Hedging with T-bond Futures

Slides:



Advertisements
Similar presentations
Managing Commodity Price Risk with Futures & Options.
Advertisements

FINC4101 Investment Analysis
Techniques of asset/liability management: Futures, options, and swaps Outline –Financial futures –Options –Interest rate swaps.
1 Futures Futures Markets Futures and Forward Trading Mechanism Speculation versus Hedging Futures Pricing Foreign Exchange, stock index, and Interest.
Getting In and Out of Futures Contracts By Peter Lang and Chris Schafer.
Intermediate Investments F3031 Hedging Using Interest Rate Futures Contracts There are two main interest rate futures contracts –Eurodollar futures –US.
McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Futures Markets and Risk Management CHAPTER 17.
Chapter 14 Futures Contracts Futures Contracts Our goal in this chapter is to discuss the basics of futures contracts and how their prices are quoted.
1 1 Ch22&23 – MBA 567 Futures Futures Markets Futures and Forward Trading Mechanism Speculation versus Hedging Futures Pricing Foreign Exchange, stock.
Chapter 9. Derivatives Futures Options Swaps Futures Options Swaps.
Techniques of asset/liability management: Futures, options, and swaps Outline –Financial futures –Options –Interest rate swaps.
BONUS Exotic Investments Lesson 1 Derivatives, including
Chapter 7 The Foreign Exchange Market. Outlines… Introduction, The Structure Of Foreign Exchange Market, Functions of foreign exchange markets Spot Market.
Using Options and Swaps to Hedge Risk
Finance 300 Financial Markets Lecture 25 © Professor J. Petry, Fall 2001
Page 1 of 4 HW 4 Due on Tuesday, FEB 23 in class. Study carefully the following article: Crude oil protective puts by the State of Texas Texas, Other Governments,
Finance 300 Financial Markets Lecture 24 © Professor J. Petry, Fall 2002
Global foreign exchange market turnover. Foreign Exchange Transactions A foreign exchange market transaction is composed of: spot, outright forward and.
The Foreign Exchange Market (Part II). © 2002 by Stefano Mazzotta 1 Learning Outcomes 1.Foreign currency forwards 2.Foreign currency futures.
Hedging Strategies Using Derivatives. 1. Basic Principles Goal: to neutralize the risk as far as possible. I. Derivatives A. Option: contract that gives.
Chapter Eight Risk Management: Financial Futures, Options, and Other Hedging Tools Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.
Currency Futures Introduction and Example. 2 Financial instruments Future contracts: –Contract agreement providing for the future exchange of a particular.
1 Farm and Risk Management Team Cooperative Extension – Ag and Natural Resources Dairy Price Risk Management: Session 5 – Hedging With Futures Last Update.
Currency Futures Introduction and Example. FuturesDaniels and VanHoose2 Currency Futures A derivative instrument. Traded on centralized exchanges (illustrated.
Currency Futures Introduction and Example. 2 Financial instruments Future contracts: –Contract agreement providing for the future exchange of a particular.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer.
Rates for PKR/US$ are quoted as follows: Rates for PKR/US$ are quoted as follows: Spot – Spot – month –
1 FORWARDS Definition: n An FX Transaction in which two parties agree TODAY to exchange currencies on a SPECIFIC FUTURE date & at a SPECIFIC RATE. n The.
Futures Markets and Risk Management
Financialization of Energy Products
Module 3 - Foreign Exchange Market
Institutions & Derivative Instruments
Interest Rate Futures Chapter 6
Stock Index Futures A contract for stock index futures is based on the level of a particular stock index such as the S&P 500. The agreement calls for the.
Chapter 6 Interest Rate Futures (part2)
Copyright © 2004 by Thomson Southwestern All rights reserved.
Commodity Marketing ~A Review
Derivative Markets and Instruments
Interest Rate Futures Chapter 6
Institutions & Derivative Instruments
Chapter Eight Risk Management: Financial Futures,
Study carefully the following article:
Futures Contracts Basics Mechanics Commodity Futures
Chapter 30 – Interest Rate Derivatives
P.Krishnaveni/MBA/SNSCT
Futures Markets and Risk Management
Using Derivatives to Manage Interest Rate Risk
Derivative Financial Instruments
As A Novice CFD Dealer You Have The Gain Of Being Able To Draw At The Experience Of Many A Hit Buyers A Contract For Difference (CFD) is a widespread.
Financial Markets and Financial Products
Agricultural Marketing
Agricultural Marketing
Module 8: Futures, Forwards, and Swaps
Agricultural Marketing
17 Futures Markets and Risk Management Bodie, Kane, and Marcus
Agricultural Marketing
Definition of Risk Variability of Possible Returns Or The Chance That The Outcome Will Not Be As Expected copyright anbirts.
Agricultural Marketing
Options Contracts Slide Show Courtesy of:
Derivative Financial Instruments
CHAPTER 22 Futures Markets.
Professor Chris Droussiotis
Crop Marketing Winnebago County Grain Marketing Thompson, Iowa
Risk Management with Financial Derivatives
Corporate Financial Theory
In–Class Exercise Suppose you wish to purchase 30 May corn futures contracts. The current price of the May contract is $3.70/bushel (see earlier slide.
Futures Contracts Basics Mechanics Commodity Futures
Futures Contracts Interest Rate Futures “Cheapest to Deliver” Bonds.
Hedging with Futures Takeo Aoki.
OUTLINE Questions? News?
Presentation transcript:

Hedging with T-bond Futures Example: Suppose a mortgage banker has agreed on March 1st to supply $1 million in funds to clients wishing to purchase homes. The terms of the agreement are for 12% mortgages over 20 years. So, 12% is the “market rate” as of March 1st, when this agreement is made. Furthermore, the broker has agreed to supply these funds on May 1st, (2 months later).

