Topic 4: Price Relationship Leuthold, Chapter 3 & 7

Contents I. Basis: Seasonal Storable Commodity 1)The Definition of Basis 2)Theory of Carrying Charge 3)Full Carry 4)Supply of Storage II. Basis for Other Commodities 1)Nonseasonal Storable Commodities (metal) 2)Nonstorable Commodities III. Spread 1)Definition 2)Important Terminologies 3)Spread Problems IV. Financial Instrument 1)Interest Rates (Bond) 2)Discount Bond (Pure-discount Loan) 3)Storable vs. Nonstorable Interest Rates 4)Treasury Bond 5)Spread Relationship for Bonds 6)Eurodollars 7)Bond Spread Problems

I. Basis: Seasonal Storable Commodity

4 Basis describes price relationships. Basis is the difference between the cash price at the local market and futures price for a particular delivery month. Basis= _______________________ I.1) The Definition of Basis

5 The cash price is __________ below the futures prices by the ______________________ The storage cost is a charge for holding the physical commodity not for holding futures contracts, and is ________________________________________. In the short-run, cash and futures prices maintain their relative position, and the basis remains fairly constant. In the long-run, cash price rises relative to futures, meaning that basis gradually gets ________ as the futures contract nears maturity. This gives the basis _________________. I.2) Theory of Carrying Charge

6 Theoretically, the basis should be ________________ ______________ in anywhere the exchanges are located. If cash and futures prices are not equal, ________ will occur by simultaneously buying at the low-priced market and selling at the high priced market to profit from the price discrepancy. I.2) Theory of Carrying Charge

7 In reality, the basis is not equal to zero because of _______________. If cash price > futures price at delivery month Market Uncertainty: We don’t know (1) exact delivery day (2) the quality of the commodity (3) location. (4) cost of delivery I.2) Theory of Carrying Charge

[1] If cash price > futures price at delivery month then what kind of action do you have to take? _____________________________________: __________________ [2] If cash price < futures price at delivery month : futures price has a premium because elevator is full. _________________________________________ I.2) Theory of Carrying Charge

9 Basis consists of three dimensions: (1) Time: the costs of storing the physical commodity until delivery month (storage cost). (2) Space: the cost of transporting the commodity to the par delivery point (transportation cost). (3) Quality: differences in product quality between the cash commodity and specifications of the futures contract may affect the size of the basis. I.2) Theory of Carrying Charge

10 Basis varies in size from year to year due to: (1) Changes in the size of the inventory, or the crop size, and demand for storage. Large crops result in large basis than do small crops (2) Interest rates (3) Government program I.2) Theory of Carrying Charge

11 Definition : An upper limit regarding how much the futures price can exceed the cash price of the commodity. : _____________________________ Example Warehouse Costs : Oct.1 – Jan. 1 = $0.15/bu After Jan. 1 = $0.03/bu/month Interest : 6.5%/year Insurance Cost : $0.001/month I.3) Full Carry

Actual Price 9/9, 2003 Full Carry estimated at 9/9 Chicago (Cash)$3.43 ¼ December$3.46 ¼ March$3.58 ¾ May$3.65 July$3.71 ½

Actual Price 9/10, 2003 Full Carry estimated at 9/10 Chicago (Cash)$3.48 ¾ December$3.18 ¾ March$3.29 ¼ May$3.38 ½ July$3.44

14 I.4) Supply of Storage

II. Basis for Other Commodities

16 Production of a metal is the same throughout a year, and hence no seasonal pattern exists. Futures are a ________ to cash: they always tend to move in tandem. Distant futures prices are a premium to nearby futures: the premium reflects ______________. Spread is the difference between distant futures price and nearby futures price, and reflects the __________________ _______________________. II.1) Basis for Nonseasonal Storable Commodities (metals)

17 Example: What’s the cost of holding silver? II.1) Basis for Nonseasonal Storable Commodities (metals)

18 Can’t take delivery in one month and hold for delivery next month. Each month is _____________ from previous one. No connecting link from one delivery month to another delivery month. Cash price and futures price are ____________________. II.2) Basis for Nonstorable Commodities

19 The characteristics of basis for nonstorable commodities: 1. No theoretical minimum or maximum size of basis. 2. ___________during the delivery month theoretically. 3.Prior to delivery: Cash prices reflect demand and supply, while futures prices reflect expected demand and expected supply. 4. Can be _______ or _______, depending on how traders expect cash prices to change over time relative to futures prices. II.2) Basis for Nonstorable Commodities

