Forward Market Relationships Futures Trading and Its Changing Face in Indonesia Jakarta June 13, 2001 Robert I. Webb University of Virginia © 2001

Hedging Hedging is analogous to putting on a spread position. That is, there is one long leg and one short leg of the hedge. The idea is that the losses (gains) on the short leg will partially or fully offset the gains (losses) on the long leg of the hedge.

Perfect Hedge A perfect hedge means that losses on one leg of the hedge fully and exactly offset gains on the other leg of the hedge. In practice, most hedges are imperfect. That is, the gains on one leg will not exactly offset the losses on the other leg. This is known as basis risk.

Hedging Losses on hedged positions may arise for a number of reasons including: Maturity mismatches; Hedging vehicle mismatches (that is, cross- hedging) Incorrect hedge ratio Liquidity crises.

Hedging Basis risk exists for many hedge positions. Normally, the basis risk is less than the risk of holding a position outright. During a liquidity crisis one may experience losses on both legs of the hedge.

Synthetic Securities Basically, a perfect hedge is equivalent to a default-free Treasury bill position. Put differently, one may regard the creation of hedge positions as equivalent to the creation of synthetic treasury bills.

Synthetic T-Bill Position A hedged position is equal to a comparable maturity synthetic Treasury bill position. S – F = PV(X) That is, a long spot market position and short forward position equals the present value of a zero coupon bond.

When Yields on Synthetic and Actual Treasury Bills Differ Not surprisingly, occasionally the prices or yields of synthetic Treasury Bills will differ from the yields on actual Treasury bills. This creates an arbitrage profit opportunity. If actual Treasury bills yield more than synthetics one can invest in actual Treasury bills and finance the investment by selling synthetics (that is, borrowing at a lower risk free rate).

When Yields on Synthetic and Actual Treasury Bills Differ Similarly, if actual Treasury bills yield less than synthetic Treasury bills then one can sell the actual and buy the synthetic. This is tantamount to being able to borrow at the same rate the Treasury can and invest at a higher but still risk-free yield.

Synthetic Cash Market Position Not surprisingly, one can create synthetic long cash market positions by combining an investment in Treasury bills with a long futures position. S = F + PV(X) Conversely, one can create a synthetic short cash market position by combining a short futures position with a short Treasury bill position (that is, borrowing at the Treasury bill rate. -S = -F – PV(X)

Implied Repo Rate The “repo” or repurchase agreement market is a collateralized short-term loan market. The yield on a perfect hedge is known as the implied repo rate.

Exploiting Yield Discrepancies If the implied repo rate (IRR) exceeds the T-bill yield then one should create a synthetic long T-bill position and sell the actual T-bill. If the implied repo rate is less than the actual T-bill yield one should create a synthetic short T-bill position and buy the actual T-bill.

Synthetic Spot Position Solving the previous equation for S yields: S = F + PV(X) That is, a synthetic cash market position can be replicated by combining a long forward position with a long T-bill position.

Synthetic Forward Position Solving the earlier equation for F yields: F = S – PV(X) A forward position can be thought of as a levered cash market position. Initially, S = PV(X) because no money changes hands when a forward position is opened.

Synthetic Short Security Positions Synthetic short security positions can be easily created by multiplying through any of the above equations by a –1. -S = -PV(X) –F -F = PV(X) –S -PV(X) = F-S

Uses of Futures Futures allow one to quickly change the risk profile of a portfolio without changing the composition of the cash market position. This can be very important when the sale or purchase of cash market securities would be very time consuming. When illiquid securities are involved quick sales or purchases may have a price impact.