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Part1 Introduction

Part1 Introduction. Forward Contract and Financial Futures. Forward Contract. An agreement to buy or sell a specified amount of a specified commodity at a specified price on a future day. What cash flows take place? When? Credit Risk? Private, custom-tailored agreement.

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Part1 Introduction

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  1. Part1 Introduction • Forward Contract and • Financial Futures

  2. Forward Contract • An agreement to buy or sell a specified amount of a specified commodity at a specified price on a future day. • What cash flows take place? When? • Credit Risk? Private, custom-tailored agreement

  3. Futures contract • Standardized contract = Futures contract • Allows daily trading = liquidity • Requires margin • "Marked to market" daily • Exchange acts as intermediary • Credit risk?

  4. Valuing a Forward Contract • No storage costs: gold • Price set so that initial value of contract is zero. How is this possible? • Gold, one year hence, current price = $400, interest rate = 10% • Suppose: forward (futures) price = $450

  5. Valuing a Forward Contract • Now: • Borrow funds +400 • Buy gold -400 • Sell gold futures contract 0 • Net cash flow 0 • One year later: • Deliver gold at contract price +450 • Pay off loan -440 • Net cash flow +10 • Risk?

  6. Suppose: Forward (futures) price =$420 • Strategy: "Sell the Basis" • Now: • Short gold in cash market +400 • Invest funds in 10% loan -400 • Buy gold futures contract 0 • Net cash flow 0 • One year later: • Buy gold at contracted price - 420 • Deliver on short position • Receive payment on loan + 440 • Net cash flow + 20 • Risk?

  7. Equilibrium (No Arbitrage) Price? • 440 • Cost of carry formula • F = S (1+r) = 400(1.10) = 440

  8. Stock Index Futures • Suppose stocks pay 3% dividend, current level = 500 interest rate = 10% • If forward price at $550: • Now: • Borrow funds +500 • Buy stocks -500 • Sell index futures contract 0 • Net cash flow 0

  9. One period hence: • Receive dividends +15 • Deliver stock at contract price +550 • Pay off loan -550 • Net cash flow +15

  10. If forward price at $525: • Now: • Short stocks in cash market 500 • Invest funds at 10% -500 • Buy index futures contract 0 • Net cash flow 0

  11. One year later: • Pay dividends on short position -15 • Buy stocks at contracted price -525 • Deliver on short • Receive payment on loan +550 • Net cash flow +10 • Equilibrium Price?

  12. Stock Index Futures • Risk: Program Trading • Transaction costs • Short sale • Cash settlement • Borrowing/lending rates • Marking to market • Question: • Is the prevailing futures (forward) price an estimate of the expected index level in the future?

  13. "Interest Rate" Futures • Really bond futures • Suppose $1000 Treasury bond with 8% coupon, currently trading at 920, 6% short term rate • If futures contract selling at 910: • Now: • Borrow funds +920 • Buy bond -920 • Sell Treasury futures 0 • Net cash flow 0

  14. "Interest Rate" Futures • One year later: • Receive coupon +80 • Deliver bond at contract price +910 • Pay off loan -920 • Pay off loan interest -55 • Net cash flow +15 • Which bond to buy? • "Cheapest to deliver" • Which bonds can be used?

  15. Chicago Board of TradeLong-Term U.S. Treasury Bonds • delivery months: The current month and any subsequent months are determined by the Financial Instruments Committee or the Board of Directors, including March, June, September, and December • trading unit: U.S. Treasury bonds having a face value at maturity of $100,000 or multiples thereof • minimum fluctuation: Minimum price fluctuations shall be in multiples of one thirty-second (1/32) point per 100 points ($31.25 per contract); par shall be on the basis of 100 points

  16. daily price movement limits: 64/32 above or below the previous day's settlement price • position limits: None; positions of 100 contracts require reporting to the CFTC(Commodity Futures Trading Commission); positions of 50 contracts require reporting to the exchange • grades deliverable: Long-term U.S. Treasury bonds which, if callable, are not callable for at least 15 years or, if not callable, have a maturity of at least 15 years • Delivery: By book-entry in accordance with Department of theTreasury

  17. MidAmerica Commodity ExchangeTreasury Bonds • delivery months: March, June, September, and December • trading unit: U.S. Treasury bonds with a face value at maturity of $50,000 • minimum fluctuation: 1/32 of a percentage point ($15.62 per contract) • daily price movement limits: 64/32 of a percentage point ($1,000 per contract); no limit in the spot month

  18. position limits: $100 million face value net long or short • grades deliverable: U.S. Treasury bonds maturing at least 15 years from the date of delivery if not callable; if callable, not callable for at least 15 years from date of delivery • Delivery: Federal Reserve book-entry wire transfer system; invoice is adjusted for coupon rates and term to maturity or call

  19. If futures contract selling at 880: • Now: • Short bond in cash market +920 • Invest funds at 6% -920 • Buy bond futures 0 • Net Cash Flow 0 • One year later: • Receive loan principal +920 • Receive loan interest +55 • Pay coupon on shorted bond -80 • Buy bond at contracted price -880 • Deliver on bond ___ _ • Net Cash Flow 15 • Equilibrium Price?

