Chapter 20 Charles P. Jones, Investments: Analysis and Management, Twelfth Edition, John Wiley & Sons 20 -1

 Two types of cash markets ◦ Spot: price refers to item available for immediate delivery ◦ Forward: price refers to item available for deferred delivery  Futures exchange ◦ Sets features (contract size, delivery date, and conditions) for delivery 20 -2

 Futures market characteristics ◦ Centralized marketplace allows investors to trade ◦ Performance is guaranteed by a clearinghouse  Valuable economic functions ◦ Hedgers shift price risk to speculators ◦ Price discovery conveys information 20 -3

 Commodities - agricultural, metals, and energy related  Financials - foreign currencies as well as debt and equity instruments  Exchanges are firms that create markets  Foreign markets are increasingly competitive 20 -4

 A corporation separate from, but associated with, each exchange  Exchange members must be members or pay a member for these services ◦ Buyers and sellers settle with clearinghouse, not with each other  Helps facilitate an orderly market  Keeps track of obligations 20 -5

 A obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today ◦ Involve credit risk (either party could default) ◦ Involve liquidity risk ◦ Offset is taking opposite position on same asset  Commodity Futures Trading Commission regulates trading 20 -6

 Buyer and seller agree to make/take delivery ◦ No money is exchanged at the time of contract negotiation ◦ Short position (seller) commits a trader to deliver an item at contract maturity ◦ Long position (buyer) commits a trader to purchase an item at contract maturity ◦ Like options, futures trading a zero sum game 20 -7

 Contracts can be settled in two ways: ◦ Delivery (less than 5% of transactions) ◦ Offset: liquidation of a prior position by an offsetting transaction  Each exchange establishes price fluctuation limits on contracts  Open interest is measure of contracts not offset 20 -8

 Good faith deposit (earnest money) made by both buyer and seller to ensure contract completion ◦ Not an amount borrowed from broker ◦ Required of all participants  Each clearinghouse sets minimum initial margin ◦ Brokerage houses can require higher margin  Margin requirement generally about 6% of contract value 20 -9

 Margin calls occur when price goes against investor ◦ Transactor must restore account to initial margin level ◦ Position marked-to-market daily  Profit can be withdrawn  Each contract has maintenance or variation margin level below which equity cannot drop

 Hedgers ◦ Parties at risk because of exposure to price changes ◦ Buy or sell futures to offset the risk ◦ Used as a form of insurance ◦ Willing to forgo some profit in order to reduce risk  Hedged return has smaller chance of low return but also smaller chance of high return

 Position in cash market is hedged with opposite position in futures market  Short (sell) hedge ◦ Cash market inventory exposed to a fall in value ◦ Sell futures now to profit if the value of the inventory falls  Long (buy) hedge ◦ Anticipated purchase exposed to a rise in cost ◦ Buy futures now to profit if costs increase

 Basis: difference between cash price and futures price of hedged item ◦ Must be zero at contract maturity  Basis risk: the risk of an unexpected change in basis ◦ Hedging reduces risk if basis risk less than variability in price of hedged asset  Risk cannot be entirely eliminated

 Speculators ◦ Buy or sell futures contracts in an attempt to earn a return ◦ Assume the risk of price fluctuations that hedgers wish to avoid, hope to profit by doing so ◦ Absorb excess demand or supply generated by hedgers ◦ Attracted by leverage, ease of transacting, low costs

 Individual investors better off using futures for hedging, not speculation  Return on Investment is (Selling price of contracts - Purchase price) / Margin deposit

 Contracts on currencies, fixed income securities, and equity indexes  Opportunity to fine-tune risk-return characteristics of portfolio  At maturity, stock index futures settle in cash ◦ Difficult to deliver all stocks in a particular index

 Every exchange rate is a relative price  Hedging often used by companies exposed to foreign exchange risk  Investors can speculate on exchange rate differences ◦ Requires accepting additional price risk ◦ Can have large payoffs or staggering losses Foreign Currency Futures

 Allow bondholders to transfer risk  Hedging ◦ Short hedge used to offset anticipated changes in rates ◦ Long hedge used as substitute for buying security  Speculating ◦ Investors assess likely interest rate movements  If rates expected to increase (decrease), sell (buy) futures ◦ Difficult to short bonds in cash market Interest Rate Futures

 Can be used to hedge against systematic risk ◦ Selling futures contracts against diversified stock portfolio allows the transfer of systematic risk ◦ Hedging against overall market decline ◦ Does not eliminate basis risk ◦ Does not generally provide good hedge for undiversified portfolios

 Index arbitrage: a version of program trading ◦ Exploitation of price difference between stock index futures and index of stocks underlying futures contract ◦ Arbitrageurs build hedged portfolio that earns low risk profits equaling the difference between the value of cash and futures positions

 Futures effective for speculating on movements in stock market because: ◦ Low transaction costs involved in establishing futures position ◦ Stock index futures prices mirror the market  Traders expecting the market to rise (fall) buy (sell) index futures

 Futures contract spreads ◦ Both long and short positions at the same time in different contracts ◦ Intramarket (or calendar or time) spread  Same contract, different maturities ◦ Intermarket (or quality) spread  Same maturities, different contracts  Interested in relative price as opposed to absolute price changes

 Futures contracts on individual stocks and ETF for DJIA  Settle to physical delivery, not cash  Investor buys (sells) if believe price will rise (decline)  Offer low costs, ease of shorting  Do not truncate returns distribution Single Stock Futures

Copyright 2013 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back- up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein