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BUFN 722

BUFN 722. ch-24 Futures and Forwards. Overview.

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BUFN 722

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  1. BUFN 722 ch-24 Futures and Forwards BUFN722- Financial Institutions

  2. Overview • Derivative securities have become increasingly important as FIs seek methods to hedge risk exposures. The growth of derivative usage is not without controversy since misuse can increase risk. This chapter explores the role of futures and forwards in risk management. BUFN722- Financial Institutions

  3. Futures and Forwards • Second largest group of interest rate derivatives in terms of notional value and largest group of FX derivatives. • Swaps are the largest. BUFN722- Financial Institutions

  4. Derivatives • Rapid growth of derivatives use has been controversial • Orange County, California • Bankers Trust • As of 2000, FASB requires that derivatives be marked to market BUFN722- Financial Institutions

  5. Spot and Forward Contracts • Spot Contract • Agreement at t=0 for immediate delivery and immediate payment. • Forward Contract • Agreement to exchange an asset at a specified future date for a price which is set at t=0. BUFN722- Financial Institutions

  6. Futures Contracts • Futures Contract • Similar to a forward contract except • Marked to market • Exchange traded (standardized contracts) • Lower default risk than forward contracts. BUFN722- Financial Institutions

  7. Hedging Interest Rate Risk • Example: 20-year $1 million face value bond. Current price = $970,000. Interest rates expected to increase from 8% to 10% over next 3 months. • From duration model, change in bond value: P/P = -D R/(1+R) P/ $970,000 = -9  [.02/1.08] P = -$161,666.67 BUFN722- Financial Institutions

  8. Example continued:Naive hedge • Hedged by selling 3 months forward at forward price of $970,000. • Suppose interest rate rises from 8%to 10%. $970,000 - $808,333 = $161,667 (forward (spot price price) at t=3 months) • Exactly offsets the on-balance-sheet loss. • Immunized. BUFN722- Financial Institutions

  9. Hedging with futures • Futures used more commonly used than forwards. • Microhedging • Individual assets. • Macrohedging • Hedging entire duration gap. • Basis risk • Exact matching is uncommon. BUFN722- Financial Institutions

  10. Routine versus Selective Hedging • Routine hedging: reduces interest rate risk to lowest possible level. • Low risk - low return. • Selective hedging: manager may selectively hedge based on expectations of future interest rates and risk preferences. BUFN722- Financial Institutions

  11. Macrohedging with Futures • Number of futures contracts depends on interest rate exposure and risk-return tradeoff. DE = -[DA - kDL] × A × [DR/(1+R)] • Suppose: DA = 5 years, DL = 3 years and interest rate expected to rise from 10% to 11%. A = $100 million. DE = -(5 - (.9)(3)) $100 (.01/1.1) = -$2.09 million. BUFN722- Financial Institutions

  12. Risk-Minimizing Futures Position • Sensitivity of the futures contract: DF/F = -DF [DR/(1+R)] Or, DF = -DF × [DR/(1+R)] × F and F = NF × PF BUFN722- Financial Institutions

  13. Risk-Minimizing Futures Position • Fully hedged requires DF = DE DF(NF × PF) = (DA - kDL) × A Number of futures to sell: NF = (DA- kDL)A/(DF × PF) • Perfect hedge may be impossible since number of contracts must be rounded down. BUFN722- Financial Institutions

  14. Payoff profiles Long Position Short Position Futures Price Futures Price BUFN722- Financial Institutions

  15. Futures Price Quotes • T-bond futures contract: $100,000 face value • T-bill futures contract: $1,000,000 face value • quote is price per $100 of face value • Example: 103 14/32 for T-bond indicates purchase price of $103,437.50 per contract • Delivery options • Conversion factors used to compute invoice price if bond other than the benchmark bond delivered BUFN722- Financial Institutions

  16. Basis Risk • Spot and futures prices are not perfectly correlated. • We assumed in our example that DR/(1+R) = DRF/(1+RF) • Basis risk remains when this condition does not hold. Adjusting for basis risk, NF = (DA- kDL)A/(DF × PF ×br) where br = [DRF/(1+RF)]/ [DR/(1+R)] BUFN722- Financial Institutions

  17. Hedging FX Risk • Hedging of FX exposure parallels hedging of interest rate risk. • If spot and futures prices are not perfectly correlated, then basis risk remains. • Tailing the hedge • Interest income effects of marking to market allows hedger to reduce number of futures contracts that must be sold to hedge BUFN722- Financial Institutions

  18. Basis Risk • In order to adjust for basis risk, we require the hedge ratio, h = DSt/Dft • Nf = (Long asset position × h)/(size of one contract). BUFN722- Financial Institutions

