Chapter 29 – Applications of Futures and Options BA 543 Financial Markets and Institutions.

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Chapter 29 – Applications of Futures and Options BA 543 Financial Markets and Institutions

Chapter 29 – Applications of Futures Two types of Positions Hedge Position Buying or Selling Futures when one owns the underlying (long in commodity) or will need the commodity (short in the commodity) Buys or Sells Futures to offset price volatility Speculator No position in underlying commodity (Naked) Betting on price movement to make money Zero-Sum Game in Futures (and Options)

Chapter 29 – Applications of Futures The Basic Hedge From the long commodity position From the short commodity position The role of speculation Price discovery Risk transfer Some historical issues with “speculators” Mechanics of the recording of trades and allocation of buys and sells within a trading company

Chapter 29 – Applications of Options Why hedge with options over futures? Switch from risk neutral to potential upside With Futures you avoid the downside by giving up the upside With Options you pay a premium to avoid the downside but still have the upside potential Other side of the contract Speculator (no position with underlying asset) Taking risk for a premium – insurance company

Chapter 29 – Applications of Options Generic Model of Options Hedging Long in Stock – protective put on stock Portfolio of Stocks – buy put on a stock index Long in Commodity – Need option to “sell” futures contract if prices fall Buy a put option Short in Commodity – Need option to “buy” futures contract if prices rise Buy a call option Interest Rate Options