1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 22 Futures Markets

2. 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. 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. 22-4 Profits: Futures Buyers and Call Buyers Profit Price 0 Call Buyer Futures Buyer FoFo

5. 22-5 Profits: Futures Sellers and Put Buyers 0 Profits Price Futures Seller Put Buyer Fo

6. 22-6 Agricultural commodities Metals and minerals (including energy contracts) Foreign currencies Financial futures Interest rate futures Stock index futures Types of Contracts

7. 22-7 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

8. 22-8 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

9. 22-9 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

10. 22-10 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

11. 22-11 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

12. 22-12 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

13. 22-13 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

14. 22-14 Hedge Example: pp.806-807 Investor owns and S&P 500 fund that has a current value equal to the index of $900 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 $925 Assume the investor hedges by selling or shorting one contract

15. 22-15 Hedge Example Outcomes Value of S T 885925 965 Payoff on Short (1,345 - S T ) 40 0 -40 Dividend Income 20 20 20 Total 945945 945

16. 22-16 Rate of Return for the Hedge

17. 22-17 General Spot-Futures Parity Rearranging terms

18. 22-18 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

19. 22-19 Theories of Futures Prices Expectations Normal Backwardation Contango

20. 22-20 Contango Normal Backwardation Time Delivery date Futures prices Expectations Hypothesis Futures and Expected Spot Price: Theories