Hedging with T-bond Futures Many mortgage bankers (including this one) make these agreements before they have the $1 million dollars in hand. So, they must shop around to find a buyer for the 12% mortgages that will be established on May 1st. The buyer purchases the mortgages and provides funds to be passed on to the home buyers. The mortgage banker will play middle man.

Hedging with T-bond Futures It takes time to shop around for a buyer. Many insurance companies look for such opportunities to invest part of their excess cash. Suppose on April 15th, the mortgage banker finds a willing insurance company to buy the mortgages.

Example continued: Mar 1 Apr 15 May 1 Between Mar 1st (when the prevailing interest rates were 12%) and April 15th, when the insurance company entered the picture, interest rates could have changed! If interest rates went up, the insurance firm might only give the mortgage broker, say, $940,000 for the $1 million in mortgages. This would leave the banker to have to come up with the additional $60,000. If interest rates went down, however, the insurance firm might be willing to pay a premium for the $1 million in mortgages, say, $1,050,000. This would be an unexpected increase in revenue to the banker, as he only needed $1 million.

Questions: How could the Mortgage Broker hedge against this Interest Rate Risk using Treasury Bond Futures (a.k.a. Interest Rate Futures)? Should the broker take a long or short position? How many contracts to cover exposure? When should these contracts be entered into and when should they be closed out (reverse the position)?

Example continued: How could the Mortgage Broker hedge against this Interest Rate Risk? Use Treasury Bond Futures (a.k.a. Interest Rate Futures). Current situation: If interest rates go up, banker gets hurt If interest rates go down, banker profits. To hedge, we want an instrument that has the opposite reactions to interest rate changes!

When is money made with a Long position When is money made with a Long position? 1 Long Treasury Bond Futures Contract Treasury Bond Futures have a $100,000 contract size Day Futures Price (in 32nds) Futures Price (in decimals) Daily Gain (Loss) Cumulative Gain (Loss) Margin Account Balance Maintenance Call? (at $3,923.44) Initial 104-20 104.625 5231.25 Nov 17 104-28 104.875 250 5481.25 No … Nov 27 105-14 105.438 563 813 7981.75 Our hedge goal: Profits when rates rise; Losses when rates fall. With a LONG position above, we see that when interest rates fall (and therefore the bond prices rise), it leads to a gain. This will compound our gains when rates rise and compound our losses when rates rise. So, a long position won’t work for hedging purposes.

When is money made with a Short position When is money made with a Short position? 1 Short Treasury Bond Futures Contract Treasury Bond Futures have a $100,000 contract size Day Futures Price (in 32nds) Futures Price (in decimals) Daily Gain (Loss) Cumulative Gain (Loss) Margin Account Balance Maintenance Call? (at $3,923.44) Initial 104-20 104.625 5231.25 Nov 17 104-28 104.875 -250 4981.25 No … Nov 27 105-14 105.438 -563 -813 4418.25 Our hedge goal: Profits when rates rise; Losses when rates fall. With a SHORT position above, we see that when interest rates fall (and therefore the bond prices rise), it leads to a loss. This is the pattern that we want for our hedging purposes.

How many contracts to short? We have a $1 million in mortgages to hedge. Contract size for Treasury bonds are $100,000 each. So, short 10 contracts ($1 million / $100,000). Note: this example assumes that the mortgages and the T-bond futures contracts react similarly to changes in interest rates. In fact, this is a bit more complicated. But we haven’t covered Duration yet!

When to open and close contracts Date/Event Mortgage Markets Futures Markets March 1 Banker agrees to loan $1 million at 12% for 20 years. The loans are to be funded on May 1st. No cash exchanges hands here. Banker simultaneously shorts (sells) 10 Treasury-bond futures contracts with a delivery date past May 1st. April 15 Loans are sold to Insurance Company. Banker will receive these sale proceeds on May 1 based on Apr 15th interest rates. Mortgage banker will conduct reversing trades (buy 10 contracts), thereby locking in the gain/loss associated with them. If Interest rates rise between March 1 and April 15… Loans are sold to Insurance Company for a price below $1 million. Banker LOSES. Each short Futures contract is closed out at a GAIN because the increase in interest rates have driven down futures prices for bonds. If Interest rates fall between March 1 and April 15… Loans are sold to Insurance Company for a price above $1 million. Banker GAINS. Each short Futures contract is closed out at a LOSS because the decrease in interest rates have pushed up futures prices for bonds.