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Futures. Futures Markets Futures and Forward Trading Mechanism Speculation versus Hedging Futures Pricing Foreign Exchange, stock index, and Interest Rate Futures Using Futures to manage foreign exchange rate risk Index futures Interest rate futures. Futures and Forwards.

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futures
Futures
  • Futures Markets
    • Futures and Forward
    • Trading Mechanism
    • Speculation versus Hedging
    • Futures Pricing
  • Foreign Exchange, stock index, and Interest Rate Futures
    • Using Futures to manage foreign exchange rate risk
    • Index futures
    • Interest rate futures
futures and forwards
Futures and Forwards
  • 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
key terms for futures contracts
Key Terms for Futures Contracts
  • 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

  • CBOT futures contract – page 788
  • Different types of futures contracts – page 789
trading mechanics
Trading Mechanics
  • 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
margin and trading arrangements
Margin and Trading Arrangements

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 arrangements1
Margin and Trading Arrangements

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

example
Example
  • Related to marking to market
  • Maintenance margin – page 793-794
trading strategies
Trading Strategies
  • 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
basis and basis risk
Basis and Basis Risk
  • 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
futures pricing
Futures Pricing

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

With a perfect hedge the futures payoff is certain -- there is no risk. A perfect hedge should return the riskless rate of return

hedge example
Hedge Example
  • 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
hedge example outcomes
Hedge Example Outcomes

Value of ST 1,305 1,345 1,405

Payoff on Short

(1,345 - ST)

Dividend Income

Total 1,365 1,365 1,365

general spot futures parity
General Spot-Futures Parity

Rearranging terms

Multiple period formula: page 802 (22.2).

arbitrage possibilities
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
theories of futures prices
Theories of Futures Prices
  • Expectations
  • Normal Backwardation
  • Contango
foreign exchange futures
Foreign Exchange Futures
  • Futures markets
    • Chicago Mercantile (International Monetary Market)
    • London International Financial Futures Exchange
    • MidAmerica Commodity Exchange
  • Active forward market
  • Differences between futures and forward markets
  • Spot and forward prices in foreign exchange – page 815
  • Foreign exchange futures
pricing on foreign exchange futures
Pricing on Foreign Exchange Futures

Interest rate parity theorem

Developed using the US Dollar and British Pound

where

F0 is the forward price

E0 is the current exchange rate

text pricing example
Text Pricing Example

rus = 5% ruk = 6% E0 = $1.60 per pound T = 1 yr

If the futures price varies from $1.58 per pound arbitrage opportunities will be present.

hedging foreign exchange risk
Hedging Foreign Exchange Risk

A US firm wants to protect against a decline in profit that would result from a decline in the pound

  • Estimated profit loss of $200,000 if the pound declines by $.10
  • Short or sell pounds for future delivery to avoid the exposure
hedge ratio
Hedge Ratio

Hedge Ratio in pounds

$200,000 per $.10 change in the pound/dollar exchange rate

$.10 profit per pound delivered per $.10 in exchange rate

= 2,000,000 pounds to be delivered

Hedge Ratio in contacts

Each contract is for 62,500 pounds or $6,250 per a $.10 change

$200,000 / $6,250 = 32 contracts

stock index contracts
Stock Index Contracts
  • Available on both domestic and international stocks
  • Advantages over direct stock purchase
    • lower transaction costs
    • better for timing or allocation strategies
    • takes less time to acquire the portfolio
  • Major stock index futures – page 821
index arbitrage
Index Arbitrage

Exploiting mispricing between underlying stocks and the futures index contract

  • Futures Price too high - short the future and buy the underlying stocks
  • Futures price too low - long the future and short sell the underlying stocks
market neutral strategy
Market Neutral Strategy

To protect against a decline in level stock prices, short the appropriate number of futures index contracts

  • Less costly and quicker to use the index contracts
example1
Example

Portfolio Beta = .8 S&P 500 = 1,000

Decrease = 2.5% S&P falls to 975

Portfolio Value = $30 million

Project loss if market declines by 2.5% = (.8) (2.5) = 2%

2% of $30 million = $600,000

Each S&P500 index contract will change $6,250 for a 2.5% change in the index

example continued
Example -- continued

Change in the portfolio value

Profit on one futures contract

$600,000

$6,250

H =

=

= 96 contracts short

uses of interest rate hedges
Uses of Interest Rate Hedges
  • Owners of fixed-income portfolios protecting against a rise in rates
  • Corporations planning to issue debt securities protecting against a rise in rates
  • Investor hedging against a decline in rates for a planned future investment
  • Exposure for a fixed-income portfolio is proportional to modified duration
example2
Example

Portfolio value = $10 million

Modified duration = 9 years

If rates rise by 10 basis points (.1%)

Change in value = ( 9 ) ( .1%) = .9% or $90,000

Present value of a basis point (PVBP) = $90,000 / 10 = $9,000

example continued1
Example -- continued

PVBP for the portfolio

PVBP for the hedge vehicle

$9,000

$90

H =

=

= 100 contracts

slide33
SWAP
  • A portfolio manager owns a $100 million of long-term bonds paying a coupon of 7%
  • He switches it to a floating rate issue based on the 6-month LIBOR rate
  • Page 832 shows the payoff from SWAP
swap dealer
Swap Dealer

Page 831

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