1. CHAPTER 22 Investments Futures Markets Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

2. 22- 2 Cover image  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 Futures and Forwards

3. 22- 3 Cover image  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 Key Terms for Futures Contracts

4. 22- 4 Cover image Figure 22.1 Futures Listings

5. 22- 5 Cover image Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts

6. 22- 6 Cover image Figure 22.3 CBOT Trading Volume in Futures Contracts

7. 22- 7 Cover image Table 22.1 Sample of Future Contracts

8. 22- 8 Cover image  Clearinghouse - acts as a party to all buyers and sellers. –Obligated to deliver or supply delivery  Closing out positions –Reversing the trade –Take or make delivery –Most trades are reversed and do not involve actual delivery  Open Interest Trading Mechanics

9. 22- 9 Cover image Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse

10. 22- 10 Cover image Initial Margin - funds deposited to provide capital to absorb losses Marking to Market - each day the profits or losses from the new futures price are reflected in the account. Maintenance or variation margin - an established value below which a trader’s margin may not fall. Margin and Trading Arrangements

11. 22- 11 Cover image 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 Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets Margin and Trading Arrangements

12. 22- 12 Cover image  Speculation - –short - believe price will fall –long - believe price will rise  Hedging - –long hedge - protecting against a rise in price –short hedge - protecting against a fall in price Trading Strategies

13. 22- 13 Cover image  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 Basis and Basis Risk

14. 22- 14 Cover image Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15)

15. 22- 15 Cover image 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 Futures Pricing

16. 22- 16 Cover image 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

17. 22- 17 Cover image Hedge Example: Section 22.4  Investor owns an S&P 500 fund that has a current value equal to the index of $1,300  Assume dividends of $20 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 $1,345  Assume the investor hedges by selling or shorting one contract

18. 22- 18 Cover image Hedge Example Outcomes Value of S T 1,3051,345 1,405 Payoff on Short (1,345 - S T ) 40 0 -60 Dividend Income20 20 20 Total1,365 1,365 1,365

19. 22- 19 Cover image Rate of Return for the Hedge

20. 22- 20 Cover image General Spot-Futures Parity Rearranging terms

21. 22- 21 Cover image Figure 22.6 S&P 500 Monthly Dividend Yield

22. 22- 22 Cover image Arbitrage Possibilities  If spot-futures parity is not observed, then arbitrage is possible  If the futures price is too high, short the futures and acquire the stock by borrowing the money at the riskfree rate  If the futures price is too low, go long futures, short the stock and invest the proceeds at the riskfree rate

23. 22- 23 Cover image Spread Pricing: Parity for Spreads

24. 22- 24 Cover image Figure 22.7 Gold Futures Prices

25. 22- 25 Cover image Theories of Futures Prices  Expectations  Normal Backwardation  Contango

26. 22- 26 Cover image Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged