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Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–1.

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Presentation on theme: "Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–1."— Presentation transcript:

1 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–1 Chapter 18 Futures Contracts

2 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–2 Learning Objectives Understand what a futures contract is and how futures markets are organised. Understand the system of deposits, margins and marking-to-market used by futures exchanges. Have some understanding of the determinants of futures price.

3 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–3 Learning Objectives (cont.) Understand and be able to explain that speculation and hedging with futures contracts may be imperfect. Understand and explain the features of the major financial futures contracts traded on the Sydney Futures Exchange. Explain speculation and hedging strategies using the major financial futures contracts traded on the Sydney Futures Exchange.

4 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–4 Learning Objectives (cont.) Understand the valuation of 90-day bank-accepted bill futures contracts and share-price index futures contracts. Understand and explain the uses of forward-rate agreements.

5 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–5 Futures Contracts A futures contract is an agreement which provides that something will be sold in the future at a fixed price. The price is decided today, but the transaction is to occur later. Australian futures contracts are traded on the Sydney Futures Exchange (SFE).

6 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–6 Forward Contracts A forward contract will have the following features: – The forward price is decided now but the transaction is to occur on a nominated future date. – The details of the commodity which is the subject of the contract are spelt out. – The contract is a private contract between you and I. I cannot pass on to anyone else my responsibility to deliver the commodity and, likewise, you cannot pass on to anyone else your responsibility to accept delivery of the commodity.

7 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–7 Futures Contracts A futures contract on gold will also have features 1 and 2 of a forward contract. However, feature 3 is not true of a futures contract. – A futures contract is not a personalised agreement. – It is essentially a forward contract which can be traded on an exchange.

8 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–8 Characteristics of Futures Market Standardised contract sizes and maturity dates. Clearing house guarantees performance of all contracts, both buyers and sellers. Futures contracts require you to put up deposits and satisfy margin calls if required. Contracts usually closed out at or before maturity rather than physically delivered.

9 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–9 Deakin Futures Market DateNumberPrice $ Number 1 MarchB1B1 610 S1S1

10 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–10 Deakin Futures Market (cont.) DateNumberPrice $ Number 1 MarchB 1 = S 1 610 B 1 = S 1

11 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–11 Deakin Futures Market (cont.) DateNumberPrice $ Number 1 MarchB 1 = S 1 610 B 1 = S 1 1 MarchB 2 = S 2 611 B 2 = S 2

12 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–12 Deakin Futures Market (cont.) DateNumberPrice $ Number 1 MarchB 1 = S 1 610 B 1 = S 1 1 MarchB 2 = S 2 611 B 2 = S 2 1 MarchB 12 = S 12 608 B 12 = S 12 1 MarchB 19 = S 19 615 B 19 = S 19 1 MarchB 37 = S 37 614 B 37 = S 37

13 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–13 Deakin Futures Market (cont.) DateNumberPrice $ Number 1 MarchB 1 = S 1 610 B 1 = S 1 1 MarchB 2 = S 2 611 B 2 = S 2 1 MarchB 12 = S 12 608 B 12 = S 12 1 MarchB 19 = S 19 615 B 19 = S 19 1 MarchB 37 = S 37 614 B 37 = S 37 8 MarchB 200 = S 200 620 B 200 = S 200

14 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–14 Deakin Futures Market (cont.) DateNumberPrice $ Number 1 MarchB 1 = S 1 610 B 1 = S 1 1 MarchB 2 = S 2 611 B 2 = S 2 1 MarchB 12 = S 12 608 B 12 = S 12 1 MarchB 19 = S 19 615 B 19 = S 19 1 MarchB 37 = S 37 614 B 37 = S 37 8 MarchB 200 = S 200 620 B 200 = S 200

15 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–15 Deakin Futures Market (cont.) DateNumberPrice $ Number 1 March610B 1 = S 1 1 MarchB 2 = S 2 611 B 2 = S 2 1 MarchB 12 = S 12 608 B 12 = S 12 1 MarchB 19 = S 19 615 B 19 = S 19 1 MarchB 37 = S 37 614 B 37 = S 37 8 MarchB 200 = S 200 620

16 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–16 Deakin Futures Market (cont.) B 1 owes the clearing house $610. B 1 (=S 200 ) is owed by the clearing house $620. Therefore, the clearing house owes B 1 $10.

17 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–17 Deakin Futures Market (cont.) Buyers and sellers do not need to know the identity or credit worthiness of other buyers and sellers. But B 1 must notify exchange that she is S 200. Note no silver changed hands. Note ‘short selling’ is possible.

18 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–18 Deposits, Margin Calls and the Mark- to-Market Rule Deposits – All traders are required to open an account and deposit a specified amount of money with the clearing house before entering into first contract. – Mark-to-market. – The clearing house adjusts the recorded value of an asset to its market price on a daily basis. Margin calls – A requirement that extra funds be deposited as a result of adverse price movements in the price of a contract.

19 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–19 The Present Value of a Futures Contract A futures contract does not require a payment on initiation, so it is clear that the present value of a futures contract must be zero. Accordingly, it is, in a sense, impossible to calculate a rate of return on a futures contract. – If the outlay is zero, any subsequent gain is an infinite percentage gain and any subsequent loss is an infinite percentage loss.

20 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–20 The Sydney Futures Exchange (SFE) Opened for trading in 1960, was then called Sydney Greasy Wool Futures Exchange — reflecting the importance of the commodity (agricultural) futures at that stage. SFE operates own clearing house to: – Establish and collect deposits. – Call in margins. – Apportion the gains and losses.

21 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–21 SFE Contracts The contracts available include: – 90-day bank accepted bills – 3-year Australian Treasury Bond – 10-year Australian Treasury Bond – Standard & Poors, ASX 200 (SPI200) – 30-day inter-bank cash rate contract – Individual share futures (on approximately ten companies) – Australian dollar – Options on futures contracts The bulk of trading on the SFE is in the first four contracts listed above.

22 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–22 Determinants of Futures Prices Futures pricing theorem – The futures price for a late-delivery contract must be less than (or equal to) the futures price for an equivalent early- delivery contract, plus the carrying cost. – The carrying cost is the cost of holding a commodity from one time period to another.  It includes an interest factor (opportunity cost of funds used to finance the holding of the commodity) and in the case of physical commodities, the costs of insurance and storage.

23 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–23 Determinants of Futures Prices (cont.) Substituting ‘the spot price’ for ‘the futures price for an equivalent early-delivery contract’, the theorem becomes: – A futures price must be less than (or equal to) the current spot price plus the carrying cost. In this way, the theorem provides a maximum price for the futures contract, given the current spot price and the carrying cost.

24 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–24 Determinants of Futures Prices (cont.) Algebraically, the theorem can be written as:

25 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–25 Determinants of Futures Prices (cont.) The maximum value that the expected spot price, E(S), can be, given the current spot price, S, the carrying cost, C, and a risk factor is given by: Clearly, there must be some linkage between the expected spot price and the futures price. If there is a big difference between the expected spot price and futures price, it may reflect an arbitrage opportunity, depend on perceptions about the risk factor.

26 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–26 Futures Market Strategies: Speculating and Hedging Speculator: someone who has traded in a futures contract but who has no direct interest in the ‘commodity’ underlying the futures contract. – Affected by the futures price (but not the spot price) of the commodity. – By trading in futures contracts, the speculator is exposed to the risks of changes in the futures price — a risk to which they would not otherwise have been exposed.

27 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–27 Futures Market Strategies: Speculating and Hedging (cont.) Hedger: someone who has traded in a futures contract and has a ‘genuine’ interest in the ‘commodity’ underlying the futures contract. – Affected by both the futures price and the spot price of the commodity. – The hedger is exposed to the risk of changes in the futures price, but only in an attempt to offset the pre-existing risk of changes in the commodity price itself.

28 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–28 Speculating In the simplest case, a speculator hopes to: – Take a long position (that is, buy) when the futures price is ‘low’, reversing out (that is, selling later) when the futures price has increased; and/or – Take a short position (that is, sell) when the futures price is ‘high’, reversing out (that is, buying later) when the futures price has decreased. In either case, the speculator gains. However, if the opposite occurs, the speculator loses.

29 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–29 Speculating (cont.) Table 18.2

30 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–30 Speculating (cont.) Scalping: – A scalper will only hold a futures contract for an extremely short time period (seconds or minutes). – Scalpers try to develop a continuously updated ‘feel’ for the market, anticipating and exploiting perceived short- term excesses of supply or demand. – Scalpers perform the useful function of providing liquidity to the market.

31 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–31 Speculating (cont.) Spreading – A ‘spread’ is a long (bought) position in one maturity date, paired with a short (sold) position in another maturity date. – Example — A bought March bank bill futures and A sold June bank bill futures.  This spread will be adopted if speculators believe that the current difference between the two futures prices is too wide.  Speculators will gain if the difference (or ‘spread’) narrows.

32 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–32 Speculating (cont.) Straddling – A ‘straddle’ is similar in concept to a spread but refers to positions in futures contracts on different commodities. – For example  A speculator might buy a March bank bill contract and sell a March bond contract.

33 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–33 Speculating (cont.) Day trading – Day traders are prepared to trade as they see fit during a trading day, but regard an overnight position as too risky. Long-term/overnight position taking: – The simplest and riskiest type of speculation. – Speculators form a view that the current futures price is too low (or too high), trade accordingly, and wait for events to prove them right.

34 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–34 Hedging Example – A grazier intends to sell his cattle in several months’ time. – He is affected by movements in the spot price of cattle:  Gaining if it increases (his cattle become more valuable).  Losing if it decreases (his cattle become less valuable). – To be protected against these changes, he can sell cattle futures, that is, he becomes a short hedger.

35 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–35 Hedging (cont.) Table18.3 Short hedger – Someone who hedges by means of selling futures contracts today (going short).

36 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–36 Hedging (cont.) Long hedger – Someone who hedges by means of buying futures contracts today (going long). Table 18.4

37 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–37 Some Reasons Hedging with Futures is Imperfect Imperfect convergence – The price of a futures contract with zero time to maturity ought to be equal to the spot price. – However, in reality the futures price at maturity can be slightly different from the spot price. The convergence between the spot and futures price as the maturity date approaches can be imperfect. – Although this convergence will be imperfect, it may not be possible to profit from this difference, due to transaction costs.

38 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–38 Some Reasons Hedging with Futures is Imperfect (cont.) Basis risk – A hedger will plan to transact in the spot market at some future date. However, it is usual for the date of the planned spot transaction to coincide with the maturity date of a futures contract. – Futures exchanges will offer only a restricted number of maturity dates. – When the dates do not coincide, the hedger must reverse out of the futures contract before it matures and faces a risk known as ‘basis risk’.

39 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–39 Some Reasons Why Hedging With Futures is Imperfect (cont.) – Basis: the spot price S at a point in time minus the futures price F (for delivery at some later date) at that point in time. – At time zero the basis B is: B (0) = S (0) – F (0) – At time 1 the basis B is: B (1) = S (1) – F (1) – Consider a short hedger: makes a gain (loss) on the futures contract if the futures price decreases (increases), and a gain (loss) on holding the commodity if the spot price increase (decreases).

40 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–40 Some Reasons Why Hedging With Futures is Imperfect (cont.) The point is simple: the change in the basis over a given time period is not, in general, precisely zero.

41 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–41 Some Reasons Why Hedging With Futures is Imperfect (cont.) Specification differences – Refers to the fact that the specification of the ‘commodity’ that is the subject of the futures contract may not precisely correspond to the specification of the ‘commodity’ that is of interest to a hedger. – Example: a hedger may be interested in a particular grade of wool that is slightly different to the grade of wool specified in the futures contract.

42 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–42 Hedging and Regretting Hedging can be used to reduce losses which would otherwise have been incurred. However, it should not be forgotten that, by its very nature, hedging also reduces profits which would otherwise have been made.

43 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–43 Selecting the Number of Futures Contracts Suppose that a hedger has an interest in N S units of a ‘commodity’. If this interest is a long (short) position, then N S is positive (negative). The optimum number of futures contracts f * is:

44 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–44 The Bank Bill Futures Contract Contract specifications for 90-day bank- accepted bills: – Contract unit — 90-day bank accepted bill with a face value of $1m. – Delivery months — Mar., June, Sept., Dec. up to 3 years out. – Delivery day — first business day after last trading day. – Quotations — 100 minus annual percentage yield to two decimal places. – Settlement — cash or physical settlement. – Settlement date — the second Friday of the delivery month.

45 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–45 Hedging with Bank Bill Futures Annamay Ltd needs to borrow in 2 weeks’ time by issuing a 90-day bank bill with a face value of $1m. Currently, bank bill rates are 4.4%. Risk: that the bill rate would increase; therefore, the company decided to protect itself by selling one BAB futures contract at 95.78 (4.22%).

46 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–46 Hedging with Bank Bill Futures (cont.) Scenario – During the next 2 weeks, the 90-day bill rate increased and the bill was issued at 5.5%. At this date the BAB futures contract was priced at 94.70 (5.3%). Question: What is the result of this course of action? Physical market

47 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–47 Hedging with 90-day Bank Bills Futures market Hedge reduces shortfall from $2647.32 to $45.73 (a reduction of 98.3%).

48 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–48 10-Year Treasury Bond Futures Contract Contract specification – Contract unit — 10-year government bond with a face value of $100 000 and a coupon rate of 6% p.a. – Settled by cash, not delivery. – Quotations — 100 minus the annual percentage yield. Uses – Can be used in ways similar to those explained for the bank bill contract.

49 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–49 Share Price Index (SPI 200) Futures Contract Specifications – Contract unit: value of the S&P/ASX 200 Index, multiplied by $25. – Settlement — not deliverable, closed out at the close of trading at the relevant spot index value, calculated to one decimal place. – Quoted as the value of the S&P/ASX 200 Index (to one full index point). – Trading ceases at 12 noon on the third Thursday of the contract month.

50 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–50 Speculation with the SPI Futures Example – On 1 September 2004, the S&P/ASX 200 Index closed at 3575.6 and the December (2004) SPI200 futures price was 3598. – Suppose that a speculator believes that share prices are likely to rise in the following two weeks and therefore decides to buy December SPI200 futures. – On 15 September 2004, the S&P/ASX 200 Index has risen to 3625.1 and the December SPI futures price has fallen to 3638.

51 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–51 Speculation with the SPI Futures (cont.) The total gain can be calculated as follows: Notional sale at: 3598 x $25 = $89 950 (outflow) Notional purchase at: 3328 x $25 = $90 950 (inflow) Gain (net inflow): $1 000

52 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–52 Hedging with SPI Futures Example 18.14 – Michael Saint manages a portfolio of Australian shares with a current market value of $1 510 700. – The portfolio is to be sold in 4 weeks’ time. – The SPI 200 futures price today is 3162. – Assume that proportionate changes in the portfolio’s value will be matched by proportionate changes in the futures price.

53 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–53 Hedging with SPI Futures (cont.) Number of futures contracts needed to hedge the portfolio:

54 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–54 Hedging with SPI Futures (cont.) Table 18.11

55 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–55 Hedging with SPI Futures (cont.) Therefore the hedge has, in fact, resulted in a net gain of: $72 675 – $66 250 = $6 425

56 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–56 Valuation of Financial Futures Contracts A restriction on the valuation of futures contract is given by:

57 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–57 Valuation of Financial Futures Contracts (cont.) If the commodity can readily be sold short, and if the opportunity cost of investment is the only form of carrying cost, then:

58 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–58 Valuation of Bank Bill Futures Contracts If it is assumed that bank bills can be sold short, then the above equation should apply to bank bill futures. – It is usual to express C in terms of the yield i t applicable to the term t of the future contract. – The bank bill futures price is simply the spot price of the relevant bank bill, accumulated at the yield applicable to the term of the futures contract.

