Futures Markets and Risk Management Chapter 17 Futures Markets and Risk Management Describes the financial instruments traded in primary and secondary markets. Discusses Market indexes. Discusses options and futures. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 1

Futures and Forwards Forward is an agreement to buy (long position) or to sell (short) a product (or an asset) at today’s agreed-upon price. Futures is similar to forward but has standardized terms and is traded on an exchange. Key difference in futures Futures have secondary trading (liquidity) Marked to market Standardized contract terms such as delivery dates, price units, contract size Clearinghouse guarantees performance

Key Terms for Futures Contracts The Futures price: agreed-upon price paid at maturity Long position: Agrees to purchase the underlying asset at the stated futures price at contract maturity Short position: Agrees to deliver the underlying asset at the stated futures price at contract maturity Profits (accumulated) on long and short positions Long = Futures price at the moment minus original futures price Short = Original futures price minus futures price at the moment The book says spot price at maturity and this is correct due to convergence between the futures and the spot price at maturity.

Types of Contracts Agricultural commodities Metals and minerals (including energy contracts) Financial futures Interest rate futures Stock index futures Foreign currencies

Table 17.1 Sample of Futures Contracts

The Clearinghouse and Open Interest Futures Exchanges (CME, CBOT, SIMEX, etc) are the clearinghouses - acts as a counterparty to each party, buyers and sellers. A futures participant is obligated to perform against the clearinghouse. Closing out positions Reversing the initial trade OR take or make delivery Most trades are reversed and do not involve actual delivery (agreed to take the delivery (LONG) of XXX on 3rd Wed in June. Later, agreed to deliver (SHORT) XXX on 3rd Wed of June. Basically, you have no position) Open Interest The number of contracts yet to be closed out with a reversing trade Avoiding delivery: It is common to have your broker automatically close out your position on the last trading day before delivery becomes an obligation, or to roll your contract over to the next closest expiration contract. Over 90% of futures contracts do not result in delivery. For stock index contracts, the contracts are cash settled only and no delivery can take place. Why this doesn’t really matter is explained after the marking to market example.

Figure 17.3 Trading With and Without a Clearinghouse The clearinghouse eliminates counterparty default risk; this allows anonymous trading since no credit evaluation is needed. Without this feature you would not have liquid markets. The clearinghouse eliminates counterparty default risk; this allows anonymous trading since no credit evaluation is needed. Without this feature you would not have liquid markets.

Marking to Market and the Margin Account Initial Margin: funds that must be deposited initially in a margin (=equity) account to provide capital to absorb losses Marking to Market (Daily Settlement): practice of taking the profit or loss at the end of each trading day based on the settlement price and reflected in the margin account (from the loser to the gainer) to prevent anyone building up a huge loss which cannot be covered. No paper gain or loss. Maintenance margin: an established value below which the trader gets a margin call either to close out the position or add more money to keep the position. Variation margin: With the margin call, the minimum amount to be added to the margin account to keep the position.

Marking to Market Example On Monday morning you sell one T-bond futures contract at 97-27 (97 27/32% of the $100,000 face value). Futures contract price is thus _________. The initial margin requirement is $2,700 and the maintenance margin requirement is $2,000. $97,843.75 Margin Total %HPR Spot HPR Day Settle $ Value Price Change Account (cum.) (cum.) $97,843.75 $2700 Open 97 - 13 $97,406.25 - $437.50 $3137.50 16.2% 0.45% Mon. Margin requirements are available from the CME. These were current when I looked them up but they change frequently as volatility changes. The sizes of the margin requirements are chosen based on daily volatility to limit the clearinghouse’s risk. The clearinghouse basically requires the participants to prepay potential daily losses and then all the house does is transfer funds from the long to the short and vice versa. Note that brokers may require higher margin accounts than the exchange mandated minimums stated here. They typically will require high minimums for retail accounts. The total %HPR is found from as the cumulative percent change in the margin account column. For instance, 16.2% = (3137.50 – 2700)/2700, (the price fell so this is a gain to the short, who can ostensibly buy in the spot now and sell at the futures price) -5.8% = (2543.75 – 2700)/2700, -79.9% = (543.75 – 2700)/2700 The spot HPR (cum) is the percent change in the $ value column, keeping the open as the basis. This represents what the % return would have been had you 1) used the spot market rather than the futures market and 2) the $ value column = spot prices. It is useful to illustrate the leverage provided by the futures contract. 0.45% = (97,406.25-97,843.75)/97,843.75 -0.16% = (98,000 – 97,843,75)/97,843.75 -2.2% = (100,000-97,843.75)/97,843.75 The leverage multiplier can be found by taking the ratio of the futures return / Spot HPR return, for example 16.2% / 0.45%  36. 98 - 00 $98,000.00 $593.75 $2543.75 - 5.8% - 0.16% Tues. 100 - 00 $100,000.00 $2000.00 $543.75 - 79.9% - 2.2% Wed. Margin Call => Variation margin +$2156.25 $2700.00 Leverage multiplier ≈ 36

