1 Futures Futures Markets Futures and Forward Trading Mechanism Speculation versus Hedging Futures Pricing Foreign Exchange, stock index, and Interest Rate Futures Using Futures to manage foreign exchange rate risk Index futures Interest rate futures

2 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 futures Secondary trading - liquidity Marked to market Standardized contract units Clearinghouse warrants performance Futures and Forwards

3 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 Key Terms for Futures Contracts

4 Futures Listings Page 758 (with explanations on page 757). Example: Pick up agricultural contract; let’s look at the March 2010 maturity corn contract Each contract calls for delivery of 5,000 bushels Profit for long Profit for short Chapter 1: Overview

5 Futures vs Option

6 Clearinghouse - 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 Open Interest Trading Mechanics

7 Trading without and without a Clearinghouse

8 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

9 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

10 Example: Maintenance margin Suppose the maintenance margin is 5% while the initial margin was 10%. Still consider the March maturity Corn contract. The initial purchase price is $3.92 per bushel. How low the price of Corn future price can go before the investor receives a margin call?

11 Example: Marking to Market Page 764 Chapter 1: Overview

12 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

13 Hedging Revenues (Futures Price = $67.15)

14 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

15 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

16 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

17 Hedge Example Outcomes Value of S T 1,3051,345 1,405 Payoff on Short (1,345 - S T ) Dividend Income Total1,365 1,365 1,365

18 General Spot-Futures Parity Rearranging terms Multiple period formula: page 802 (22.2).

19 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

20 Theories of Futures Prices Expectations Normal Backwardation Contango

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22 Futures markets Chicago Mercantile (International Monetary Market) London International Financial Futures Exchange MidAmerica Commodity Exchange Active forward market Differences between futures and forward markets Spot and forward prices in foreign exchange – page 815 Foreign exchange futures Foreign Exchange Futures

23 Interest rate parity theorem Developed using the US Dollar and British Pound where F 0 is the forward price E 0 is the current exchange rate Pricing on Foreign Exchange Futures

24 Text Pricing Example r us = 5% r uk = 6%E 0 = $1.60 per pound T = 1 yr If the futures price varies from $1.58 per pound arbitrage opportunities will be present.

25 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

26 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

27 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 Major stock index futures – page 821 Stock Index Contracts

28 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

29 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

30 Example Portfolio Beta =.8S&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

31 Example -- continued H = = Change in the portfolio value Profit on one futures contract $600,000 $6,250 = 96 contracts short

32 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

33 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

34 Example -- continued H = = PVBP for the portfolio PVBP for the hedge vehicle $9,000 $90 = 100 contracts

35 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

36 Swap Dealer Page 831