Slides_Fundamentals of Investments - Chapter 16 pot

Futures ContractsOur goal in this chapter is to discuss the basics of futures contracts and how their prices are quoted in the financial press.. Futures contract Contract between a selle

Valuation & Management

Charles J Corrado Bradford D.Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

Futures Contracts

Our goal in this chapter is to discuss the basics of futures contracts and how their prices are quoted in the financial press We will also look at how futures contracts are used and the relationship between current cash prices and futures prices

Goal

Futures Contracts Basics

Forward contract

Agreement between a buyer and a seller, who both commit to a transaction at a future date at a price set by negotiation today

Futures contract

Contract between a seller and a buyer specifying a commodity or financial instrument to be delivered and paid for at contract maturity The specified price is

called the futures price

Futures Contracts Basics

Š While a forward contract can be struck

between any two parties, futures contracts are managed through an organized futures

exchange

Futures Contracts Basics

Š Established in 1848, the Chicago Board of

Trade (CBOT) is the oldest organized futures exchange in the United States

Š It grew with the westward expansion of

American ranching and agriculture, and is today, the largest, most active futures

exchange in the world

Š In the 1970s, financial futures were introduced They are so successful that they now constitute the bulk of all futures trading

Futures Contracts Basics

Š In general, futures contracts must stipulate at

least the following five terms:

c The identity of the underlying commodity or financial instrument.

d The futures contract size.

e The futures maturity date, also called the expiration

date.

f The delivery or settlement procedure.

Futures Contracts Basics

Work the Web

 Visit the websites of these futures

Work the Web

 For futures prices and price charts,

visit:

http://www.futuresworld.com

http://futures.pcquote.com

http://www.thefinancials.com

Š Futures contracts can be used for speculation

or for hedging Hedgers transfer price risk to speculators, while speculators absorb price risk

Î Hedging and speculating are complementary activities.

Speculating with Futures

Š Buying futures is often referred to as “going

long,” or establishing a long position A long

position profits from a futures price increase

Š Selling futures is often called “going short,” or

establishing a short position A short position

profits from a futures price decrease

Š A speculator accepts price risk by going long

or short to bet on the future direction of prices

Hedging with Futures

Š A hedger is a trader who seeks to transfer price

risk by taking a futures position opposite to an existing position in the underlying commodity

or financial instrument

Š Suppose a large operating inventory is needed The sale of futures to offset potential losses

from falling prices is called a short hedge.

Š When some commodity is needed in the future, the purchase of futures to offset potential

losses from rising prices is called a long hedge.

Work the Web

 To learn more about futures, visit:

http://www.futurewisetrading.com

http://www.usafutures.com

Futures Trading Accounts

Š A futures exchange, like a stock exchange,

allows only exchange members to trade on the exchange

Š Exchange members may be firms or

individuals trading for their own accounts, or they may be brokerage firms handling trades for customers

Futures Trading Accounts

Š There are several essential things to know

about futures trading accounts

cMargin is required - initial margin as well as

Work the Web

 For a list of online futures brokers,

visit the Commodities & Futures section of Investor Links at:

http://www.investorlinks.com

Cash Prices

Cash price (or spot price)

The price of a commodity or financial instrument for current delivery

Cash market (or spot market)

The market in which commodities or financial instruments are traded for essentially immediate delivery

Cash Prices

Cash Prices

Cash-Futures Arbitrage

Š Earning risk-free profits from an unusual

difference between cash and futures prices is

called cash-futures arbitrage.

Î In a competitive market, cash-futures arbitrage has very slim profit margins.

Š Cash prices and futures prices are seldom

equal The difference between the cash price and the futures price for a commodity is

known as basis.

basis = cash price – futures price

Cash-Futures Arbitrage

Š For commodities with storage costs, the cash

price is usually less than the futures price, i.e

basis < 0 This is referred to as a

carrying-charge market.

Š Sometimes, the cash price is greater than the

futures price, i.e basis > 0 This is referred to

as an inverted market.

