2Futures and ForwardsForward 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 futuresFutures have secondary trading (liquidity)Marked to marketStandardized contract terms such as delivery dates, price units, contract sizeClearinghouse guarantees performance
3Key Terms for Futures Contracts The Futures price: agreed-upon price paid at maturityLong position: Agrees to purchase the underlying asset at the stated futures price at contract maturityShort position: Agrees to deliver the underlying asset at the stated futures price at contract maturityProfits (accumulated) on long and short positionsLong = Futures price at the moment minus original futures priceShort = Original futures price minus futures price at the momentThe book says spot price at maturity and this is correct due to convergence between the futures and the spot price at maturity.
4Types of Contracts Agricultural commodities Metals and minerals (including energy contracts)Financial futuresInterest rate futuresStock index futuresForeign currencies
6The 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 positionsReversing the initial tradeOR take or make deliveryMost trades are reversed and do not involve actual delivery (agreed to take the delivery (LONG) of XXX on 3rd Wed in June. Later, agreed to deliver (SHORT) XXX on 3rd Wed of June. Basically, you have no position)Open InterestThe number of contracts yet to be closed out with a reversing tradeAvoiding delivery: It is common to have your broker automatically close out your position on the last trading day before delivery becomes an obligation, or to roll your contract over to the next closest expiration contract. Over 90% of futures contracts do not result in delivery. For stock index contracts, the contracts are cash settled only and no delivery can take place. Why this doesn’t really matter is explained after the marking to market example.
7Figure 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.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.
8Marking to Market and the Margin Account Initial Margin: funds that must be deposited initially in a margin (=equity) account to provide capital to absorb lossesMarking 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.
9Marking 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.$97,843.75MarginTotal %HPRSpot HPRDaySettle$ ValuePrice ChangeAccount(cum.)(cum.)$97,843.75$2700Open97-13$97,406.25-$437.50$16.2%0.45%Mon.Margin requirements are available from the CME. These were current when I looked them up but they change frequently as volatility changes. The sizes of the margin requirements are chosen based on daily volatility to limit the clearinghouse’s risk. The clearinghouse basically requires the participants to prepay potential daily losses and then all the house does is transfer funds from the long to the short and vice versa. Note that brokers may require higher margin accounts than the exchange mandated minimums stated here. They typically will require high minimums for retail accounts.The total %HPR is found from as the cumulative percent change in the margin account column. For instance, 16.2% = ( – 2700)/2700, (the price fell so this is a gain to the short, who can ostensibly buy in the spot now and sell at the futures price)-5.8% = ( – 2700)/2700,-79.9% = ( – 2700)/2700The spot HPR (cum) is the percent change in the $ value column, keeping the open as the basis. This represents what the % return would have been had you 1) used the spot market rather than the futures market and 2) the $ value column = spot prices. It is useful to illustrate the leverage provided by the futures contract.0.45% = (97, ,843.75)/97,843.75-0.16% = (98,000 – 97,843,75)/97,843.75-2.2% = (100,000-97,843.75)/97,843.75The leverage multiplier can be found by taking the ratio of the futures return / Spot HPR return, for example 16.2% / 0.45% 36.98-00$98,000.00$593.75$-5.8%-0.16%Tues.100-00$100,000.00$$543.75-79.9%-2.2%Wed.Margin Call => Variation margin+$$Leverage multiplier≈ 36
10Why delivery on futures is not necessary? 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, SpotT-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.$110,000$108,000
11More on futures contracts Delivery: Specifications of when and where delivery takes place and what (quality of the product) can be deliveredCash Settlement: Some contracts can only be settled in cash rather than delivering the underlying assets (indexes, weather, etc)
12Trading Strategies Speculation (no position in an underlying asset) Go long if you believe price will riseGo short if you believe price will fallHedging (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.
13Futures 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.
14The no arbitrage condition ActionInitial Cash FlowCash Flow at T1. Borrow SoS0-S0(1+rf)T2. Buy spot for So-S0ST3. Sell futures shortF0 - STTotalF0 - S0(1+rf)TSince the strategy cost 0 initially, the cash flow at T must also equal 0. Thus: F0 - S0(1 + rf)T = 0 F0 = S0 (1 + rf)T The futures price differs from the spot price by the cost of carry.An arbitrage argument illustrates the concept but we need a bit more. First, the only cost of carry here is the time value of money represented by the risk free rate, so we are ignoring any physical storage cost of the commodity which would normally have to be added on. One could borrow the money to buy the spot commodity, buy the spot and concurrently short the futures. This is riskless because you have the spot and you have locked up the sale price of it with the futures contract.The cost of carry can be negative if the yield on the spot commodity is greater than the storage and funding cost. Oil markets are sometimes in backwardation, usually when there are concerns about future supply disruptions. Then owning oil spot carries a convenience yield that can exceed the cost of carry.The cost of carry is typically positive and when it is the market is said to be in ‘contango.’ When the cost of carry is negative the market is said to be in backwardation.
16Creating Synthetic Stock Positions Synthetic stock purchasePurchase of stock index futures instead of actual shares of stockAllows frequent trading at low cost, especially useful for foreign investmentsIt is cheaper to buy Treasury bills and then shift stock market exposure by buying and selling stock index futures. In this strategy the investor is changing the relative weights on the riskless and risky asset.
17Index Arbitrage Difficult to do in practice Exploiting mispricing between underlying stocks and the futures index contractFutures Price too high:Short the futures and buy the underlying stocksFutures price too low:Long the futures and short sell the underlying stocksDifficult to do in practice
18Swaps Large component of derivatives market Interest Rate SwapsOne 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 SwapsTwo 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).
19Figure 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%Recall that LIBOR is the London Interbank Offer Rate, the rate that banks charge each other in the international banking market.Note that the swap dealer is not exposed to interest rate risk, but they do face counterparty credit risk. The two deals may not be done synchronously, and probably won’t be. The dealer (typically a bank) manages the ‘swap book.’ The variable side is always at LIBOR (flat), the different pricing is on the fixed rate sides. This business has become highly competitive and the dealer profit spread in the example is too high.* 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