McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 22 Futures Markets
22-2 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
22-3 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
22-4 Profits: Futures Buyers and Call Buyers Profit Price 0 Call Buyer Futures Buyer FoFo
22-5 Profits: Futures Sellers and Put Buyers 0 Profits Price Futures Seller Put Buyer Fo
22-6 Agricultural commodities Metals and minerals (including energy contracts) Foreign currencies Financial futures Interest rate futures Stock index futures Types of Contracts
22-7 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
22-8 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
22-9 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
22-10 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
22-11 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
22-12 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
22-13 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
22-14 Hedge Example: pp Investor owns and S&P 500 fund that has a current value equal to the index of $900 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 $925 Assume the investor hedges by selling or shorting one contract
22-15 Hedge Example Outcomes Value of S T Payoff on Short (1,345 - S T ) Dividend Income Total
22-16 Rate of Return for the Hedge
22-17 General Spot-Futures Parity Rearranging terms
22-18 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
22-19 Theories of Futures Prices Expectations Normal Backwardation Contango
22-20 Contango Normal Backwardation Time Delivery date Futures prices Expectations Hypothesis Futures and Expected Spot Price: Theories