Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-1 Chapter 19

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-2 Chapter Summary  Objective: To describe the workings of futures markets and the mechanics of trading in these markets. Trading mechanics Futures pricing Different types of futures contracts Swaps

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-3  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-4  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-5  Agricultural commodities  Metals and minerals (including energy contracts)  Foreign currencies  Financial futures Interest rate futures Stock index futures Types of Contracts

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-6 Summary Reminder  Objective: To describe the workings of futures markets and the mechanics of trading in these markets. Trading mechanics Futures pricing Different types of futures contracts Swaps

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-7  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 Trading Mechanics

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-8  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 19-9  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 Margin and Trading Arrangements

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: To describe the workings of futures markets and the mechanics of trading in these markets. Trading mechanics Futures pricing Different types of futures contracts Swaps

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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  These two strategies must have the same market determined costs Futures Pricing

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Spot-Futures Parity Theorem  With a perfect hedge the futures payoff is certain - there is no risk  A perfect hedge should return the riskless rate of return  This relationship can be used to develop futures pricing relationship

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedge Example (text, pp )  Investor owns an S&P/TSE 60 fund that has a current value equal to the index of $400  Assume dividends of $5 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 $408  Assume the investor hedges by selling or shorting one contract

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedge Example - Outcomes Value of S T Payoff on Short ($408 - S T ) Dividend Income Total

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Rate of Return for the Hedge

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide General Spot-Futures Parity Rearranging terms:

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 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 risk-free rate  If the futures price is too low, go long futures, short the stock and invest the proceeds at the risk-free rate

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Commodity Futures Pricing General principles that apply to stock apply to commodities Carrying costs are more for commodities Spoilage is a concern Where;F 0 = futures price P 0 = cash price of the asset C = Carrying cost c = C/P 0

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Futures Price versus Expected Spot Price: Theories  Expectations  Normal Backwardation  Contango

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Contango Normal Backwardation Time Delivery date Futures prices Expectations Hypothesis Futures Price versus Expected Spot Price: Theories

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: To describe the workings of futures markets and the mechanics of trading in these markets. Trading mechanics Futures pricing Different types of futures contracts Swaps

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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 Stock Index Contracts

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Using Stock Index Contracts to Create Synthetic Positions  Synthetic stock purchase Purchase of the stock index instead of actual shares of stock  Creation of a synthetic T-bill plus index futures that duplicates the payoff of the stock index contract

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Pricing on Stock Index Contracts  The spot-futures price parity is given as:  Empirical investigations have shown that the actual pricing relationship on index contracts follows the spot-futures relationship

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Difficult to implement in practice Transactions costs are often too large Trades cannot be done simultaneously Development of Program Trading Used by arbitrageurs to perform index arbitrage Permits acquisition of securities quickly Triple-witching hour Evidence that index arbitrage impacts volatility Index Arbitrage and Program Trading

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Futures markets Chicago Mercantile (International Monetary Market) London International Financial Futures Exchange MidAmerica Commodity Exchange  Active forward market  Differences between futures and forward markets Foreign Exchange Futures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Interest rate parity theorem  Developed using the US Dollar and British Pound where, F0 is the forward price E0 is the current exchange rate Pricing on Foreign Exchange Futures

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Text Pricing Example r CAN = 6% r uk = 5% T = 1 yr E 0 = $1.60 per pound  If the futures price varies from $2.12 per pound arbitrage opportunities will be present

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Interest Rate Futures  Domestic interest rate contracts T-bills, notes and bonds municipal bonds  International contracts Eurodollar  Hedging Underwriters Firms issuing debt

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Hedging Interest Rate Risk  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

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder  Objective: To describe the workings of futures markets and the mechanics of trading in these markets. Trading mechanics Futures pricing Different types of futures contracts Swaps

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Interest rate swap  Foreign exchange swap  Credit risk on swaps  Swap Variations Interest rate cap Interest rate floor Collars Swaptions Swaps

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide  Swaps are essentially a series of forward contracts  One difference is that the swap is usually structured with the same payment each period while the forward rate would be different each period  Using a foreign exchange swap as an example, the swap pricing would be described by the following formula Pricing on Swap Contracts