Presentation is loading. Please wait.

Presentation is loading. Please wait.

HEDGING WITH FORWARD/ FUTURES CONTRACTS Chap 22 & Chap 24 1.

Similar presentations


Presentation on theme: "HEDGING WITH FORWARD/ FUTURES CONTRACTS Chap 22 & Chap 24 1."— Presentation transcript:

1 HEDGING WITH FORWARD/ FUTURES CONTRACTS Chap 22 & Chap 24 1

2 Lecture Outline Purpose: Introduce Forwards & Futures contracts and show how they can be used to hedge.  Introduction to Forwards and Futures  Three types of prices:  Forward/Future, Spot & Delivery  Payoff of Forward/Future contract  Hedging with Forwards/Futures  Micro Hedge  Macro Hedge 2

3 Forward/Future Contract a Primer Forward & future contracts: are agreements, made at t=0, obligating parties to exchange some pre-specified amount of an asset at a pre-specified price some time in the future. Example:  If your company is a large coffee buyer (Starbucks) you may want to hedge against movements in the price of coffee – lock in a price today for the purchase of coffee in 1.5 years Coffee Forward Prices $1.87/lb $2.75/lb Contract payoff $0.88 The price that the coffee buyer can lock in at any time is the forward price The price that the coffee buyer locks-in is the delivery price Just an agreement – no exchange of money 3 $2.75/lb 1.87/lb -$0.88/lb $1.87/lb

4 Introduction to Forwards & Futures 4

5 Forward/Future Contract A Primer Differences between Forwards and Futures Forward contracts are custom Futures contracts are standardstandard 2.Forwards settled at maturity 1.Trade on OTC dealer markets 3.More exposed to counterparty default risk 4.Almost always delivered 2.Futures are marked-to-market 1.Trade on exchanges 3.Exchange guarantees performance (there is much less counter party default risk) 4.Almost never delivered Economic Hedgers Speculators Who Trades in each market Speculators or Hedgers? Every day the change in the value of the forward contract is added or subtracted from the investors account 5

6 6 Forward/ Future Price, Spot Price & Delivery Price

7 Prices You Need to Keep Straight  Spot Price (S 0 ): Price of the underlying asset (coffee)  Forward/Futures Price (F t ): The current price at which you can enter a forward contract – varies over time!  Delivery Price: The transaction price specified in the contract.  Equal to the forward/futures price when the contract is entered  Remains constant over the life of the contract. (Locked-in) F t = future price ; S 0 = underlying spot price k = compounding periods per year; r = risk-free rate; (T-t) = number of years to delivery 7 S 0 = Current Market Price of CoffeeCurrent Market Price of Ford StockCurrent Market Price of a 10-year Treasury Note: this is for the special case where the underlying asset does not make payments for the life of the contract. That is, it does not work for coupon bonds dividend paying stocks …

8 Spot Price 8

9 Example: Spot Price On June 20, 2010 JP Morgan enters into an agreement to sell a10-year Treasury note with $1000 face value. They agree to a delivery price is $900 for the March 2012 contract. 9 Price of 10- year Treasury Bonds are expensive Bonds are cheap Uncertainty On June 20, 2010 JP Morgan agrees to sell a Treasury Bond for $900 on March 23, 2012 On March 23, 2012 JP Morgan needs to deliver a 10-year Treasury Note Setup Is JP Morgan exposed to risk? Spot Prices Problem: Assuming JP Morgan will buy the 10-year Treasury Note on March 2012 to satisfy the contract, they don’t know how much they will pay for it. So, they are exposed to interest rate risk.

