1. VII: Futures 22: Hedges, Speculation, and Arbitrage

2. 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

3. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 CUSE Arbitrage Shares of Discovery Café trade in the primary market (NYSE) and in the Champaign-Urbana Stock Exchange (CUSE). DVC $100 CUSE $1.50 brokerage

4. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Arbitrage Price range on the CUSE $100 NYSE Arbitrage-free price range Buy CUSE & sell NYSE Buy NYSE & sell CUSE

5. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Arbitrage Price range on gold futures Spot gold Low price High price Arbitrage-free price range Buy futures & sell spot Buy spot & sell futures

6. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Arbitrage Gold Futures 1 year contract 1 c is 100 troy ounces Margin is $1,800 and $1000 per contract Spot Gold is trading at $370/ounce

7. Chapter 22: Hedges, Speculation, and Arbitrage Arbitrage Price range on gold futures Spot gold $370 $340 $400 Arbitrage-free price range Buy futures & sell spot Buy spot & sell futures © Oltheten & Waspi 2012

8. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Arbitrage: Buy spot; sell futures Buy spot at $370/ounce Sell futures at $400/ ounce Profit: $30/ounce (minus a few costs of carry)

9. Chapter 22: Hedges, Speculation, and Arbitrage Arbitrage October 2011 Buy 100 ounces gold @$370/oz storage & insurance Sell 1 October 08 gold contract @ $400/ozInitial Margin Borrow at 5% for 12 months Initial Investment October 2012 Deliver gold @ $400 contracted price Margin returned Repay loanPrincipal interest Arbitrage Profit © Oltheten & Waspi 2012

10. Chapter 22: Hedges, Speculation, and Arbitrage Arbitrage October 2011 Buy 100 ounces gold @$370/oz storage & insurance Sell 1 October 07 gold contract @ $X/ozInitial Margin Borrow at 5% for 12 months Initial Investment October 2012 Deliver gold at contracted price $X Margin returned Repay loanPrincipal interest Arbitrage Profit © Oltheten & Waspi 2012

11. Chapter 22: Hedges, Speculation, and Arbitrage Arbitrage Spot gold $370 $340 Arbitrage-free price range Buy futures & sell spot Buy spot & sell futures © Oltheten & Waspi 2012

12. Chapter 22: Hedges, Speculation, and Arbitrage Arbitrage October 2011 Short Sell 100 ounces gold @$370/oz borrowing fee Buy 1 October 08 gold contract @ $340/ozInitial Margin Invest at 5% for 12 months Initial Investment October 2012 Take delivery of the gold @ $340 contracted price Margin returned Cash in investmentPrincipal interest Arbitrage Profit © Oltheten & Waspi 2012

13. Chapter 22: Hedges, Speculation, and Arbitrage Arbitrage October 2011 Short Sell 100 ounces gold @$370/oz borrowing fee Buy 1 October 07 gold contract @ $X/ozInitial Margin Invest at 5% for 12 months Initial Investment October 2012 Take delivery of the gold @ $X contracted price Margin returned Cash in investmentPrincipal interest Arbitrage Profit © Oltheten & Waspi 2012

14. Chapter 22: Hedges, Speculation, and Arbitrage Arbitrage Spot gold $370 Arbitrage-free price range Buy futures & sell spot Buy spot & sell futures © Oltheten & Waspi 2012

15. 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

16. 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.

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

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

19. 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

20. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Speculation Lets really speculate. Lets use derivatives

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy $1m 20 year 6% T-bonds @100-00-$1,000,000 Strategy A: Buy T-Bonds

28. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy $1m 20 year 8% T-bonds @100-00-$1,000,000 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)+15.375%-7.5625% Strategy A: Buy T-Bonds

29. 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 $100,000 20 year 6% T- Bond Initial margin is $2,500 per contract

30. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy 400 6 month T-Bond Futures @ 100-00 [-$40,000,000] margin: -$1,000,000 Strategy B: T-Bond Futures

31. Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Buy 400 6 month T-Bond Futures @ 100-00 [-$40,000,000] margin:-$1,000,000 Six months laterI am right 5% I am wrong 7% Sell 400 T-Bond futures @ 5% [112:12] Profit: Margin: Sell 400 T-Bond futures @ 9% [89:31] Profit: Margin: Rate of Return (over six months) Strategy B: T-Bond Futures

32. Futures III