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Chapter 23

Chapter 23. Futures and Swaps: A Closer Look. 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.

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Chapter 23

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  1. Chapter 23 Futures and Swaps:A Closer Look 23-1

  2. 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 23-2

  3. Using Stock Index Contracts to Create Synthetic Positions • Synthetic stock purchase • Purchase of the stock index instead of actual shares of stock • Creation of a synthetic T-bill plus index futures that duplicates the payoff of the stock index contract 23-3

  4. Pricing on Stock Index Contracts The spot-futures price parity that was developed in Chapter 22 is given as; Empirical investigations have shown that the actual pricing relationship on index contracts follows the spot-futures relationship 23-4

  5. 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 23-5

  6. Index Arbitrage and Program Trading Difficult to implement in practice • Transactions costs are often too large • Trades cannot be done simultaneously Development of Program Trading • Used by arbitrageurs to perform index arbitrage • Permits acquisition of securities quickly Triple-witching hour • Evidence that index arbitrage impacts volatility 23-6

  7. 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 23-7

  8. 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 23-8

  9. 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 23-9

  10. Interest Rate Futures • Domestic interest rate contracts • T-bills, notes and bonds • municipal bonds • International contracts • Eurodollar • Hedging • Underwriters • Firms issuing debt 23-10

  11. Commodity Futures Pricing General principles that apply to stock apply to commodities Carrying costs are more for commodities Spoilage is a concern Where; F0 = futures price P0 = cash price of the asset C = Carrying cost c = C/P0 23-11

  12. Swaps • Interest rate swap • Foreign exchange swap • Credit risk on swaps • Swap Variations • Interest rate cap • Interest rate floor • Collars • Swaptions 23-12

  13. Pricing on Swap Contracts Swaps are essentially a series of forward contracts One difference is that the swap is usually structured with the same payment each period while the forward rate would be different each period Using a foreign exchange swap as an example, the swap pricing would be described by the following formula 23-13

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