  19. Estimating the Hedge Ratio • The hedge ratio may be estimated using ordinary least squares regression: • DSt = a + bDft + ut • The hedge ratio, h will be equal to the coefficient b. The R2from the regression reveals the effectiveness of the hedge. BUFN722- Financial Institutions

  20. Hedging Credit Risk • More FIs fail due to credit-risk exposures than to either interest-rate or FX exposures. • In recent years, development of derivatives for hedging credit risk has accelerated. • Credit forwards, credit options and credit swaps. BUFN722- Financial Institutions

  21. Credit Forwards • Credit forwards hedge against decline in credit quality of borrower. • Common buyers are insurance companies. • Common sellers are banks. • Specifies a credit spread on a benchmark bond issued by a borrower. • Example: BBB bond at time of origination may have 2% spread over U.S. Treasury of same maturity. BUFN722- Financial Institutions

  22. Credit Forwards • SF defines credit spread at time contract written • ST = actual credit spread at maturity of forward Credit Spread Credit Spread Credit Spread at End Seller Buyer ST> SF Receives Pays (ST - SF)MD(A) (ST - SF)MD(A) SF>ST Pays Receives (SF - ST)MD(A) (SF - ST)MD(A) BUFN722- Financial Institutions

  23. Futures and Catastrophe Risk • CBOT introduced futures and options for catastrophe insurance. • Contract volume is rising. • Catastrophe futures to allow PC insurers to hedge against extreme losses such as hurricanes. • Payoff linked to loss ratio BUFN722- Financial Institutions

  24. Regulatory Policy • Three levels of regulation: • Permissible activities • Supervisory oversight of permissible activities • Overall integrity and compliance • Functional regulators • SEC and CFTC • Beginning in 2000, derivative positions must be marked-to-market. BUFN722- Financial Institutions

  25. Regulatory Policy for Banks • Federal Reserve, FDIC and OCC require banks • Establish internal guidelines regarding hedging. • Establish trading limits. • Disclose large contract positions that materially affect bank risk to shareholders and outside investors. • Discourage speculation and encourage hedging BUFN722- Financial Institutions

  26. Pertinent websites Federal Reserve www.federalreserve.gov Chicago Board of Trade www.cbot.org CFTC www.cftc.gov FDIC www.fdic.gov FASB www.fasb.org OCC www.occ.ustreas.gov SEC www.sec.gov Web Surf BUFN722- Financial Institutions

  27. FuturesFutures Markets Dr. Elinda Fishman Kiss BUFN722- Financial Institutions

  28. Futures • Definition • economic function - purpose • futures vs. forwards • role - clearinghouse • mark-to-market & margin requirements • risk/return • how price • why actual differ from theoretical futures price • spot-futures parity • hedging & risks • GAO study on derivatives BUFN722- Financial Institutions

  29. Derivative Instruments • Some contracts give the contract holder either the obligation or choice to buy or sell a financial asset. • the price of those contracts derive its value from the price of the underlying financial asset • so, these contracts are called derivative instruments • options • futures, forwards • swaps, caps, floors, collars BUFN722- Financial Institutions

  30. The Purpose of Futures and Forward Markets • Purpose is to eliminate the price risk inherent in transactions that call for future delivery of money, a security, or a commodity. • historically - agriculture products - farmer hedged sales and miller (butcher) hedged purchases of grain (cattle, pigs) • Chicago - meat market, grain market - hence Chicago Board of Trade (CBT) • history - 1670 in Amsterdam; 1848 CBT, 1865 CBT commodity futures, 1972 IMM of CME (“Merc”) introduced financial (currency) futures; 1975 CBT fixed income futures; 1982 stock index futures BUFN722- Financial Institutions

  31. Forward Markets • Agreement - Buying/selling of a specified amount, price, and future delivery date of commodity (example, foreign currency • Direct relationship between buyer and seller • Dealers earn revenues on the spread between buying and selling • Seller delivers at the specified date • OTC • unless marked to market, no interim cash flows before delivery • credit risk exposure - because either party may default BUFN722- Financial Institutions

  32. Futures Markets • Agreement for Buying/selling of standardized contracts specifying the amount, price, and future delivery date of a currency, security, or commodity. • Buyers/sellers deal with the futures exchange, not with each other.- no credit risk • A specific trade (buy/sell) involves a hedger and a speculator. • Delivery seldom made -- buyer/seller offsets previous position before maturity. • Futures contracts expire on specific dates. • movie Trading Places - frozen OJ futures • Circuit breakers on stock index futures • Limit trading on specific stocks or stock indexes • Gives investors a chance to evaluate information or meet margin calls BUFN722- Financial Institutions

  33. Spot vs. Futures Market • Trading for immediate or very-near-term delivery is called the spot market. • Trading for future delivery -- futures market. BUFN722- Financial Institutions

  34. 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 • Regulated by the Commodities Futures Trading Commission or CFTC BUFN722- Financial Institutions

