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

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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

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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 positionsReversing 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

Related to marking to market

Maintenance margin – page 793-794

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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 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).

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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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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

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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.

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

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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

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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

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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

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