10 Example: Spot Price On June 20, 2010 JP Morgan enters into an agreement to sell a10-year Treasury Note with $1000 face value. They agree to a delivery price is $900 for the March 2012 contract. 10 Can JP Morgan hedge using a forward contract? Yes JP Morgan can enter a forward contract to buy the 10 year Treasury. That would lock-in a price to buy the 10- Treasury on March 23, 2012 $900 Can JP Morgan hedge using a forward contract? Spot Prices Problem: Assuming JP Morgan will buy the 10-year Treasury Note on March 2012 to satisfy the contract, they don’t know how much they will pay for it. So, they are exposed to interest rate risk. JP Morgan needs to sell a bond for 900 on March

11 Example: Spot Price Main Point:  Spot prices vary through time which exposes banks/investors to risk (interest rate risk, price risk, FX risk … )  Forward/Futures contracts can be used to hedge that risk How? 11

12 12 Forward/Future Price

13 Example: Forward/Futures Prices On June 20, 2010 JP Morgan enters into an agreement to sell a10-year Treasury Note with $1000 face value. They agree to a delivery price is $900 for the March 2012 contract. 13 Spot price S 0 Price of the bond Forward/Future Price is a function of the spot price. Forward/Future & Spot Prices At any point in time I can enter a forward/futures contract at the forward/futures price

14 Example: Forward/Futures Price Main Point:  The Forward/Futures price is a function of the spot price and varies through time.  At any point in time you can enter a forward/futures at the current forward/futures price 14

15 15 Delivery Price

16 Example: Delivery Price On June 20, 2010 JP Morgan enters into an agreement to sell a10-year Treasury Note with $1000 face value. They agree to a delivery price is $900 for the March 2012 contract. 16 Spot price S 0 Price of the bond Forward/Future Price is a function of the spot price. Forward/Future & Spot Prices We know that we can enter a forward/future at any time at the forward/futures price. This locks-in the future buy price $938 $880 $975 Obligated to buy at $938 Delivery Price $938 Delivery Price !!! $880$975

17 Example: Delivery Price Main Point:  The delivery price is specified in the contract. Once you enter the contract the delivery price does not change.  This is the price you agree to buy or sell at in the future 17

18 Hedging with a Forward Basic Idea 18

19 Example: Bring it all together On June 20, 2010 JP Morgan enters into an agreement to sell a 10-year Treasury note with $1000 face value. They agree to a delivery price is $900 for the March 23, 2012 contract. 19 Spot price S 0 Price of the bond Forward/Future Price is a function of the spot price. Forward/Future & Spot Prices Agreed to sell T- note for $900 Enter forward contract to buy a T-Note at the delivery price -$890 $900 $10 $890

20 20 Forward/Futures Payoff

21 Payoff of a forward/futures contract 21  Payoff – Refers to the cash flow that occurs at maturity for a contract with cash settlement.

22 Example: Forward/Future Payoff JP Morgan entered a forward contract to buy a Treasury Note on March 23, 2012 with a delivery price of $890. They have locked-in a buy price. The question is: what happens at maturity? 22 Forward/Future Price (March 2012 contract) Forward/Future & Spot Prices $933 Payoff ONLY CONSIDER THE FORWARD TO BUY AT $890: - $890 Delivery Price If the contract is financial (cash) settled, what does JP Morgan receive at maturity? 1.Buy at the delivery price 2.Immediately sell in the market at the current spot price (also the forward price) $43

23 Example: Forward/Future Payoff JP Morgan entered a forward contract to buy a Treasury Note on March 23, 2012 with a delivery price of $890. They have locked-in a buy price. The question is: what happens at maturity? 23 - $890 Forward/Future Price (March 2012 contract) Forward/Future & Spot Prices $933 Payoff ONLY CONSIDER THE FORWARD TO BUY AT $890: Delivery Price $43

24 Example: Forward/Future Payoff 24 Take Away The payoff of the forward/futures contract is difference between the price of the underlying asset (bond) at maturity and the delivery price that was locked in the on the contract Payoff = (S – F D ) - long position Payoff = (F D – S) - short position Question: Will the Forward/Future contract payoff always be positive? Question: Can you calculate the payoff on a forward/future prior to maturity?

