Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 22

Chapter 22 Forward and Futures Contracts Questions to be answered: What are the differences in the way forward and futures contracts are structured and traded? How are the margin accounts on a futures contract adjusted for daily changes in market conditions? How can an investor use forward and futures contracts to hedge an existing risk exposure?

Chapter 22 Forward and Futures Contracts What is a hedge ratio and how should it be calculated? What economic functions do the forward and futures markets serve? How are forward and futures contracts valued after origination? What is the relationship between futures contract prices and the current and expected spot price for the underlying commodity or security?

Chapter 22 Forward and Futures Contracts How can an investor use forward and futures contracts to speculate on a particular view about changing market conditions? How do agricultural futures contracts differ from those based on financial instruments, such as stock indexes, bonds, and currencies? How can forward and futures contracts be designed to hedge interest rate risk?

Chapter 22 Forward and Futures Contracts How are implied forward rates and actual forward rates related? What is stock arbitrage and how is it related to program trading? How can forward and futures contracts be designed to hedge foreign exchange rate risk? What is interest rate parity and how would you construct a covered hedge interest arbitrage transaction?

An Overview of Forward and Futures Trading Forward contracts are negotiated directly between two parties in the OTC markets. –Individually designed to meet specific needs –Subject to default risk Futures contracts are bought through brokers on an exchange –No direct interaction between the two parties –Exchange clearinghouse oversees delivery and settles daily gains and losses –Customers post initial margin account

Hedging With Forwards and Futures Create a position that will offset the price risk of another holding –holding a short forward position against the long position in the commodity is a short hedge –a long hedge supplements a short commodity holding with a long forward position

Hedging With Forwards and Futures Relationship between spot and forward price movements –basis is spot price minus the forward price for a contract maturing at date T: B tT = S t - F t,T –forward price converges to the spot price as the contract expires –hedging exposure is correlation between future changes in the spot and forward contract prices and can be perfectly correlated with customized contracts

Hedging With Forwards and Futures Calculating the Optimal Hedge Ratio –net profit from the position

Forward and Futures Contracts: Basic Valuation Concepts Forward and futures contracts are not securities but, rather, trade agreements that enable both buyers and sellers of an underlying commodity or security to lock in the eventual price of their transaction

Valuing Forwards and Futures Valuing forwards Valuing futures contracts are marked to market daily * = the possibility that forward and futures prices for the same commodity at the same point in time might be different

The Relationship Between Spot and Forward Prices If you buy a commodity now for cash and store it until you deliver it, the price you want under a forward contract would have to cover: –the cost of buying it now –the cost of storing it until the contract matures –the cost of financing the initial purchase These are the cost of carry necessary to move the asset to the future delivery date

The Relationship Between Spot and Forward Prices Contango - high storage costs and no dividends Premium for owning the commodity –convenience yield –results from small supply at date 0 relative to what is expected at date T (after the crop harvest) Backwardated market - future is less than spot

Financial Forwards and Futures: Applications and Strategies Originally, forward and futures markets were organized largely around trading agricultural commodities Recent developments in this area have involved the use of financial securities as the asset underlying the contract Interest rate forwards and futures were among the first derivatives to specify a financial security as the underlying asset –forward rate agreements –interest rate swaps

Financial Forwards and Futures: Applications and Strategies Long-term interest rate futures –Treasury bond and note contract mechanics CBT $100,000 face value T-bond >15 year maturity T-note 10 year - bond with 6.5 to 10 year maturity T-note 5 year - bond with years Delivery any day during month of delivery Last trading day 7 days prior to the end of the month Quoted in 32nds Yield quoted is for reference Treasury bonds pay semiannual interest Conversion factors for differences in deliverable bonds

Financial Forwards and Futures: Applications and Strategies A duration based approach to hedging

Financial Forwards and Futures: Applications and Strategies A T-Bond/T-Note (NOB) Futures Spread –expecting a change in the shape of the yield curve –unsure which way rates will change –long one point on curve and short another point

Short-Term Interest Rate Futures Eurodollar and Treasury bill contract mechanics –Chicago Mercantile Exchange (CME or “Merc”) International Monetary Market (IMM) –LIFFE –LIBOR Altering bond duration with futures contracts Creating a synthetic fixed-rate funding with a Eurodollar strip Creating a TED spread

Stock Index Futures Intended to provide a hedge against movements in an underlying financial asset Hedging an individual stock with an index isolates the unsystematic portion of that security’s risk Stock index arbitrage –prominent in program trading

Currency Forwards and Futures Currency quotations –Direct (American) quote in U.S. dollars –Indirect (European) quote in non U.S. currency –Reciprocals of each other Interest rate parity and covered interest arbitrage

Currency Forwards and Futures

The Internet Investments Online

End of Chapter 22 –Forward and Futures Contracts

Future topics Chapter 23 Option Contracts