III. Spread

21 A lot of traders make spread trade based on the expectation of spread movements because they think the price relationship is not correct. Goal of spread trading: buy low and sell high. Spread trader does not care about price level but only cares of spread III.1) Definition of Spread

22 There are 3 types of spread trading: Interdelivery: same commodity but using two different contract months Intercommodity: different commodities but the same delivery month (e.g.) buy may corn and sell may soybean Intermarket: same commodity but different exchange (e.g.) gold in U.S. and gold in Hong Kong Special Case : Commodity-product spread (e.g.) soybean as an input and soybean oil or meal as an output III.1) Definition of Spread

23 Bull spread: ______ on nearby contract and _____ on more distant contract Bear spread: ____ on nearby and ____ on more distant III.2) Important Terminologies of Position

24 You are on September 14 and you expect interest rates will go up within next month.  Storage cost will _______  Spread will be ______ than before III.3) Spread Problems : Corn Case

25 What is the appropriate spread trade, and how much would you have made or lost when price are given as follows? III.3) Spread Problems : Corn Case DateFutures Price Sept. 14Dec. $2.15/buJuly $2.36/bu Nov. 30Dec. $2.03/buJuly $2.19/bu

26 You are on September 14 and you expect interest rates will go down within next month.  Storage cost will ___________  Spread (positive cost of carry) will be __________ than before III.3) Spread Problems : Silver

27 What is the appropriate spread trade, and how much would you have made or lost when price are given as follows? III.3) Spread Problems : Silver DateFutures Price Sept. 14Dec. 09 $5.15/ozDec. 10 $5.21/oz Nov. 30Dec. 09 $5.06/ozDec. 10 $5.08/oz

28 You expect cattle slaughter in February to be smaller than current beliefs and expect slaughter in June to be larger than current beliefs.  Expect slaughter to be smaller, meaning expected supply will be _______, which causes the price to ________ in February.  Expect slaughter to be larger, meaning expected supply will be _____, which causes the price to be ______ in June.  Then the spread between Feb. and June will become _____. III.3) Spread Problems : Live Cattle

29 What is the appropriate spread trade, and how much would you have made or lost when price are given as follows? III.3) Spread Problems : Live Cattle DateFutures Price Sept. 14Feb. $69.10/cwtJune $68.25/cwt Nov. 30Feb. $66.75/cwtJune $67.30/cwt

IV. Financial Instrument

31 A fixed income security (bond) promises to pay fixed coupon payments at prespecified dates and a fixed principal amount at the maturity date. where fixed coupon payment = market-determined interest rates IV.1) Interest Rates (Bond)

32 When there is no promised coupon and a fixed income security only pays a fixed principal amount at maturity, the security is called a pure discount bond or zero coupon bond. Otherwise, it is a coupon bond. IV.1) Interest Rates (Bond)

33 이자지급에 따라 Coupon Bond ( 이표채 ): 채권의 권면에 이표가 붙어있어 이자 지급일에 일정이자를 지급받는 채권으로 일반적인 채권을 의미. Discount Bond ( 할인채 ): 액면금액에서 상환일까지의 이자를 공제한 금액으로 매출하는 채권. Compound Bond ( 복리채 ): 이자가 단위기간수만큼 복리로 재투자되어 만기시에 원금과 이자가 지급되는 채권. IV.1) Interest Rates (Bond)

34 Example (U.S.) 1. Treasury securities with a maturity less than one year are all discount bonds and are called Treasury Bills (Eurodollars). 2.Treasury securities with maturities b/w one and ten years pay coupons and are called Treasury Notes. 3.Treasury securities with maturities longer than ten years pay coupons and are called Treasury bond. IV.1) Interest Rates (Bond)

35 Example (Korea) 1. 양도성 예금 (CD): 만기 91 일 액면 5 억. 2.3 년 국채선물 : 만기 3 년 액면 1 억, 표면금리 8% 3.5 년 국채선물 : 만기 5 년 액면 1 억, 표면금리 8% IV.1) Interest Rates (Bond)

36 Interest is taken out in advance. Suppose that today you take out a $1,000 loan with the promise to pay it back in one year at a rate of 10%. Then the amount of money you receive today is 1,000(1.10) -1 = The Spot rate: the interest rate on a loan made immediately. IV.2) Discount Bond (Pure-discount Loan)

