17-2 Futures and Forwards Forward is an agreement to buy (long position) or to sell (short) a product (or an asset) at today’s agreed-upon price. Futures is similar to forward but has standardized terms and is traded on an exchange. Key difference in futures –Futures have secondary trading (liquidity) –Marked to market –Standardized contract terms such as delivery dates, price units, contract size –Clearinghouse guarantees performance
17-3 Key Terms for Futures Contracts The Futures price: agreed-upon price paid at maturity Long position: Agrees to purchase the underlying asset at the stated futures price at contract maturity Short position: Agrees to deliver the underlying asset at the stated futures price at contract maturity Profits (accumulated) on long and short positions –Long = Futures price at the moment minus original futures price –Short = Original futures price minus futures price at the moment
17-4 Types of Contracts Agricultural commodities Metals and minerals (including energy contracts) Financial futures –Interest rate futures –Stock index futures –Foreign currencies
17-5 Table 17.1 Sample of Futures Contracts
17-6 The Clearinghouse and Open Interest Futures Exchanges (CME, CBOT, SIMEX, etc) are the clearinghouses - acts as a counterparty to each party, buyers and sellers. –A futures participant is obligated to perform against the clearinghouse. Closing out positions –Reversing the initial trade –OR take or make delivery Most trades are reversed and do not involve actual delivery (agreed to take the delivery (LONG) of XXX on 3 rd Wed in June. Later, agreed to deliver (SHORT) XXX on 3 rd Wed of June. Basically, you have no position) Open Interest –The number of contracts yet to be closed out with a reversing trade
17-7 Figure 17.3 Trading With and Without a Clearinghouse The clearinghouse eliminates counterparty default risk; this allows anonymous trading since no credit evaluation is needed. Without this feature you would not have liquid markets.
17-8 Marking to Market and the Margin Account Initial Margin: funds that must be deposited initially in a margin (=equity) account to provide capital to absorb losses Marking to Market (Daily Settlement): practice of taking the profit or loss at the end of each trading day based on the settlement price and reflected in the margin account (from the loser to the gainer) to prevent anyone building up a huge loss which cannot be covered. No paper gain or loss. Maintenance margin: an established value below which the trader gets a margin call either to close out the position or add more money to keep the position. Variation margin: With the margin call, the minimum amount to be added to the margin account to keep the position.
17-9 Marking to Market Example On Monday morning you sell one T-bond futures contract at (97 27/32% of the $100,000 face value). Futures contract price is thus _________. The initial margin requirement is $2,700 and the maintenance margin requirement is $2,000. $97, Margin Call => Variation margin DaySettle$ ValuePrice Change Margin Account Total %HPR (cum.) Spot HPR (cum.) Open $97,843.75$2700 Mon $97, $437.50$ %0.45% Tues $98,000.00$593.75$ %-0.16% Wed $100,000.00$ $ %-2.2% +$ $ Leverage multiplier ≈ 36
17-10 Long = get paid the difference(+/-) to buy at the spot market, if you want. Short= pay the difference(+/-) to the counterparty so that she can buy at the market, if she wants. No reason to do the actually delivery. Cash settlements for the gifts you promised (e.g., insurance settlements). If you go long on T-Bond futures at Futures = ___________ => It means that you agreed to buy the T-Bond for $110,000 at the expiration date. Suppose that at contract expiration, Spot T-Bonds = ________ => Then 1) You can pay $110,000 to your counter party and receive the T-Bond which is worth $108,000. Alternatively, 2) you can just pay the other party $2,000 (or take a loss of $2,000) and the other party takes this $2,000 to settle. If you really want to buy T-Bond at that moment, you can go out to the spot market and buy the T-Bond for $108,000. The total amount you spend to buy the T-Bond is $2,000 + $108,000 =$110,000, which is the same as 1). Because of the marking-to-market, your loss is already $2,000 as the futures exchange has debited the amount. Why delivery on futures is not necessary? $110,000 $108,000
17-11 More on futures contracts Delivery: Specifications of when and where delivery takes place and what (quality of the product) can be delivered Cash Settlement: Some contracts can only be settled in cash rather than delivering the underlying assets (indexes, weather, etc)
17-12 Trading Strategies Speculation (no position in an underlying asset) –Go long if you believe price will rise –Go short if you believe price will fall Hedging (has a position in an underlying asset => value of the “portfolio” is not affected. The gain from your position is just to offset your “otherwise” loss) –Long hedge: When you need to buy a product (asset) in the future and are concerned about an increase in price and would like to protect against a rise in price. E.g, An oil company try to secure oil in the future. An importer needs to secure euro to make an euro payment in the future. –Short hedge: When you need to sell a product (asset) and are worried about an decrease in price and would like to protect against a fall in price. E.g, A farmer would like to fix the future selling price of his crop today. An exporter would like to fix today the selling price of euro she expects to receive in the future.
17-13 Futures Pricing Spot-futures parity theorem –Purchase the commodity now and store it to T, –Simultaneously take a short position in futures, –The ‘all in cost’ of purchasing the commodity and storing it (including the cost of funds) must equal the futures price to prevent arbitrage.
17-14 The no arbitrage condition Since the strategy cost 0 initially, the cash flow at T must also equal 0. Thus: F 0 - S 0 (1 + r f ) T = 0 F 0 = S 0 (1 + r f ) T The futures price differs from the spot price by the cost of carry. Action Initial Cash FlowCash Flow at T 1. Borrow SoS0S0 -S 0 (1+r f ) T 2. Buy spot for So-S 0 STST 3. Sell futures short0F 0 - S T Total0F 0 - S 0 (1+r f ) T
17-15 Table 17.2 Stock Index Futures
17-16 Creating Synthetic Stock Positions Synthetic stock purchase –Purchase of stock index futures instead of actual shares of stock Allows frequent trading at low cost, especially useful for foreign investments
17-17 Index Arbitrage Exploiting mispricing between underlying stocks and the futures index contract Futures Price too high: –Short the futures and buy the underlying stocks Futures price too low: –Long the futures and short sell the underlying stocks Difficult to do in practice
17-18 Swaps Large component of derivatives market –Interest Rate Swaps One party agrees to pay the counterparty a fixed rate of interest in exchange for paying a variable rate of interest, No principal is exchanged. –Currency Swaps Two parties agree to swap principal and interest payments at a fixed exchange rate. A series of forward contracts. Can be used to avoid risks or to take advantage of comparative advantage (gains from trading).
17-19 Figure 17.8 Interest Rate Swap Company A wants a variable rate financing to match their variable rate investments (e.g., mismatch with L+2% funded by 7% fixed). They will pay LIBOR for 6.95%. Company B wants a fixed rate financing to mach their fixed rate investments (e.g., mismatch with 9% financed by L%). They will pay 7.05% for L% * Both companies can avoid the interest rate risks and secure locked-in spreads. If the swap dealer has both deals, it can also eliminate the risk