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VII: Futures 22: Speculation
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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
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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.
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Chapter 22: Hedges, Speculation, and Arbitrage Speculation © Oltheten & Waspi 2012 Soybean Futures Soybeans
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Soybean Futures Soybeans Speculation
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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
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012 Speculation Let’s really speculate. Let’s use derivatives
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Futures IV
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