37 Suppose you actually do not need the money until 1 year from now. You ask a lender what the rate would be if you borrowed one year from now. The lender quotes you a rate of 12%. The amount of money you receive in 1 year is 1,000(1.12) -1 = A year after that, or 2 years from today, you will pay back $1,000. IV.2) Discount Bond (Pure-discount Loan)

38 Forward Rate: a loan is to be made at a future point in time but the terms and conditions, such as the rate and maturity, are established today. IV.2) Discount Bond (Pure-discount Loan)

39 Long Term: T-bonds (CBOT) : year maturity : storable : face value (size) = $100,000 : tick value = 1/32 IV.3) Storable vs. Nonstorable Interest Rates Short Term: Eurodollars (CME) : 3 month to maturity : nonstorable : face value (size) = $1,000,000 : tick value = 1/100

40 Long Term:“Storable” means deliverable into several different maturity contracts. Thus, differed contract must reflect “cost of carry” For the bond futures, any T-bond with at least 15 years to maturity is eligible for delivery. Thus, some long-term maturity bonds can meet delivery specifications on the bond futures contract for several delivery month. IV.3) Storable vs. Nonstorable Interest Rates

41 In a cash market, if 6.5% coupon rate (amount interest you can get) then you pay $100,000 T-bond and get 6.5% interest rate. Bond price and interest are inversely related. : as market interest rate goes up, the value of bond decreases. IV.4) Treasury Bond

: /32 of par value ($100,000) : you expect $112, at delivery. If i-rate $100,000 If i-rate > coupon rate: the price < $100,000 You can think of interest rate as a _____________ IV.4) Treasury Bond

43 Inverse relationship b/w bond price and interest rates IV.4) Treasury Bond : Bond Price

44 Relationship b/w interest rates on bonds and time to maturity is called yield or term structure. IV.4) Treasury Bond : Yield Curve

45 FP = SP + Storage Cost If you buy 10,000 bonds, there is no warehouse cost, but the biggest cost is borrowing money at certain interest rate or opportunity cost. IV.5) Spread Relationship for Bonds FP = SP + i SP – y SP Short-term Interest Rate y = yield

46 FP = SP + i SP – y SP = SP + (i – y)SP  i – y < 0 as long as yield curve is upper slope  (i – y) = k is called net financing FP = SP – kSP  SP > FP for Bonds Yield curve positively sloped = Positive Carry. IV.5) Spread Relationship for Bonds

47 IV.5) Spread Relationship for Bonds NearbyDistant Bull Spread Bear Spread

48 Positive yield curve becomes flatter  _________________________________ Positive yield curve becomes steeper  _________________________________ Negative yield curve becomes flatter  ___________ Negative yield curve becomes steeper  ___________ IV.5) Spread Relationship for Bonds

49 Eurodollars are dollars deposited outside the U.S. Eurodollars have 90 days to maturity as of futures delivery date. (e.g.) June Eurodollar futures contract calls for delivery of $1 million of a Eurodollar deposit with a maturity of 90 days as of approximately June 15. ( 즉 6 월 15 일을 기준으로 90 일의 maturity days 가 있으므로, 9 월 15 일 즈음 the June 90 days deposit 은 완료가 된다.) IV.6) Eurodollars

50 The price set in the futures market for delivery in some later time period is equal to the spot price expected to prevail for the commodity at delivery time. Eurodollars are priced at a discount from their face value, and the difference between price paid for the Eurodollars and the maturity face value, called the discount, represents the interest earned on the Eurodollars until maturity. IV.6) Eurodollars

51 A $1 million face value Eurodollars with 90 days to maturity, yielding 8 percent on an annual basis would be priced as follows: Price = Face value – Discount IV.6) Eurodollars

52 IV.6) Eurodollars

53 Q. What is appropriate spread trade and are your trading result? 1.T-bond:10/15March 10: Sept. 10: What if you believe on 10/21 the yield curve will flatten? 11/30 you observe March 10: Sept. 10: What if you believe the yield curve will become steeper? 11/30 you observe March 10: Sept. 10: IV.7) Bond Spread Problems

54 Q. What is appropriate spread trade and are your trading result? 2.Eurodollars: 10/15March 10: Dec. 10: What if you believe the yield curve will become steeper? 11/30 you observe March 10: Dec. 10: What if you believe the yield curve will flatten? 11/30 you observe March 10: Dec. 10: IV.7) Bond Spread Problems