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Introduction to Financial Futures Markets

Introduction to Financial Futures Markets. F520 Asset Valuation and Strategy. Derivatives and Spot Prices. Derivative A security whose value depends on the values of other “underlying” securities (also know as “contingent claims”)

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Introduction to Financial Futures Markets

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  1. Introduction to Financial Futures Markets F520 Asset Valuation and Strategy F520 – Futures

  2. Derivatives and Spot Prices • DerivativeA security whose value depends on the values of other “underlying” securities (also know as “contingent claims”) • Spot PriceRate or price quoted for delivery in one or two business days from the date of the transaction F520 – Futures

  3. Derivative Securities • Forward Contracts -- A forward market is a market in which a commodity/exchange rate for a future exchange of commodities or financial contracts is fixed today. • Futures Contracts -- An agreement reached at one point in time calling for the delivery of some commodity at a specified later date at a price established at the time of contracting. • Options Contracts -- The right (but not the obligation) to buy or sell a particular good at a specified price • Swap Contract – An agreement where two parties agree to exchange periodic cash flows. F520 – Futures

  4. Roles of Derivative Markets • Risk management and risk transference: Firms can take on projects which otherwise might be rejected due to their high levels of risk • Examples are expansion of facilities in other countries, your choice of obtaining a fixed or adjustable rate mortgage, ect. • Due to the existence of speculators risk averse individuals are able to transfer their risk more easily through a more active market • Derivatives provide another market that investors can use to alter their risk exposure to an asset when new information is acquired. Competition between markets should increase efficiency of the financial markets • Trading financial derivatives generates publicly observable prices F520 – Futures

  5. Hedging versus Speculating • Speculating -- In contrast to hedging, the purpose of speculation is to profit from a change in a future rate or price. Speculating involves the assumption of additional risk • Hedging -- Hedging is typically defined as utilizing financial instruments or contracts to reduce or eliminate the risk from future changes in rates or prices. The purpose of hedging a transaction is to replace an uncertain future cash flow, rate, or price, with a fixed and certain cash flow, rate, or price • Microhedging -- Using futures (forward) contract to hedge a specific asset or liability • Macrohedging -- Hedging the entire exposure of an FI • Routine Hedging versus Selective Hedging • Routine Hedge -- Seeking to hedge all exposure • Selective Hedge -- Only partially hedging the gap or hedging occasionally F520 – Futures

  6. Forward Contracts • An agreement to buy or sell an asset at a specified future time at a specified price • The specified price is the delivery price and it stays fixed • The party which agrees to buy has a “long position”; the seller has a “short position” • A rise in the spot price generates a profit for those holding a long position and a loss for those holding a short position. The net effect is a “zero sum” game. • Cash flows are exchanged only on the maturity date. F520 – Futures

  7. Spot 0 1 2 3 Months Price agreed / paid Between buyer / seller Commodity Delivered Forward 0 1 2 3 Months Price agreed between buyer / seller Time of delivery / payment Agreed between buyer / seller (3 months) Buyer pays forward price / seller delivers commodity F520 – Futures

  8. Key Elements of Forward Contracts • Forward contracts involve no exchange of cash initially • Forward contracts cannot be traded on an exchange • Forward contracts typically are used in foreign exchange markets, but there is also a large forward market now in interest-rate contracts  • Forwards have credit risk and are illiquid (do not trade frequently) F520 – Futures

  9. Pricing Forwards • Risk-Free Arbitrage Opportunity arises when an investment is identified that requires no initial outlays yet guarantees nonnegative payoffs in the future • Zero investment • Zero risk • Guaranteed return F520 – Futures

  10. Given information • Following are current prices and information • In the cash market Asset XYZ is selling for $100 • Asset XYZ pays the holder (with certainty) $12 per year in four quarterly payments of $3, and the next quarterly payment is 3 months from now. • The forward contract requires delivery 3 months from now. • The current three month interest rate at which funds can be loaned or borrowed is 8% per year (2 percent quarterly). F520 – Futures

  11. Assume the forward price is 107. Is this a fair price? F520 – Futures

  12. Assume the forward price is 107. Is this a fair price? F520 – Futures

  13. Assume the forward price is $92.Is this a fair price? F520 – Futures

  14. Assume the forward price is $92.Is this a fair price?

  15. What is the fair price? • F = P + P(r - y) • F = $100 + $100(0.02 - 0.03) = $99 • P is the current spot price • r is the finance rate, risk-free rate • y is the cash yield, such as dividends F520 – Futures

  16. Using a Forward Price of 99, we obtain the fair price. F520 – Futures

  17. F520 – Futures

  18. Besides interest, what factors should be considered in our carrying costs? • Financing/Investment costs may differ (rb and rl) Range of Prices • F = P + P(rb - y) • F = P + P(rl - y) • Costs as a percent are deducted from y or added to r. Most common for commodities • Transaction costs • Storage cost • Insurance costs • Transportation costs Range of Prices Costs as a percent are deducted from y or added to r. Most common for commodities F520 – Cha Futures

  19. What market imperfections cause our arbitrage pricing model to break down and provide us a range of prices that we should consider? • Interim cash flows are not considered (not important for commodities, but are for dividend paying stocks) • Differences between the borrowing and lending rate • Proceeds from short selling may not be available • Deliverable asset and settlement date may be unknown (contract may be contingent or allow for a range of dates or more than one type of asset is allowed for delivery) • Deliverable asset may be a basket of securities which may be difficult to track • Differences in the tax treatment of securities and forwards/futures F520 – Futures

  20. Futures Contracts • Like forwards, a financial futures contract is an agreement to buy or sell an asset at a specified time at a specified price • But Futures are: • “Standardized” contracts • Traded on an organized exchange which “guarantees” performance • “Marked” to market daily • Supported by a “margin account” (performance bond) • Only rarely do buyers and sellers of futures contracts accept or make delivery. Most futures contracts are “offset” by taking an opposite position. F520 – Futures

  21. Forward 0 1 2 3 Months Forward price agreed between buyer / seller Time of delivery / payment agreed between buyer / seller (3 months) Buyer pays forward price / seller delivers commodity Futures Marking to Market Daily 0 1 2 3 Months Futures price agreed between buyer / seller Time of delivery / payment agreed between buyer / seller (3 months) Buyer pays futures price / seller delivers commodity F520 – Futures

  22. Net Payoff of a Futures Contract Net Payoff Long Position in Futures Contract Payoff of Future ($) 0 Security Price X–futures price Short Position in Futures Contract Payoff of Future ($) Net Payoff 0 Security Price Xfutures price

  23. Exchange vs. Over-the-Counter Markets • Exchange Market is a market with a centralized exchange and trading floor. Each futures exchange has a clearinghouse which guarantees contract performance to both parties • Major products sold on Exchanges • Options • Futures • Over-the-Counter market is a market with out a centralized exchange or trading floor • Major products sold Over-the-Counter • Options • Forwards • Swaps

  24. Advantages of Over-the-Counter markets (relative to Exchanges) • Exchange products may lack flexibility in the variety of instruments available and the horizon over which they trade. • Exchanges are regulated by the government. While providing some benefits, it also restricts the kinds of trading that can be conducted. • Complying with exchange rules and regulations may increase the cost of trading on exchanges F520 – Futures

  25. Disadvantages of Over-the-Counter Markets (relative to Exchanges) • Credit risk -- both parties must trust each other to complete the contract as promised. • Difficulty of finding a trading partner -- It may be difficult to find a counter party willing to buy (sell) a commodity at a specific day in the future • Difficulty of fulfilling an obligation without actually completing delivery F520 – Futures

  26. Why Hedges are Imperfect • Amount -- Since exchange traded derivatives have specified contract amounts, if the amount that we wish to hedge is not exactly equal to some multiple of the contract size, we must choose to either under-hedge or over-hedge. • Delivery Date -- If the date of our future transaction does not perfectly match with the derivative delivery date, we must choose a contract with a longer delivery date and close it (Future and spot rates converge as they get closer to maturity, therefore the correlation between the future and spot rate is not equal to 1.) out early or an earlier delivery date and remain unhedged for a period of time. • Basis Risk – When price movements on the futures contract and the underlying asset are not perfectly correlated, an imperfect hedge results, even though they are the same asset. This risk can be estimated by obtaining the correlation between the two prices from past price movements.

  27. Why Hedges are Imperfect (cont.) • Cross-hedging Risk -- When we try to hedge an asset with a similar, but not identical asset. For example, hedge platinum with a gold futures contract. While historically highly correlated, there is the risk that these past price patterns may not continue.Maturity of Contract Security -- For interest rate derivatives, if the item we are hedging does not have the same maturity of the item that we are using to hedge the instrument, we are exposed to risk. For short-term financial contracts we estimate the number of contracts needed as $ amt. of security duration of asset.# of Contracts = ------------------ X ------------------------ $ amt. of contract dur of derivative sec • Transaction Costs -- Commissions and margin requirements take up cash and make it difficult to get a perfect hedge.

  28. Hedging Illustration • Page 175 of text Assume that a gold mining company expects to sell 1,000 ounces of gold one week from now and that the management of a jewelry company plans to purchase 1,000 ounces of gold one week from now. The managers of both the gold mining company and the jewelry company want to lock in today’s price – that is, they both want to eliminate the price risk associated with gold one week from now. The cash price for gold is currently $352.40 per ounce. The cash price is also called the spot price. The futures price for gold is currently $397.80 per ounce. Each futures contract is for 100 ounces. F520 – Futures

  29. Devise the appropriate hedge F520 – Futures

  30. TABLE 10-2: How well did your hedge fair? Assume the following prices in one week – cash $304.20 and futures $349.60.

  31. TABLE 10-3: How well did your hedge fair? Assume the following prices in one week – cash $392.50 and futures $437.90.

  32. TABLE 10-4 (Basis Widens): How well did your hedge fair? Assume the following prices in one week – cash $304.20 and futures $385.80.

  33. TABLE 10-5 (Basis Widens): How well did your hedge fair? Assume the following prices in one week – cash $392.50 and futures $474.10.

  34. What would the hedge look like if we entered a forward contract?Assume a forward price of $370 per ounce F520 – Futures

  35. Cross-Hedging Illustration • Page 178 of textSuppose that a mining company on a far-away planet plans to sell 2,500 ounces of kryptonite one week from now and that a jewelry company plans to purchase the same amount of kryptonite in one week. Both parties want to hedge against price risk. However, kryptonite futures contracts are not currently traded. Both parties believe that there is a close relationship between the price of kryptonite and the price of gold. Specifically, both parties believe that the cash price of kryptonite will remain at 40% of the cash price of gold. The cash price of kryptonite is currently $140.96 per ounce and the cash price of gold is currently $352.40 per ounce. The futures price of gold is currently $397.80 per ounce. F520 – Futures

  36. Devise the appropriate cross-hedge F520 – Futures

  37. TABLE 10-6 (Basis&Ratio Stable): How well did your hedge fair?

  38. TABLE 10-7 (Basis Stable, Ratio Changes):How well did your hedge fair?

  39. TABLE 10-8 (Basis Stable, Ratio Changes):How well did your hedge fair?

  40. http://www.lme.com/metals/non-ferrous/copper/ F520 – Futures

  41. Copper Futures, price per pound, 25,000 pounds per contract Daily Settlements for Copper Future Futures (FINAL) - Trade Date: 09/13/2013 | http://www.cmegroup.com/trading/metals/base/copper_quotes_settlements_futures.html F520 – Futures

  42. Product Calendar for Copper Futures F520 – Futures

  43. What is the estimated forward price? • Dividend: 0.00% on a commodity • Rate: 0.00% to 0.30% for 3 month to 1 year ratehttp://finance.yahoo.com/bonds • F = P + P(r - y) • F = 3.19 + 3.19 (r - 0.00)*(month/12) F520 – Futures

  44. Using Futures to Replicate the Returns of a Portfolio • Futures Price is for delivery in 1 year • F = P + P(r - y) • P is the current spot price – Assume S&P500 is 1,000and I buy 1000 contracts (my total exposure is $1 million) • r is the finance rate, risk-free rate of 4% • y is the cash yield, such as dividends of 2% • Futures Price (based on fair value formula)F = $1,000 + $1,000(0.04 - 0.02) = $1,020 F520 – Futures

  45. S&P500 Stocks • Assume I buy the stocks representing the S&P500 Index and hold it to its delivery date in 1 year. What is my dollar return if in 1 year the spot price is $1100? Note that the spot price and futures price should converge on the delivery date since both have 2 days to settlement.(P1 - P0 + D) ($1.1m-$1m+$1m*.02) = $120,000 F520 – Futures

  46. S&P500 Futures • How many Futures contracts do I needInformation from earlier • Current spot price – on S&P500 is $1,000 • Current futures price _ S&P futures is $1,020an emini S&P futures controls 50 S&P indexesa S&P futures controls 250 S&P indexes • The total exposure I want is $1 million • The calculation for the number of contracts is similar to a cross-hedge. # futures = Market value of portfolio / Cash Value of 1 future# futures = $1 mil / $1000*50 using the emini# futures = 20 contracts F520 - Futures

  47. Assume I buy 20 Futures contract and hold them till the delivery date in 1 year. What is my return if on the date of delivery the futures price is $1100?(P1 - P0) ($1100-$1020)*50*20 = $80,000 • How can the return on a futures replicate the return on holding the S&P 500 contract? • What were the cash outflows on the futures contract at t=0?Nothing!So what should I do with the money? So far I have nothing invested in the futures contract. Remember a margin simply means I have funds accessible to my broker in a liquid account (assume a money market earning the risk-free return) Invest the full $1 million in the risk-free rate (this is far more than I need for the margin), earning 4% in our example. Assume I have the same $1 million that I assumed for the spot purchase.$1 mil *.04 = $40,000 return on investment in risk-free rate(This underestimates my return since I did not take into account that the futures price is increasing and marking to market will add to the amount of funds in my investment account that earns the risk-free rate.)So what is my return on the Futures in the S&P500 and the risk free portfolio?$40,000 + $80,000 = $120,000 on my original $1 million of investment or 12% • Note, both made $120,000 on my investment. Both required $1 million as the initial investment. Therefore, the futures portfolio can replicate the expected return in the underlying asset.

  48. Adjusting for the Hedge Ratio • What would I do if the portfolio had a beta of 1.2. This is greater risk than the S&P500 contract. How could I mimic the expected return on this portfolio? # futures = ($1 mil / $1000*50 using the emini)*1.2 # futures = 20*1.2 = 24 contracts • Our expected dollar return(P1 - P0) ($1100-$1020)*50*24 = $96,000 from the futures $1 mil *.04 = $40,000 from the risk free return $40,000 + $96,000 = $136,000 • Since this is a cross-hedge (portfolio beta of 1.2 and S&P500 futures beta of 1.0) the hedge will not be perfect. This is an approximate number of contracts. F520 – Futures

  49. S&P 500 (^GSPC) -SNP 1,687.99 4.57(0.27%) Sep 13, 2013 http://finance.yahoo.com/q?s=^GSPC&ql=1 Daily Settlements for E-mini S&P 500 Future Futures (FINAL) Trade Date: 09/13/2013 http://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500_quotes_settlements_futures.html F520 – Futures

  50. What is the estimated forward price? • Dividend: 2.04%http://finance.yahoo.com/q?s=SPY&ql=0 • Rate: 0.00%http://finance.yahoo.com/bonds • F = P + P(r - y) • F = 1,687.99 + 1,687.99 (0.00 - 0.0204)*(month/12) F520 – Futures

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