25 25 Hedging with Forward/Futures Contracts

26 Hedging 26 1.Find the hedging position long or short forward 2.Find the number of contracts 3.Show that the position is hedged

27 Long & Short Positions 27 Underlying Asset:  Long: you own the asset  Short: you owe the asset Forward Contract  Long: you have agreed to buy the asset in the future at a pre- specified price (locked-in a price to buy)  Short: you have agreed to sell the asset in the future at a pre- specified price (locked-in a price to sell) Example: Stock → If you are long the stock you own it Example: Stock → If you are short the stock you have borrowed # shares from a dealer and sold them. So, you owe # shares back to the dealer

28 1. Finding the Hedging Position 28 Investors Investors have some obligation that exposes them to risk (price fluctuations) ie. their position in the underlying asset (Long or Short). They want to offset this exposure this exposure by taking the opposite position in the forward contract. This locks in a payment in the future T-Bill Underlying Basic Idea 1.Find the position in the underlying asset 2.Take the opposite position in the futures 3.LONG vs. SHORT – underlying LONG: Better off (happy) when the price goes up SHORT: Better off (happy) when the price goes down

29 1. Finding the Hedging Position 29 Investors Hedged Position T-Bill Underlying Future Time PeriodCurrent Time (t=0) Are you long or short the T-Bill? Short Do go long or short the forward? Long Underlying Position Forward/Futures Position

30 1. Finding the Hedging Position 30 Investors Hedged Position T-Bill Underlying Future Time PeriodCurrent Time (t=0) Short Long Underlying Position Forward/Futures Position The object of hedging is to eliminate risk – ie. lock in a future value. That value does not have to be the same as the present value!!!!!

31 1. Finding the Hedging Position 31 Investors Hedged Position T-Bill Underlying Future Time PeriodCurrent Time (t=0) Short Long Underlying Position Forward/Futures Position Goldman Sachs wants to hedge $5M of corporate bonds on its balance sheet.

32 1. Finding the Hedging Position 32 Investors Hedged Position T-Bill Underlying Future Time PeriodCurrent Time (t=0) Short Long Underlying Position Forward/Futures Position Goldman Sachs agrees to deliver $5M of corporate bonds in six months – payment on delivery?

33 1. Finding the Hedging Position 33 Investors Hedged Position Underlying Future Time PeriodCurrent Time (t=0) Short Long Underlying Position Forward/Futures Position Exxon will deliver 5M barrels of oil in 6 months for $55/barrel.

34 1. Finding the Hedging Position 34 Investors Hedged Position Underlying Future Time PeriodCurrent Time (t=0) Short Long Underlying Position Forward/Futures Position A corn farmer will sell 50M bushels of corn at market price in 3 months.

35 1. Finding the Hedging Position 35 These 3 questions can help determine the hedging position: 1.Does the hedging party own or owe the underlying asset?  Answer: own. Then they are long the underlying and need to take a short position in the forward contract to hedge  Answer: owe. Then they are short the underlying and need to take a long position in the forward contract to hedge 2.Does the hedging party want to lock in a price to buy or sell in the future?  Answer: lock-in a price to buy. Then they need to go long the forward  Answer: lock-in a price to sell. Then they need to go short the forward

36 1. Finding the Hedging Position 36 These 3 questions can help determine the hedging position: 3.Is the hedging party happy if the price of the underlying asset increases or decreases?  Answer: Increases. Then the hedging party is long the underlying asset and needs to take a short position in the forward contract  Answer: Decreases. Then the hedging party is short the underlying and needs to take a long position in the forward contract

37 2. Find the number of contracts 37  Forward contract:  These are custom contracts. The hedging party can specify the exact notional amount. Therefore, only one contract is needed.  Futures contracts:  These are standard contracts with a standard notional amount.  To find the number of contracts you must divide the total notional by the standard contract notional  Example: Goldman wants to hedge 10-year Treasury bonds with $5M face value with a CME contract. The standard contract size is $100,000

38 3. Show that the position is hedged 38  Show that no matter what the price of the underlying asset is in the future the hedged portfolio has locked-in a payoff Underlying position Forward Payoff t = 0t = 6 months Hedged portfolio Scenario 1 price Scenario 2 price Value an asset Payoff on Forward/Futures Sum to get hedged payoff