  35. 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 BUFN722- Financial Institutions

  36. Position in the Futures Market - return/risk • Long -- an agreement to buy (purchase) in the future. • Short -- an agreement to sell (deliver) in the future. • Buyer realizes profit if futures price increases; seller realizes profit if futures price falls. • Leveraging aspect of futures • suppose XYZ sells for $100 & you think price will rise; you can buy 1 share of XYZ, or you can purchase 20 futures contracts if initial margin = $5. Can leverage position - if price rises, make 20 x as much as if buy only 1 unit. - example, price rises to 120 [earn 20 on XYZ vs. 20 x 20 (less commission & other costs) on futures position] (of course, leverage works both ways & can magnify losses) BUFN722- Financial Institutions

  37. Types of Contracts • Agricultural commodities • Metals and minerals (including energy contracts) • Foreign currencies • Financial futures Interest rate futures - we will look at Eurodollar, T-bond & Fed Funds futures Stock index futures BUFN722- Financial Institutions

  38. Trading Mechanics • Associated with every futures exchange is a Clearinghouse - acts as a party to all buyers and sellers. • Obligated to deliver or supply delivery • Clearing house - Functions performed are: • Guaranteeing that the two parties to the transaction will perform • Make it simple for parties to futures contract to unwind their position prior to the settlement date • Closing out positions • Reversing the trade • Take or make delivery - physical commodity (specific grade) or cash settlement • Most trades are reversed and do not involve actual delivery BUFN722- Financial Institutions

  39. Margin Requirements & Trading Arrangements • Initial margin -- small percentage deposit required to trade a futures contract -- funds deposited to provide capital to absorb losses • Daily settlements -- reflect gains/losses daily and cash payments. • Maintenance margin (a.k.a variation margin) -- minimum deposit requirements on futures contracts. an established value below which a trader’s margin may not fall. • Marking to Market - each day the profits or losses from the new futures price are reflected in the account • Futures position is marked to market at close of each trading day “margin call” Mr. Duke from Trading Places) BUFN722- Financial Institutions

  40. 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 at maturity ST = FT; futures profits = ST - Fo at maturity(for long position). Delivery - Actual commodity of a certain grade with a delivery location, or for some contracts - cash settlement (most financial futures have cash settlement) S&P index contract calls for delivery of $250 X value of index - e.g., at maturity index lists at 775, cash settlement contract calls for $250 x 775 = $198,250 BUFN722- Financial Institutions

  41. Trading Strategies • Speculation - • short - believe price will fall • long - believe price will rise • Hedging - • long hedge - protecting against a rise in price - analogue to short hedge for purchaser of an asset- view T-bonds as attractively priced now but anticipate cash inflow in 2 months- want to lock in current prices & yields by entering long side of contract, which commits to purchasing at current futures price • short hedge - protecting against a fall in price BUFN722- Financial Institutions

  42. 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 BUFN722- Financial Institutions

  43. 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 • These two strategies must have the same market determined costs BUFN722- Financial Institutions

  44. Spot-Futures Parity Theorem • With a perfect hedge the futures payoff is certain -- there is no risk • A perfect hedge should return the riskless rate of return • This relationship can be used to develop futures pricing relationship • See Fair Value discussion • http://money.cnn.com/2000/04/17/investing/fairvalue/ BUFN722- Financial Institutions

  45. Parity Example Stock that pays no cash dividend • no storage costs • no seasonal patterns in prices Strategy 1: Buy the stock now and hold it until time T Strategy 2: Put funds aside today to perform on a futures contract for delivery at time T that is acquired today BUFN722- Financial Institutions

  46. Parity Example Outcomes Strategy A: Action Initial flows Flows at T Buy stock -So ST Strategy B: Action Initial flows Flows at T Long futures 0 ST - FO Invest in Bill FO/(1+rf)T - FO/(1+rf)T FO Total for B - FO/(1+rf)T ST BUFN722- Financial Institutions Irwin/McGraw-Hill 18-21 • The McGraw-Hill Companies, Inc., 1998

  47. Price of Futures with Parity Since the strategies have the same flows at time T FO / (1 + rf)T = SO FO = SO (1 + rf)T The futures price has to equal the carrying cost of the stock BUFN722- Financial Institutions

  48. 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 BUFN722- Financial Institutions

  49. 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 Difficult to do in practice Transactions costs are often too large Trades cannot be done simultaneously Program Trading on SuperDot Triple-Witching hour - 3rd Friday of 4 months, if simultaneous expiration of S&P index options, options on individual stocks & expiration of S&P futures contracts Double Witching – simultaneous expiration of index options and listed options on individual stocks

  50. Hedge Example • Investor owns an S&P 500 fund that has a current value equal to the index of $960 • Assume dividends of $18 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 $990 • Assume the investor hedges by selling or shorting one contract BUFN722- Financial Institutions

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