Š Basis is kept at an economically appropriate

Spot-Futures Parity

Š The relationship between spot prices and

futures prices that holds in the absence of

arbitrage opportunities is known as the

spot-futures parity condition.

Š Let F be the futures price, and S be the spot

price If r is the risk-free rate per period, and the futures contract matures in T periods, then

the spot-futures parity condition is:

( )T

More on Spot-Futures Parity

Š Let D be the dividend (or coupon payment)

paid in one period, at or near the end of the futures contract’s life Then, the spot-futures

parity condition becomes F = S(1 + r) – D.

Š Alternatively, we can write the

dividend-adjusted parity result as F = S(1 + r – d), where dividend yield d = D/S Then

( + − )

= 1

Stock Index Futures

Š There are a number of futures contracts on

stock market indexes The S&P 500 contract is one of the most important ones

Š Because of the difficulty of actual delivery,

stock index futures are usually settled in cash

Index Arbitrage

Š Index arbitrage refers to the strategy of

monitoring the futures price on a stock index and the level of the underlying index to exploit deviations from parity

Š Index arbitrage is often implemented as a

program trading strategy Program trading

accounts for about 15% of total trading volume

on the NYSE, and about 20% of all program

Index Arbitrage

Š Another phenomenon often associated with

index arbitrage (and more generally, futures

and options trading) is the triple witching hour

effect

Š S&P 500 futures contracts and options, and

various stock options, all expire on the third Friday of four particular months per year The closing out of all the positions held sometimes lead to unusual price behavior

Work the Web

 For more information on stock index

futures, visit the CBOT website at:

http://www.cbot.com

 For information on program trading,

visit:

http://www.programtrading.com

Hedging Stock Market Risk with Futures

Š Cross-hedging refers to hedging a particular

spot position with futures contracts on a related, but not identical, commodity or financial instrument

Š For example, you may decide to protect your

stock portfolio from a fall in value (caused by

a falling stock market) by establishing a short hedge using stock index futures

Hedging Stock Market Risk with Futures

Š The number of stock index futures contracts

needed to hedge a stock portfolio effectively can be determined as follows:

F

P P

V

V

×

= βcontracts

ofNumber

where βP = beta of the stock portfolio

V = value of the stock portfolio

Hedging Interest Rate Risk with Futures

Š The protect a bond portfolio against changing interest rates, we may cross-hedge using

futures contracts on U.S Treasury notes

Š A short hedge will protect your bond portfolio against the risk of a general rise in interest

rates during the life of the futures contracts

Hedging Interest Rate Risk with Futures

Š To hedge a bond portfolio effectively,

F F

P P

V D

ofNumber

where D P = duration of the bond portfolio

V P = value of the bond portfolio

D F = duration of the futures contract

= value of a single futures contract

Hedging Interest Rate Risk with Futures

Š As a useful rule of thumb, the duration of an

interest rate futures contract is equal to the duration of the underlying instrument plus the time remaining until contract maturity

F U

F D M

where D F = duration of the futures contract

D U = duration of the underlying instrument

M F = time remaining until contract maturity

Futures Contract Delivery Options

Š The cheapest-to-deliver option refers to the

seller’s option to deliver the cheapest instrument when a futures contract allows several instruments for delivery

Š For example, U.S Treasury note futures allow delivery of any Treasury note with a maturity between 6 1/2 and 10 years Note that the

cheapest-to-deliver note may vary over time

Chapter Review

Š Futures Contracts Basics

Î Modern History of Futures Trading

Î Futures Contract Features

Î Futures Prices

Š Why Futures?

Î Speculating with Futures

Î Hedging with Futures

Š Futures Trading Accounts

Chapter Review

Š Stock Index Futures

Î Basics of Stock Index Futures

Î Index Arbitrage

Î Hedging Stock Market Risk with Futures

Î Hedging Interest Rate Risk with Futures

Î Futures Contract Delivery Options