1. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-1 Futures Markets Chapter 22

2. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-2 Forward - an agreement calling for a future delivery of an asset at an agreed-upon price Futures - similar to forward but feature formalized and standardized characteristics Key difference in futures -Secondary trading - liquidity -Marked to market -Standardized contract units -Clearinghouse warrants performance Futures and Forwards

3. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-3 Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot Key Terms for Futures Contracts

4. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-4 Agricultural commodities Metals and minerals (including energy contracts) Foreign currencies Financial futures Interest rate futures Stock index futures Types of Contracts

5. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-5 Clearinghouse - acts as a party to all buyers and sellers. -Obligated to deliver or supply delivery Closing out positions -Reversing the trade -Take or make delivery -Most trades are reversed and do not involve actual delivery Trading Mechanics

6. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-6 Initial Margin - funds deposited to provide capital to absorb losses Marking to Market - each day the profits or losses from the new futures price are reflected in the account. Maintenance or variation margin - an established value below which a trader’s margin may not fall. Margin and Trading Arrangements

7. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-7 Margin call - when the maintenance margin is reached, broker will ask for additional margin funds Convergence of Price - as maturity approaches the spot and futures price converge Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement Margin and Trading Arrangements

8. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-8 Speculation - -short - believe price will fall -long - believe price will rise Hedging - -long hedge - protecting against a rise in price -short hedge - protecting against a fall in price Trading Strategies

9. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-9 Basis - the difference between the futures price and the spot price -over time the basis will likely change and will eventually converge Basis Risk - the variability in the basis that will affect profits and/or hedging performance Basis and Basis Risk

10. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-10 Spot-futures parity theorem - two ways to acquire an asset for some date in the future Purchase it now and store it Take a long position in futures These two strategies must have the same market determined costs Futures Pricing

11. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-11 Spot-Futures Parity Theorem With a perfect hedge the futures payoff is certain -- there is no risk A perfect hedge should return the riskless rate of return This relationship can be used to develop futures pricing relationship

12. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-12 Hedge Example: pp.753-754 Investor owns and S&P 500 fund that has a current value equal to the index of $1,300 Assume dividends of $20 will be paid on the index at the end of the year Assume futures contract that calls for delivery in one year is available for $1,345 Assume the investor hedges by selling or shorting one contract

13. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-13 Hedge Example Outcomes Value of S T 1,2951,3351,395 Payoff on Short (1,345 - S T ) 50 10 -50 Dividend Income20 20 20 Total1,365 1,365 1,365

14. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-14 Rate of Return for the Hedge

15. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-15 General Spot-Futures Parity Rearranging terms

16. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-16 Arbitrage Possibilities If spot-futures parity is not observed, then arbitrage is possible If the futures price is too high, short the futures and acquire the stock by borrowing the money at the riskfree rate If the futures price is too low, go long futures, short the stock and invest the proceeds at the riskfree rate

17. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-17 Futures Price versus Expected Spot Price: Theories Expectations Normal Backwardation Contango

18. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-18 Contango Normal Backwardation Time Delivery date Futures prices Expectations Hypothesis Futures Price versus Expected Spot Price: Theories

19. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 22-19 Home Assignment Required: problems 3, 7, 9, 11 (3 rd ed). problems 3, 7, 9, 11 (5 th ed). closely follow financial news!