39 Example: Hedging with Forwards/Futures A hedge fund currently holds year treasury notes each note has face value of $1000. The current spot price is $994 per bond. They decide to hedge using a 3-month futures contract on the 20 year treasury bond. The current futures price is $99.5 per $100 of face value and contract size is $100,000. a)How many contracts do they need? b)Show that the position is hedged if the price of the 20-year Treasury is $905 or $1,050 in three months. 39 Step #1: What contract position do they need to hedge their exposure?  They own the bonds. So, they are long the underlying.  To hedge, they need to take a short position in the forward contract Step #2: How many contracts do they need to short? Total face value held by the hedge fund Once you know the number of contracts to long or short you have enough information to set up the hedge. What we do in the last step is show that the hedge works

40 Example: Hedging with Forwards/Futures A hedge fund currently holds year treasury notes each note has face value of $1000. The current spot price is $994 per bond. They decide to hedge using a 3-month futures contract on the 20 year treasury bond. The current futures price is $99.5 per $100 of face value and contract size is $100,000. a)How many contracts do they need? b)Show that the position is hedged if the price of the 20-year Treasury is $905 or $1,050 in three months. Forward Payoff Futures contracts = $0.00 forward/future cost nothing at inception Sell 1M face value at the forward price $0.995(1,000,000) = $995,000 Buy a bond in the market: -$905(1,000) = - $905,000 Bond Position (1000)(994) = 994,000 They hold 1000 bonds worth $994 a piece (1000)(905) = 905,000 They hold 1000 bonds worth $905 a piece $994,000$995, Bond Price = $905 t = 0t = 3m (1000)(1,050) = $1,050,000 They hold 1000 bonds worth $1,050 a piece Bond Price = $1,050 Forward Payoff $90,000 $995,000 Sell 1M face value at the forward price $0.995(1,000,000) = $995,000 Buy a bond in the market: -$1,050(1,000) = - $1,050,000 Forward Payoff - $55,000 Hedged Portfolio

41 $995,000 $994,000 Hedged Portfolio Forward Payoff Futures contracts = $0.00 forward/future cost nothing at inception Bond Position (1000)(994) = 994,000 They hold 1000 bonds worth $994 a piece (1000)(905) = 905,000 They hold 1000 bonds worth $905 a piece Bond Price = $905 (1000)(1,050) = $1,050,000 They hold 1000 bonds worth $1,050 a piece Bond Price = $1,050 t = 0t = 3m Example: Hedging with Forwards/Futures A hedge fund currently holds year treasury notes each note has face value of $1000. The current spot price is $994 per bond. They decide to hedge using a 3-month futures contract on the 20 year treasury bond. The current futures price is $99.5 per $100 of face value and contract size is $100,000. a)How many contracts do they need? b)Show that the position is hedged if the price of the 20-year Treasury is $905 or $1,050 in three months. Sell 1M face value at the forward price $0.995(1,000,000) = $995,000 Buy a bond in the market: -$905(1,000) = - $905, Forward Payoff $90,000 Sell 1M face value at the forward price $0.995(1,000,000) = $995,000 Buy a bond in the market: -$1,050(1,000) = - $1,050,000 Forward Payoff - $55,000 These are the transactions you would have to execute if the contract was physically settled – For financially, settled you just think through these transactions to get to the payoff

42 The company you work for is obligated to deliver 5,000 5-year zero coupon bonds in one year. Payment will be maid upon delivery. The current YTM for a 5-year zero is 12%. Each bond has face value of 1,000 Hedge your position using a one-year futures contract. Assume a standard contract size of 250,000 and the current future price is $64 per $100 of face value. Show that you are hedged if the YTM increases to 13% or decreases to 11% in one year. 42

43 Types of Hedging Strategies 1. Microhedge: The FI manager chooses to hedge the risk from a specific asset  Example: An FI manager may believe that American auto manufactures are going to suffer unexpected earnings losses in the near future causing their interest rates (financing cost) to increase. The manager shorts futures contracts on the Ford 5 ¼% 10 year bond which he currently holds  Managers will pick contracts where the underlying asset closely matches assets being hedged 2. Macrohedge: The FI uses futures contracts to hedge the risk of its entire portfolio (balance sheet).  Example: using futures contracts to reduce the duration gap  Managers hedging strategies must consider the duration of the entire portfolio because durations of individual assets will cancel or multiply (“net out”) 3. Routine Hedging: The FI uses forward contracts to reduce the interest rate risk on its balance sheet to its lowest level 4. Selective Hedging: The FI chooses to bear some of the risk on its balance sheet by hedging only certain components of the balance sheet 43

