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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

Chapter 23

Futures and Swaps:A Closer Look


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


using stock index contracts to create synthetic positions
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


pricing on stock index contracts
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


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


index arbitrage and program trading
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


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


pricing on foreign exchange futures
Pricing on Foreign Exchange Futures

Interest rate parity theorem

Developed using the US Dollar and British Pound


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


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


commodity futures pricing
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


  • Interest rate swap
  • Foreign exchange swap
  • Credit risk on swaps
  • Swap Variations
    • Interest rate cap
    • Interest rate floor
    • Collars
    • Swaptions


pricing on swap contracts
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