VII: Futures 22: Speculation

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Futures  Hedge  use futures to reduce risk on an existing position  Speculate  use futures to take on risk in the hope of making a profit  Arbitrage  Use the difference between spot and futures prices to generate risk-free profit

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 SpeculationSusan 50,000 bushels of soybeans costs $210,000. The price of soybeans is going up $ $$ $ 50,000 bushels in soybeans futures costs $8100.

Chapter 22: Hedges, Speculation, and Arbitrage Speculation © Oltheten & Waspi 2012 Soybean Futures Soybeans

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Soybean Futures Soybeans Speculation

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Speculation & Leverage  Susan Speculates  Futures contracts  Pays $8,100 for the contract  Earns profit on $215,500 worth of soybeans  Soybeans  Earns profit on $210,000 worth of soybeans  Pays $210,000

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Speculation Let’s really speculate. Let’s use derivatives

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Derivative Securities  A derivative is a financial instrument whose underlying security is another financial instrument.  Soybean Futures  The underlying security is soybeans. Soybeans are real so soybean futures are NOT Derivatives

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Derivatives  Shares of Exxon Mobil  The underlying security is Exxon Mobil. Exxon Mobile is real so Exxon Mobile shares are NOT Derivatives. Exxon Mobil 100 Shares Exxon Mobil

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Derivatives  Exxon Mobile Stock Options  The security underlying the option is a share of Exxon Mobile. Shares are financial instruments; the options on the shares are derivatives. Exxon Mobil 100 Shares Exxon Mobil OPTION 100 Shares Exxon Mobil

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Derivatives  Mutual Funds  The security underlying the mutual fund unit is shares of Exxon Mobile, etc. The Mutual Fund is a derivative security. 100 Shares Exxon Mobil Equity Mutual Fund 1 Unit 100 Shares General Motors 100 Shares JP Morgan 100 Shares Illinois Water

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Speculating with Interest Rate Futures  Speculation on interest rates is easier in the futures market than in the spot market.  It is as easy to sell as to buy  Investments are leveraged

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Speculating with Interest Rate Futures  Example:  Interest rates are 6%  You expect them to decline to 5% within 6 months  You have $1,000,000 with which to speculate  Strategy A – buy bonds  Strategy B – buy interest rate futures

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy $1m 20 year 6% Strategy A: Buy T-Bonds

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy $1m 20 year 8% Six months laterI am right 7% I am wrong 9% Coupon [$1,000,000 *.06 * ½]+$30,000. Sell 19½ year 6% T-Bonds at 5% [112:12]+$1,123,750. Sell 19½ year 6% T-Bonds at 7% [89:14]+$894,375. Final Market Value$1,153,750.$924,375. Rate of Return (over six months) % %  Strategy A: Buy T-Bonds

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 T-Bond Futures  The T-Bond future is defined as a contract to deliver the equivalent of a $100, year 6% T- Bond  Initial margin is $2,500 per contract

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy month T-Bond [-$40,000,000] margin: -$1,000,000 Strategy B: T-Bond Futures

Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy month T-Bond [-$40,000,000] margin:-$1,000,000 Six months laterI am right 5% I am wrong 7% Sell 400 T-Bond 5% [112:12] Profit: Margin: Sell 400 T-Bond 9% [89:31] Profit: Margin: Rate of Return (over six months)  Strategy B: T-Bond Futures

Futures IV