FINANCIAL FUTURES MARKETS CHAPTER 13 All Rights Reserved Dr David P Echevarria

Derivative Securities What are Derivative Securities? High leverage securities that can be used to; Speculate or Hedge How do we speculate? Suppose we believe that the weather will reduce this year’s wheat harvest. A poor harvest will result in higher prices. We can open a long futures October contract for wheat. If as the year progresses, the weather cooperates – the price will go up > profit! All Rights Reserved Dr David P Echevarria

Derivative Securities How do we hedge? A hedge is a form of insurance. Suppose we are a jeweler and we use a lot of gold to make custom pieces. If the price of gold rises, so will our costs. To hedge against a rise in prices we open a long gold hedge. If prices rise – we will profit from the long hedge and offset the increased cost of buying new supplies of gold. If we are a seller of gold – our fear is that prices will drop. We will open a short futures hedge. If prices drop, we will profit on the short position. All Rights Reserved Dr David P Echevarria

VALUATION OF FINANCIAL FUTURES Market Value of Futures Contracts Value is dependent on the value of the underlying security Derivative Securities may also be called contingent claims Primary economic function = HEDGING MARKET RISK Interest Rate Futures used to hedge against adverse changes in interest rates The hedger is protecting a long or short position in the market The speculator expect to profit if rates in the expected direction (up or down) All Rights Reserved Dr David P Echevarria

VALUATION OF FINANCIAL FUTURES Forward Contracts; (Not publicly traded) Agreement to buy/sell at a future time The LONG position: party agreeing to buy the asset The SHORT position: party agreeing to deliver (sell) asset Delivery Price: price specified in the forward contract Settlement on a Forward contract occurs at maturity All Rights Reserved Dr David P Echevarria

VALUATION OF FINANCIAL FUTURES Futures Contracts: (publicly traded) Contracts are standardized Delivery date: by month and the exchange on which contract is traded sets the delivery date For commodities, may be anytime during the expiration month Daily Settlement or Marking-to-Market on price changes All Rights Reserved Dr David P Echevarria

VALUATION OF FINANCIAL FUTURES Arbitrage and the Law of One Price: Two identical goods cannot sell for two different prices When prices are not in sync, arbitrage opportunity Risk Management: Hedging against adverse future price movements (market risk) Price discovery; expectations of future price levels All Rights Reserved Dr David P Echevarria

FUNDAMENTALS OF FUTURES MARKETS Forward Markets Deferred delivery (expected price at time T) Utilizing the storability factor Hedging future price movements resulting from changes in Supply and Demand Forward vs. Futures Contracts Price discovery Spot (Cash) Market: Immediate delivery (today's market price for commodity) Hedge point; we are generally hedging a spot position All Rights Reserved Dr David P Echevarria

FUNDAMENTALS OF FUTURES MARKETS Defining Profits in Spot and Futures Contracts Basis (b): Spot - Futures Price Later: Increasing basis favors Long hedger/speculator, decreasing basis the short Profit = - b (if held to T) P = -b + b (if offset prior to T) Daily Price Movements Each commodity has a maximum daily price change Trading stops when a limit is reached May reopen on authority of Exchange Floor Manager to maintain orderly market All Rights Reserved Dr David P Echevarria

FUNDAMENTALS OF FUTURES MARKETS Opening a Futures Position (assuming you meet financial qualifications) Determining Expectation Long: expect prices to go up Short: expect prices to go down Depositing initial margin Closing position before first day of expiration month (to avoid assignment) All Rights Reserved Dr David P Echevarria

TYPES OF HEDGES Interest Rate Futures Commodity futures Currency Futures Stock Index Futures Single Stock Futures All Rights Reserved Dr David P Echevarria

HOMEWORK QUESTIONS What is a forward contract? How does it differ from a futures contract? What is arbitrage? How does the law of one price relate to arbitrage opportunities? What is the difference between hedging and speculating? How does the long position profit? The short position? How are stock index futures settled? All Rights Reserved Dr David P Echevarria