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FINANCIAL FUTURES MARKETS. CHAPTER 13. Derivative Securities. What are Derivative Securities? High leverage securities that can be used to; Speculate or Hedge How do we speculate?

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FINANCIAL FUTURES MARKETS


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financial futures markets

FINANCIAL FUTURES MARKETS

CHAPTER 13

Dr David P Echevarria

derivative securities
Derivative Securities
  • What are Derivative Securities?
    • High leverage securities that can be used to;

Speculate or

Hedge

    • How do we speculate?
      • Suppose we believe that the weather will reduce this year’s wheat harvest. A poor harvest will result in higher prices. We can open a long futures October contract for wheat. If as the year progresses, the weather cooperates – the price will go up > profit!

Dr David P Echevarria

derivative securities1
Derivative Securities
  • How do we hedge?
    • A hedge is a form of insurance.
    • Suppose we are a jeweler and we use a lot of gold to make custom pieces. If the price of gold rises, so will our costs. To hedge against a rise in prices we open a long gold hedge. If prices rise – we will profit from the long hedge and offset the increased cost of buying new supplies of gold.
    • If we are a seller of gold – our fear is that prices will drop. We will open a short futures hedge. If prices drop, we will profit on the short position.

Dr David P Echevarria

valuation of financial futures
VALUATION OF FINANCIAL FUTURES
  • Market Value of Futures Contracts
    • Value is dependent on the value of the underlying security
    • Derivative Securities may also be called contingent claims
      • Primary economic function = HEDGING MARKET RISK
    • Interest Rate Futures used to hedge against adverse changes in interest rates
    • The hedger is protecting a long or short position in the market
    • The speculator expect to profit if rates in the expected direction (up or down)

Dr David P Echevarria

valuation of financial futures1
VALUATION OF FINANCIAL FUTURES
  • Forward Contracts; (Not publicly traded)
    • Agreement to buy/sell at a future time
    • The LONG position: party agreeing to buy the asset
    • The SHORT position: party agreeing to deliver (sell) asset
    • Delivery Price: price specified in the forward contract
    • Settlement on a Forward contract occurs at maturity

Dr David P Echevarria

valuation of financial futures2
VALUATION OF FINANCIAL FUTURES
  • Futures Contracts: (publicly traded)
    • Contracts are standardized
    • Delivery date: by month and the exchange on which contract is traded sets the delivery date
    • For commodities, may be anytime during the expiration month
    • Daily Settlement or Marking-to-Market on price changes

Dr David P Echevarria

valuation of financial futures3
VALUATION OF FINANCIAL FUTURES
  • Arbitrage and the Law of One Price:
    • Two identical goods cannot sell for two different prices
    • When prices are not in sync, arbitrage opportunity
  • Risk Management:
    • Hedging against adverse future price movements (market risk)
    • Price discovery; expectations of future price levels

Dr David P Echevarria

fundamentals of futures markets
FUNDAMENTALS OF FUTURES MARKETS
  • Forward Markets
    • Deferred delivery (expected price at time T)
    • Utilizing the storability factor
    • Hedging future price movements resulting from changes in Supply and Demand
    • Forward vs. Futures Contracts
    • Price discovery
  • Spot (Cash) Market:
    • Immediate delivery (today's market price for commodity)
    • Hedge point; we are generally hedging a spot position

Dr David P Echevarria

fundamentals of futures markets1
FUNDAMENTALS OF FUTURES MARKETS
  • Defining Profits in Spot and Futures Contracts
    • Basis (b): Spot - Futures Price
      • Later: Increasing basis favors Long hedger/speculator, decreasing basis the short
      • Profit = - b (if held to T) P = -b + b (if offset prior to T)
  • Daily Price Movements
    • Each commodity has a maximum daily price change
    • Trading stops when a limit is reached
    • May reopen on authority of Exchange Floor Manager to maintain orderly market

Dr David P Echevarria

fundamentals of futures markets2
FUNDAMENTALS OF FUTURES MARKETS
  • Opening a Futures Position (assuming you meet financial qualifications)
    • Determining Expectation
      • Long: expect prices to go up
      • Short: expect prices to go down
    • Depositing initial margin
    • Closing position before first day of expiration month (to avoid assignment)

Dr David P Echevarria

types of hedges
TYPES OF HEDGES
  • Interest Rate Futures
  • Commodity futures
  • Currency Futures
  • Stock Index Futures
  • Single Stock Futures

Dr David P Echevarria

homework questions
HOMEWORK QUESTIONS
  • What is a forward contract? How does it differ from a futures contract?
  • What is arbitrage? How does the law of one price relate to arbitrage opportunities?
  • What is the difference between hedging and speculating?
  • How does the long position profit? The short position?
  • How are stock index futures settled?

Dr David P Echevarria