44 Duration of a Forward Contract  Suppose you enter into a forward contract to purchase a 10 year treasury bond in 3 months. The duration of the treasury is currently 7.5 years. What is the duration of the forward contract?  Draw the cash flows of each investment assuming there are no payments made on the underlying during the life of the forward contract The string of cash flows from the forward contract and the 10 year note are the same. Therefore, the duration of the futures contract is the same as the duration of the underlying asset year Treasury Forward Contract on a10 year Treasury 3 months 44

45 Hedging with Forwards (Macrohedge)  Object: immunize the balance sheet against changes in interest rates  Basic Idea: Construct a portfolio of futures contracts such that any gains/losses in equity capital on the balance sheet will be offset by gains/losses on the portfolio of futures (held off balance sheet)  Step #1 Calculate the potential gain or loss in equity capital 45 If interest rates change – how much will I gain or lose in equity capital

46 Hedging with Forwards (Macrohedge)  Step #2 Find the total forward position needed to hedge the change in equity  We know that D F = D underlying we can use this to find the total forward position Note: we can use a forward on any asset as long as we know its duration  Set the change in equity equal to the negative change in the value of the forward position and solve for F 46 What position (futures price × total face value) in the futures contract will offset the gain/loss in equity S&P500 shares, bushels of corn, barrels of oil …

47 Macrohedge (continued) Step #3 Find the Number of Contracts: 47 How many contracts do we need to enter (long/short) to get this position

48 Macrohedge (continued) Step #3 Find the Number of Contracts:  F is the total position in the futures contracts but how many contracts do we need to buy to cover the position? 48 Total position in futures contracts (futures price × total face value) Total position per contract

49 Example: Suppose a FI has assets and liabilities on its balance sheet with total values shown below. The duration of its assets and liabilities is 5 years and 3 years respectively. Management at the FI expects interest rates to increase from 10% to 11%. They hire you as a consultant to recommend a macrohedge. Futures contract: A futures contract on a 20 year Treasury bond with 8% coupon and 100,000 face value is available. The current futures price is $97 / $100 face value. Analysts have computed the duration of the bond to be 9.5 years AssetsLiabilities A=$100 millL = $90 mill E = $10 mill $100 mill

50 Lecture Summary  What are Forward and Future contracts  Three types of prices:  Spot  Forward/Future  Delivery  Payoffs of Forwards/Futures  Hedging with Forwards/Futures  Micro Hedge  Macro Hedge 50

51 Appendix  Valuing a forward/futures  Forward/Futures Payoff Graphs  Difficulties with Forward/Futures Hedging  Basis risk 51

52 Contract Value 52

53 Example: Forward/Future Value On June 20, 2010, JP Morgan entered the forward contract to buy a 10-year Treasury with $1000 face value for $890 on March 23, Spot price S 0 Delivery Price Forward/Future Price (March 2012 contract) ONLY CONSIDER THE FORWARD/FUTURE CONTRACT: Forward/Future & Spot Prices $941 For example: Oct 8, $890 Sell Buy $51 Locked–in a sure CF = $51 Because this is sure CF we can discount at the risk free rate Value = PV(51) =$47.73

54 Example: Forward/Future Value 54 ONLY CONSIDER THE FORWARD/FUTURE CONTRACT: Take Away:  The forward price will continue to change after you enter the forward contract. This will cause the value of your contract to change over time.  At any point in time the value of the forward/futures contract is the present value of the difference between the delivery price and the price that you can close out your contract for. On June 20, 2010, JP Morgan entered the forward contract to buy a 10-year Treasury with $1000 face value for $890 on March 23, 2012.