59 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–59 Valuation of SPI Futures Contracts  The valuation of the SPI futures contract is slightly more complex, because dividends are paid on many shares in the index but the calculation of the SPI excludes dividends.

60 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–60 Forward Rate Agreements An agreement to pay or receive a sum of money representing an interest differential, such that the interest rate applicable to a specified period is fixed. Typically a private arrangement that cannot be traded on a secondary market. Usually at least one of the parties to a FRA will be a bank or some other financial institution.

61 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–61 Example of FRA Company A intends to borrow $1m in 3 months, to be repaid in a lump sum 180 days later. Present interest rate on 180-day loan is 9.4%. Company A approaches Bank B to set up a forward rate agreement. Bank B does this at 9.5%.

62 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–62 Example of FRA (cont.) At the FRA settlement date the market interest rate is 10.25%. Settlement amount is the difference between the present value of $1m discounted at the contract rate and the present value of $1m discounted at the current market rate (differential: $3363.11).

63 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–63 Speculation — Barings Barings Bank is a notorious example of futures speculation gone wrong. Barings Bank collapsed in 1995 because of futures losses incurred by a Singapore-based trader, Nick Leeson. He bought Japanese stock index futures contracts on the Singapore International Money Exchange (SIMEX) and sold them on the Osaka exchange.

64 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–64 Speculation — Barings (cont.) This is basically an arbitrage activity, which in efficient markets (or on average) should not yield excess returns. However, he managed to separate losses and profits into two separated accounts, exposing profits of ¥28m and hiding losses of ¥180m. In January 1995, he took long positions in Japanese stock index futures, hoping they would rise and deliver a profit.

65 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–65 Speculation — Barings (cont.) However, an earthquake in Japan caused the market to fall 13%, delivering huge losses. Leeson fled Singapore with US$3b in open positions, which resulted in total losses of US$1.4b.

66 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–66 Hedging — Metallgesellschaft Metallgesellschaft was a German company operating in the US as MG Refining and Marketing(MGRM). In 1992, sales strategy of offering US firms long- term fixed-price contracts on gasoline, heating oil and diesel fuel. If firms agreed to buy from MGRM, they would receive 10-year fixed-price contracts.

67 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–67 Hedging — Metallgesellschaft (cont.) These contracts could result in large losses for MGRM if oil prices rose significantly. To cover their obligations, MGRM bought long positions on the New York Mercantile Exchange. Problem: 10-year futures contracts did not exist. Solution: MGRM bought the longest contracts available and, when they expired, rolled over into new ones.

68 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–68 Hedging — Metallgesellschaft (cont.) In 1993, oil prices fell by one-third. This was good for the business with contracts to deliver at fixed prices. However, the futures contracts incurred large losses, offsetting potential profits and resulting in large margin calls.

69 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–69 Hedging — Metallgesellschaft (cont.) The gains on their contracts to deliver would not be realised for up to 10 years. Their futures losses were being margin called immediately. Parent company decided to liquidate futures contracts, incurring losses.

70 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–70 Hedging — Metallgesellschaft (cont.) Soon after, oil prices rose and the potential gains on contracts to deliver over the next 10 years disappeared, serving a double blow to the company. Company losses for the year totalled US$1.7b. If the firm could have raised funds to meet margin calls, the hedge probably would have succeeded.

71 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–71 Summary Futures: Obligation to deliver/receive a physical or financial commodity at a future date. Futures markets are based on a clearing house, system of deposits, marking to market and margin calls. Futures prices depend on the spot price, carrying costs and cost of uncertainty or the risk factor.

72 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder Prepared by Dr Buly Cardak 18–72 Summary (cont.) Futures can be used for hedging or for speculation. Futures may not provide perfect hedging or speculative features: Basis risk, specification differences and imperfect convergence. Forward rate agreements are similar to futures and offer an alternative means of risk management when futures do not exist.


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