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CHAPTER 22 Investments Futures Markets Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image
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22- 2 Cover image 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
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22- 3 Cover image 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
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22- 4 Cover image Figure 22.1 Futures Listings
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22- 5 Cover image Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts
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22- 6 Cover image Figure 22.3 CBOT Trading Volume in Futures Contracts
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22- 7 Cover image Table 22.1 Sample of Future Contracts
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22- 8 Cover image 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 Open Interest Trading Mechanics
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22- 9 Cover image Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse
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22- 10 Cover image 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
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22- 11 Cover image 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 Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets Margin and Trading Arrangements
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22- 12 Cover image 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
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22- 13 Cover image 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
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22- 14 Cover image Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15)
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22- 15 Cover image 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
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22- 16 Cover image 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
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22- 17 Cover image Hedge Example: Section 22.4 Investor owns an S&P 500 fund that has a current value equal to the index of $1,300 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 $1,345 Assume the investor hedges by selling or shorting one contract
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22- 18 Cover image Hedge Example Outcomes Value of S T 1,3051,345 1,405 Payoff on Short (1,345 - S T ) 40 0 -60 Dividend Income20 20 20 Total1,365 1,365 1,365
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22- 19 Cover image Rate of Return for the Hedge
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22- 20 Cover image General Spot-Futures Parity Rearranging terms
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22- 21 Cover image Figure 22.6 S&P 500 Monthly Dividend Yield
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22- 22 Cover image 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
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22- 23 Cover image Spread Pricing: Parity for Spreads
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22- 24 Cover image Figure 22.7 Gold Futures Prices
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22- 25 Cover image Theories of Futures Prices Expectations Normal Backwardation Contango
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22- 26 Cover image Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged
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