Why delivery on futures is not necessary? Long = get paid the difference(+/-) to buy at the spot market, if you want. Short= pay the difference(+/-) to the counterparty so that she can buy at the market, if she wants. No reason to do the actually delivery. Cash settlements for the gifts you promised (e.g., insurance settlements). If you go long on T-Bond futures at Futures = ___________ => It means that you agreed to buy the T-Bond for $110,000 at the expiration date. Suppose that at contract expiration, SpotT-Bonds = ________ => Then 1) You can pay $110,000 to your counter party and receive the T-Bond which is worth $108,000. Alternatively, 2) you can just pay the other party $2,000 (or take a loss of $2,000) and the other party takes this $2,000 to settle. If you really want to buy T-Bond at that moment, you can go out to the spot market and buy the T-Bond for $108,000. The total amount you spend to buy the T-Bond is $2,000 + $108,000 =$110,000, which is the same as 1). Because of the marking-to-market, your loss is already $2,000 as the futures exchange has debited the amount. $110,000 $108,000

More on futures contracts Delivery: Specifications of when and where delivery takes place and what (quality of the product) can be delivered Cash Settlement: Some contracts can only be settled in cash rather than delivering the underlying assets (indexes, weather, etc)

Trading Strategies Speculation (no position in an underlying asset) Go long if you believe price will rise Go short if you believe price will fall Hedging (has a position in an underlying asset => value of the “portfolio” is not affected. The gain from your position is just to offset your “otherwise” loss) Long hedge: When you need to buy a product (asset) in the future and are concerned about an increase in price and would like to protect against a rise in price. E.g, An oil company try to secure oil in the future. An importer needs to secure euro to make an euro payment in the future. Short hedge: When you need to sell a product (asset) and are worried about an decrease in price and would like to protect against a fall in price. E.g, A farmer would like to fix the future selling price of his crop today. An exporter would like to fix today the selling price of euro she expects to receive in the future.

Futures Pricing Spot-futures parity theorem Purchase the commodity now and store it to T, Simultaneously take a short position in futures, The ‘all in cost’ of purchasing the commodity and storing it (including the cost of funds) must equal the futures price to prevent arbitrage.

The no arbitrage condition Action Initial Cash Flow Cash Flow at T 1. Borrow So S0 -S0(1+rf)T 2. Buy spot for So -S0 ST 3. Sell futures short F0 - ST Total F0 - S0(1+rf)T Since the strategy cost 0 initially, the cash flow at T must also equal 0. Thus: F0 - S0(1 + rf)T = 0 F0 = S0 (1 + rf)T The futures price differs from the spot price by the cost of carry. An arbitrage argument illustrates the concept but we need a bit more. First, the only cost of carry here is the time value of money represented by the risk free rate, so we are ignoring any physical storage cost of the commodity which would normally have to be added on. One could borrow the money to buy the spot commodity, buy the spot and concurrently short the futures. This is riskless because you have the spot and you have locked up the sale price of it with the futures contract. The cost of carry can be negative if the yield on the spot commodity is greater than the storage and funding cost. Oil markets are sometimes in backwardation, usually when there are concerns about future supply disruptions. Then owning oil spot carries a convenience yield that can exceed the cost of carry. The cost of carry is typically positive and when it is the market is said to be in ‘contango.’ When the cost of carry is negative the market is said to be in backwardation.

Table 17.2 Stock Index Futures

Creating Synthetic Stock Positions Synthetic stock purchase Purchase of stock index futures instead of actual shares of stock Allows frequent trading at low cost, especially useful for foreign investments It is cheaper to buy Treasury bills and then shift stock market exposure by buying and selling stock index futures. In this strategy the investor is changing the relative weights on the riskless and risky asset.

Index Arbitrage Difficult to do in practice Exploiting mispricing between underlying stocks and the futures index contract Futures Price too high: Short the futures and buy the underlying stocks Futures price too low: Long the futures and short sell the underlying stocks Difficult to do in practice

Swaps Large component of derivatives market Interest Rate Swaps One party agrees to pay the counterparty a fixed rate of interest in exchange for paying a variable rate of interest, No principal is exchanged. Currency Swaps Two parties agree to swap principal and interest payments at a fixed exchange rate. A series of forward contracts. Can be used to avoid risks or to take advantage of comparative advantage (gains from trading).

Figure 17.8 Interest Rate Swap Company A wants a variable rate financing to match their variable rate investments (e.g., mismatch with L+2% funded by 7% fixed). They will pay LIBOR for 6.95%. Company B wants a fixed rate financing to mach their fixed rate investments (e.g., mismatch with 9% financed by L%). They will pay 7.05% for L% Recall that LIBOR is the London Interbank Offer Rate, the rate that banks charge each other in the international banking market. Note that the swap dealer is not exposed to interest rate risk, but they do face counterparty credit risk. The two deals may not be done synchronously, and probably won’t be. The dealer (typically a bank) manages the ‘swap book.’ The variable side is always at LIBOR (flat), the different pricing is on the fixed rate sides. This business has become highly competitive and the dealer profit spread in the example is too high. * Both companies can avoid the interest rate risks and secure locked-in spreads. If the swap dealer has both deals, it can also eliminate the risk