1. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-1 Futures and Swaps: A Closer Look Chapter 23

2. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-2 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

3. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-3 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

4. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-4 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.

5. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-5 Hedging Foreign Exchange Risk A US firm wants to protect against a decline in profit that would result from a decline in the pound: Estimated profit loss of $200,000 if the pound declines by $.10. Short or sell pounds for future delivery to avoid the exposure.

6. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-6 Hedge Ratio for Foreign Exchange Example Hedge Ratio in pounds $200,000 per $.10 change in the pound/dollar exchange rate $.10 profit per pound delivered per $.10 in exchange rate = 2,000,000 pounds to be delivered Hedge Ratio in contacts Each contract is for 62,500 pounds or $6,250 per a $.10 change $200,000 / $6,250 = 32 contracts

7. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-7 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

8. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-8 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.

9. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-9 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.

10. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-10 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

11. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-11 This is 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

12. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-12 Hedging Systematic Risk To protect against a decline in level stock prices, short the appropriate number of futures index contracts. Less costly and quicker to use the index contracts. Use the beta for the portfolio to determine the hedge ratio.

13. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-13 Hedging Systematic Risk: Text Example Portfolio Beta =.8S&P 500 = 1,000 Decrease = 2.5%S&P falls to 975 Portfolio Value = $30 million Project loss if market declines by 2.5% = (.8) (2.5) = 2% 2% of $30 million = $600,000 Each S&P500 index contract will change $6,250 for a 2.5% change in the index

14. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-14 Hedge Ratio: Text Example H = = Change in the portfolio value Profit on one futures contract $600,000 $6,250 = 96 contracts short

15. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-15 Interest Rate Futures Domestic interest rate contracts -T-bills, notes and bonds -municipal bonds International contracts -Eurodollar Hedging -Underwriters -Firms issuing debt

16. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-16 Uses of Interest Rate Hedges Owners of fixed-income portfolios protecting against a rise in rates. Corporations planning to issue debt securities protecting against a rise in rates. Investor hedging against a decline in rates for a planned future investment. Exposure for a fixed-income portfolio is proportional to modified duration.

17. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-17 Hedging Interest Rate Risk: Text Example Portfolio value = $10 million Modified duration = 9 years If rates rise by 10 basis points (.1%) Change in value = ( 9 ) (.1%) =.9% or $90,000 Present value of a basis point (PVBP) = $90,000 / 10 = $9,000

18. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-18 Hedge Ratio: Text Example H = = PVBP for the portfolio PVBP for the hedge vehicle $9,000 $90 = 100 contracts

19. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-19 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

20. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-20 Interest rate swap Foreign exchange swap Credit risk on swaps Swap Variations -Interest rate cap -Interest rate floor -Collars -Swaptions Swaps

21. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-21 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

22. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 23-22 Home Assignment Required: problems 1, 8, 11 (3 rd ed). problems 1, 11, 15 (5 th ed). closely follow financial news!