Futures Markets and Risk Management

CHAPTER 17 17.1 THE FUTURES CONTRACT Futures Markets and Risk Management Futures and Forwards Forward - an agreement calling for a future delivery of an asset at an agreedagreed-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 Figure 17.2 Profits to Buyers and Sellers of Futures and Options Contracts Key Terms for Futures Contracts Futures price - agreedagreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot Types of Contracts Agricultural commodities Metals and minerals (including energy contracts) Foreign currencies Financial futures Interest rate futures Stock index futures 16-1 Table 17.1 Sample of Futures Contracts 17.2 MECHANICS OF TRADING IN FUTURES MARKETS The Clearinghouse and Open Interest Clearinghouse - acts as a party to all buyers and sellers. Figure 17.3 Trading With and Without a Clearinghouse – 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 Marking to Market and the Margin Account Margin and Trading Arrangements Initial Margin - funds deposited to provide capital to absorb losses Margin call - when the maintenance margin is reached, broker will ask for additional margin funds Marking to Market - each day the profits or losses from the new futures price and reflected in the account. Maintenance or variance margin - an established value below which a trader’ trader’s margin may not fall. 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 16-2 Trading Strategies Speculation 17.3 FUTURES MARKET STRATEGIES – 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 Figure 17.4 Hedging Revenues Using Futures, Example 17.5 (Futures Price = 61.79) Basis and Basis Risk 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 Futures Pricing 17.4 THE DETERMINATION OF FUTURES PRICES SpotSpot-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 – These two strategies must have the same market determined costs 16-3 Parity Example Using Gold Strategy 1: Buy gold now at the spot price (S0) and hold it until time T when it will be worth ST Strategy 2: Enter a long position in gold futures today and invest enough funds in T-bills (F0) so that it will cover the futures price of ST Price of Futures with Parity Since the strategies have the same flows at time T Parity Example Outcomes Strategy A: Action Buy gold Strategy B: Action Initial flows -So Initial flows Flows at T ST Flows at T Long futures 0 ST - FO Invest in Bill FO(1+rf)T - FO(1+rf)T FO Total for B - FO(1+rf)T ST Figure 17.5 S&P 500 Monthly Dividend Yield FO / (1 + rf)T = SO FO = SO (1 + rf)T The futures price has to equal the carrying cost of the gold Figure 17.6 Gold Futures Prices 17.5 FINANCIAL FUTURES 16-4 Stock Index Futures Table 17.2 Stock Index Futures 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 Table 17.3 Correlations Among Major US Stock Market Indexes Creating Synthetic Stock Positions Synthetic stock purchase – Purchase of the stock index instead of actual shares of stock Creation of a synthetic TT-bill plus index futures that duplicates the payoff of the stock index contract – Shift between Treasury bills and broadbroad-based stock market holdings Index Arbitrage 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 Additional Financial Futures Contracts Foreign Currency – Forwards versus futures Interest Rate Futures Difficult to do in practice Transactions costs are often too large Trades cannot be done simultaneously 16-5 Figure 17.7 U.S. Dollar ForeignExchange Rates 17.6 SWAPS Swaps Figure 17.8 Interest Rate Swap Large component of derivatives market – Over $200 trillion outstanding – Interest Rate Swaps – Currency Swaps Interest rate swaps are based on LIBOR 16-6