Foreign Exchange Futures
2121Ch22&23 – MBA 567
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
2222Ch22&23 – MBA 567
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.
2323Ch22&23 – MBA 567
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
2424Ch22&23 – MBA 567
Hedge Ratio
Hedge 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
2525Ch22&23 – MBA 567
Available on both domestic and international stocks
Advantages over direct stock purchaselower transaction costs
better for timing or allocation strategies
takes less time to acquire the portfolio
Major stock index futures – page 821
Stock Index Contracts
2626Ch22&23 – MBA 567
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
2727Ch22&23 – MBA 567
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
2828Ch22&23 – MBA 567
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
2929Ch22&23 – MBA 567
Example -- continued
H =
=
Change in the portfolio value
Profit on one futures contract
$600,000
$6,250= 96 contracts short
3030Ch22&23 – MBA 567
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
3131Ch22&23 – MBA 567
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
3232Ch22&23 – MBA 567
Example -- continued
H =
=
PVBP for the portfolio
PVBP for the hedge vehicle
$9,000
$90= 100 contracts
3333Ch22&23 – MBA 567
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
3434Ch22&23 – MBA 567
Swap Dealer
Page 831