55 55 Payoff Graphs

56 Long & Short Positions 56 Underlying Asset:  Long: you own the asset  Short: you owe the asset Forward Contract  Long: you have agreed to buy the asset in the future at a pre- specified price (locked-in a price to buy)  Short: you have agreed to sell the asset in the future at a pre- specified price (locked-in a price to sell) Example: Stock → If you are long the stock you own it Example: Stock → If you are short the stock you have borrowed # shares from a dealer and sold them. So, you owe # shares back to the dealer

57 Underlying Asset Long Payoff Graphs 57 Spot Price Payoff All possible spot prices for the Treasury Bond This gives us all the possible payoffs for one Treasury Bond Example: suppose the price of a Treasury bond is $550 $550 Spot Price $550 If you sell one Treasury bond the Payoff is $550 Long One Treasury Bond Payoff For one share

58 Underlying Asset Short Payoff Graphs 58 Payoff Example: suppose the price of a Treasury bond is $425 $425 Spot Price - $425 You will have to pay $425 to buy one Treasury bond Short One Treasury Bond Payoff

59 Long Forward Payoff Graphs 59 Even if the price of the bond is zero you have still agreed to pay $900 for it If the price of the bond is $900, then you can buy it using the forward for $900 and sell it in the market for $900. payoff = 0 Long Treasury Bond Forward Payoff If the price of the bond is $1,380, then you can buy it using the forward for $900 and sell it in the market for $1,380. payoff = 1, = Payoff =500 If the price of the bond is $280, then you must buy it using the forward for $900 and sell it in the market for $280. payoff = =

60 Short Forward Payoff Graphs 60 Short Treasury Bond Forward Payoff If the price of the bond is $1,380, then you can buy it in the market for $1,380 and sell it at the delivery price of 900. payoff = 900-1,380 = Payoff = -480 If the price of the bond is $280, then you can buy it in the market for $280 and sell it using the forward for 900. payoff = =

61 Payoff Graphs 61 Underlying Asset: Forward Contract: Long Short Long Short Delivery Price

62 Difficulties Hedging with Futures Contracts 62

63 Difficulties with Futures Hedge  Basis Risk: the risk that the gains/losses on the forward position do not exactly match the gains/losses on the underlying economic position over time  Example:  Suppose you are a farmer in the heartland of America  Your crop of choice is white corn (you think it makes you stand out)  You routinely use forward contracts to hedge against unexpected price movements.  You will have 5,000 bushels of corn to sell in September Forward contract  You have entered into the September contract to sell 5000 bushels of yellow corn for $6.78/bushel. (6.78 x 5000 = $33,900)  The fact that the contract is on yellow corn dose not concern you because the prices have always been very similar 63

64 Difficulties with hedging  In September there is a large shock to the demand for white corn in the global market. International producers divert excess supply to the US driving the price of white corn down to $5/bushel  Surprisingly, the price of yellow corn is unaffected and still sells for $6.50 / bushel Calculate the unexpected gain or loss on your position  With the forward contract you would have expected to be able to sell white corn for $6.78/bushel but the actual sale price was $5 loss = $5.00(5,000)-$6.78(5,000) = -$8,900  But you have the futures contract:  Buy 5000 bushels of yellow corn in the market = - ($6.50/bushel)(5000) = - 32,500  Sell 5000 bushels of yellow corn using the forward = + ($6.78/bushel)(5000) = +33,900 The gains from the forward position do not cover the economic losses +1,400 64

65 Routine vs. Selective Hedging Question: why would a manager choose to perform a selective hedge instead of a routine hedge? Answer: In finance, there is always a risk vs. return tradeoff!  As managers reduce the FI’s risk by hedging positions, they also decrease the expected return on their investments.  This also reduces the expected return to shareholders  Therefore, routine hedging usually occurs when interest rates are extremely unpredictable 65

66 Lecture Summary  We talked about how banks can hedge some or all of their interest rate risk exposure using Forward/Futures contracts  Forwards/Futures  Introduction  Prices: Forward/Future, Spot, and Delivery  Payoffs vs Value  Payoff Graphs  Microhedge with Forward/Future contracts  Macrohedge with Forward/Futures contracts  Basis Risk – difficulties with Forward/Future hedge 66


Download ppt "HEDGING WITH FORWARD/ FUTURES CONTRACTS Chap 22 & Chap 24 1."

Similar presentations


Ads by Google