Futures Markets Chapter 22 22-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-1

Futures and Forwards Forward Futures Key difference in futures an agreement calling for a future delivery of an asset at an agreed-upon price Futures similar to forward but feature formalised and standardised characteristics Key difference in futures Secondary trading – liquidity Marked to market Standardised contract units Clearinghouse warrants performance Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-2

Key Terms for Futures Contracts Futures price agreed-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 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-3

Profits: Futures Buyers and Call Buyers Fo Price Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-4

Profits: Futures Sellers and Put Buyers Fo Put Buyer Price Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-5

Types of Contracts Agricultural commodities Metals and minerals (including energy contracts) Foreign currencies Financial futures Interest rate futures Stock index futures Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-6

Snapshot of Australian Futures Market (1960) The Sydney Greasy Wool Futures Exchange Grain and electricity a part from wool (1972) Exchange renamed as SFE Gold Futures; 1978 BAB Futures; 1979 AUD Futures; 1980 SPI Futures; 1983 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-7

Trading Mechanics Clearinghouse Closing out positions Acts as a party to all buyers and sellers 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 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-8

Margin and Trading Arrangements 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 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-9

Margin and Trading Arrangements 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 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-10

Clearinghouse Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-11

Open Interest Open Interest: Number of outstanding contracts Open interest is zero at the beginning Contracts gets reversed Reversal depends on movements Few contracts gets delivered/purchased Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-12

Cash vs. Actual Delivery Delivery of contract on expiration Physical delivery Quality of the underlying Cash settlement (difference in price counts) Concept started with actual delivery Nowadays, mostly cash settled Index Futures – cash settled Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-13

Regulatory Bodies Regulation: It’s why, different to Forward contracts CFTC in US ASIC in Australia Except of few commodities, laws regulating mining & agriculture takes care of them Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-14

Trading Strategies Speculation: Hedging: 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 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-15

Basis and Basis Risk Basis Basis Risk 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 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-16

Futures Pricing 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 These two strategies must have the same market determined costs Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-17

Spot-Futures Parity Theorem With a perfect hedge the futures payoff is certain – there is no risk A perfect hedge should return the riskless rate of return This relationship can be used to develop futures pricing relationship Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-18

Hedging versus speculating Protecting against adverse movements Hedgers are having exposures Speculating: Profit from movements in prices Anticipating price movements and taking positions to earn returns Speculators are the main players of the futures markets Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-19

Hedge Example: pp. 806-807 Investor owns and S&P 500 fund that has a current value equal to the index of $900 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 $925 Assume the investor hedges by selling or shorting one contract Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-20

Hedge Example Outcomes Value of ST 885 925 965 Payoff on Short (1,345 - ST) 40 0 -40 Dividend Income 20 20 20 Total 945 945 945 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-21

Rate of Return for the Hedge Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-22

General Spot-Futures Parity Rearranging terms Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-23

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 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-24

Theories of Futures Prices Expectations Normal Backwardation Contango Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-25

Futures and Expected Spot Price: Theories Futures prices Contango Expectations Hypothesis Normal Backwardation Time Delivery date Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-26

Summary Forward contracts Long trader Short trader Difference between Forward and Futures Clearinghouse and its role Role of margins Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-27

Summary Hedging purpose Speculation purpose Spot-futures parity Cost of carry model Cost of carry and arbitrage Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Investments, by Bodie, Ariff, da Silva Rosa, Kane & Marcus Slides prepared by Harminder Singh 22-28