  20. What about risk? If futures prices are risky, shouldn't an investor be compensated for bearing that risk? i.e. shouldn't futures sell below the expected price so the price increase will give the buyer a premium for risk incurred?

  21. Roles of the Clearinghouse • Interjects itself as the counterparty to all transactions • Every exchange-traded derivative contract has the same default and settlement risk • equal to the risk of the clearinghouse defaulting • Oversees Margins • Initial, Maintenance • Daily Marking-to-Market

  22. Margins • A margin is cash or marketable securities deposited by an investor with his or her broker • The balance in the margin account is adjusted to reflect daily settlement • Margins minimize the possibility of a loss through a default on a contract

  23. Example of a Futures Trade • An investor takes a long position in 2 December gold futures contracts on June 5 • contract size is 100 oz. • futures price is US$400 • margin requirement is US$2,000/contract (US$4,000 in total) • maintenance margin is US$1,500/contract (US$3,000 in total)

  24. Daily Mark-to-Market Example

  25. Other Key Points About Futures • They are settled daily • Closing out a futures position involves entering into an offsetting trade • Most contracts are closed out before maturity

  26. Delivery • If a contract is not closed out before maturity, it usually is settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. • A few contracts (for example, those on stock indices and Eurodollars) are settled in cash

  27. Some Terminology for Futures: Newspaper Quotes • Open interest: the total number of contracts outstanding • equal to number of long positions or number of short positions • Settlement price:the price just before the final bell each day • used for the marking-to-market process • Volume of trading: the number of trades in one day

  28. Convergence of Futures to Spot Futures Price Spot Price Futures Price Spot Price Time Time (a) (b)

  29. Regulation of Futures • Regulation is designed to protect the public interest • Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups

  30. Forward Contracts • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price • There is no daily settlement. At the end of the life of the contract one party buys the asset for the agreed price from the other party

  31. How a Forward Contract Works • The contract is an over-the-counter (OTC) agreement between 2 companies • No money changes hands when first negotiated & the contract is settled at maturity • The initial value of the contract is zero

  32. Forward Contracts vs Futures Contracts FORWARDS FUTURES Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Range of delivery dates Settled at maturity Settled daily Delivery or final cash Contract usually closed out settlement usually occurs prior to maturity

  33. Hedging Strategies Using Futures

  34. Long & Short Hedges • A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price • A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

  35. Arguments in Favor of Hedging • Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

  36. Arguments against Hedging • Shareholders are usually well diversified and can make their own hedging decisions • It may increase risk to hedge when competitors do not • Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult

  37. Basis Risk • Basis is the difference between spot & futures • Basis risk arises because of the uncertainty about the basis when the hedge is closed out

  38. Long Hedge • Suppose that F1 : Initial Futures Price F2: Final Futures Price S2 : Final Asset Price • You hedge the future purchase of an asset by entering into a long futures contract • Cost of Asset=S2 -F2+F1= F1 + Basis

  39. Short Hedge • Suppose that F1 : Initial Futures Price F2: Final Futures Price S2 : Final Asset Price • You hedge the future sale of an asset by entering into a short futures contract • Price Realized=S2 -F2+F1= F1 + Basis

  40. Choice of Contract • Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge • When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis

  41. Optimal Hedge Ratio Proportion of the exposure that should optimally be hedged is where sSis the standard deviation of DS, the change in the spot price during the hedging period, sF is the standard deviation of DF, the change in the futures price during the hedging period r is the coefficient of correlation between DS and DF.

  42. Hedging Using Index Futures • To hedge the risk in a portfolio the number of contracts that should be shorted is • where P is the value of the portfolio, b is its beta, and A is the value of the assets underlying one futures contract

  43. Reasons for Hedging an Equity Portfolio • Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) • Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outpeform the market.)

  44. Example Value of S&P 500 is 1,000 Value of Portfolio is $5 million Beta of portfolio is 1.5 What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?

  45. Changing Beta • What position is necessary to reduce the beta of the portfolio to 0.75? • What position is necessary to increase the beta of the portfolio to 2.0?

  46. Rolling The Hedge Forward • We can use a series of futures contracts to increase the life of a hedge • Each time we switch from 1 futures contract to another we incur a type of basis risk

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