 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-1 Futures and Swaps: A Closer Look Chapter 23

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-2 Available on both domestic and international stocks Advantages over direct stock purchase - lower transaction costs - better for timing or allocation strategies - takes less time to acquire the portfolio Stock Index Contracts

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-3 Using Stock Index Contracts to Create Synthetic Positions Synthetic stock purchase - Purchase of the stock index instead of actual shares of stock Creation of a synthetic T-bill plus index futures that duplicates the payoff of the stock index contract

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-4 Pricing on Stock Index Contracts The spot-futures price parity that was developed in Chapter 22 is given as; Empirical investigations have shown that the actual pricing relationship on index contracts follows the spot-futures relationship

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-5 Exploiting mispricing between underlying stocks and the futures index contract Futures Price too high - short the future and buy the underlying stocks Futures price too low - long the future and short sell the underlying stocks Index Arbitrage

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-6 Difficult to implement in practice Transactions costs are often too large Trades cannot be done simultaneously Development of Program Trading Used by arbitrageurs to perform index arbitrage Permits acquisition of securities quickly Triple-witching hour Evidence that index arbitrage impacts volatility Index Arbitrage and Program Trading

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-7 Futures markets - Chicago Mercantile (International Monetary Market) - London International Financial Futures Exchange - MidAmerica Commodity Exchange Active forward market Differences between futures and forward markets Foreign Exchange Futures

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-8 Interest rate parity theorem Developed using the US Dollar and British Pound where F 0 is the forward price E 0 is the current exchange rate Pricing on Foreign Exchange Futures

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill 23-9 Text Pricing Example r us = 5% r uk = 6%E 0 = $1.60 per pound T = 1 yr If the futures price varies from $1.58 per pound arbitrage opportunities will be present

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Interest Rate Futures Domestic interest rate contracts - T-bills, notes and bonds - municipal bonds International contracts - Eurodollar Hedging - Underwriters - Firms issuing debt

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Commodity Futures Pricing General principles that apply to stock apply to commodities Carrying costs are more for commodities Spoilage is a concern Where; F 0 = futures price P 0 = cash price of the asset C = Carrying cost c = C/P 0

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Interest rate swap Foreign exchange swap Credit risk on swaps Swap Variations - Interest rate cap - Interest rate floor - Collars - Swaptions Swaps

 The McGraw-Hill Companies, Inc., 1999 INVESTMENTS Fourth Edition Bodie Kane Marcus Irwin/McGraw-Hill Swaps are essentially a series of forward contracts One difference is that the swap is usually structured with the same payment each period while the forward rate would be different each period Using a foreign exchange swap as an example, the swap pricing would be described by the following formula Pricing on Swap Contracts