Essentials-of-Investments--Chapter.pptx

McGraw-Hill/Irwin 2008 The McGraw-Hill Companies,Inc.,All Rights Reserved.Futures Markets and Risk ManagementCHAPTER 1717-217.1 THE FUTURES CONTRACT17-3Futures and ForwardsForward-an agreement calling for a future Forward-an agreement calling for a future delivery of an asset at an agreed-upon pricedelivery of an asset at an agreed-upon priceFutures-similar to forward but feature Futures-similar to forward but feature formalized and standardized characteristicsformalized and standardized characteristicsKey difference in futuresKey difference in futures Secondary trading-liquiditySecondary trading-liquidity Marked to marketMarked to market Standardized contract unitsStandardized contract units Clearinghouse warrants performanceClearinghouse warrants performance17-4Key Terms for Futures ContractsFutures price-agreed-upon price at maturityLong position-agree to purchaseShort position-agree to sellProfits on positions at maturityLong=spot minus original futures priceLong=spot minus original futures priceShort=original futures price minus spotShort=original futures price minus spot17-5Figure 17.2 Profits to Buyers and Sellers of Futures and Options Contracts17-6Types of ContractsAgricultural commoditiesMetals and minerals(including energy contracts)Foreign currenciesFinancial futuresInterest rate futuresInterest rate futuresStock index futuresStock index futures17-7Table 17.1 Sample of Futures Contracts17-817.2 MECHANICS OF TRADING IN FUTURES MARKETS17-9The Clearinghouse and Open InterestClearinghouse-acts as a party to all buyers and sellers.Obligated to deliver or supply deliveryObligated to deliver or supply deliveryClosing out positionsReversing the tradeReversing the tradeTake or make deliveryTake or make deliveryMost trades are reversed and do not involve Most trades are reversed and do not involve actual deliveryactual deliveryOpen Interest17-10Figure 17.3 Trading With and Without a Clearinghouse17-11Marking to Market and the Margin AccountInitial Margin-funds deposited to provide capital to absorb lossesMarking to Market-each day the profits or losses from the new futures price and reflected in the account.Maintenance or variance margin-an established value below which a traders margin may not fall.17-12Margin and Trading ArrangementsMargin call Margin call-when the maintenance margin is-when the maintenance margin is reached,broker will ask for additional margin reached,broker will ask for additional margin fundsfundsConvergence of Price Convergence of Price-as maturity approaches-as maturity approaches the spot and futures price convergethe spot and futures price convergeDeliveryDelivery-Actual commodity of a certain grade -Actual commodity of a certain grade with a delivery location or for some contracts with a delivery location or for some contracts cash settlementcash settlementCash Settlement some contracts are settled in Cash Settlement some contracts are settled in cash rather than delivery of the underlying cash rather than delivery of the underlying assetsassets17-1317.3 FUTURES MARKET STRATEGIES17-14Trading StrategiesSpeculation-short-believe price will fallshort-believe price will falllong-believe price will riselong-believe price will riseHedging-long hedge-protecting against a rise in pricelong hedge-protecting against a rise in priceshort hedge-protecting against a fall in priceshort hedge-protecting against a fall in price17-15Figure 17.4 Hedging Revenues Using Futures,Example 17.5(Futures Price=61.79)17-16Basis and Basis RiskBasis-the difference between the futures price and the spot priceover time the basis will likely change and will over time the basis will likely change and will eventually convergeeventually convergeBasis Risk-the variability in the basis that will affect profits and/or hedging performance17-1717.4 THE DETERMINATION OF FUTURES PRICES17-18Futures PricingSpot-futures parity theorem-two ways to acquire an asset for some date in the futurePurchase it now and store itPurchase it now and store itTake a long position in futuresTake a long position in futuresThese two strategies must have the same These two strategies must have the same market determined costsmarket determined costs17-19Parity Example Using Gold Strategy 1:Buy gold now at the spot price(S0)and hold it until time T when it will be worth ST Strategy 2:Enter a long position in gold futures today and invest enough funds in T-bills(F0)so that it will cover the futures price of ST17-20Parity Example OutcomesStrategy A:Strategy A:ActionActionInitial flowsInitial flowsFlows at TFlows at TBuy goldBuy gold-So-SoSTSTStrategy B:Strategy B:ActionActionInitial flowsInitial flowsFlows at TFlows at TLong futuresLong futures0 0ST-FOST-FOInvest in BillInvest in BillFO(1+rf)TFO(1+rf)T -FO(1+rf)T-FO(1+rf)T FO FOTotal for B Total for B -FO(1+rf)T-FO(1+rf)T ST ST17-21Price of Futures with Parity Since the strategies have the same flows at time TFO/(1+rf)T=SOFO=SO(1+rf)T The futures price has to equal the carrying cost of the gold17-22Figure 17.5 S&P 500 Monthly Dividend Yield17-23Figure 17.6 Gold Futures Prices17-2417.5 FINANCIAL FUTURES17-25Stock Index FuturesAvailable on both domestic and international stocksAdvantages over direct stock purchaselower transaction costslower transaction costsbetter for timing or allocation strategiesbetter for timing or allocation strategiestakes less time to acquire the portfoliotakes less time to acquire the portfolio17-26Table 17.2 Stock Index Futures17-27Table 17.3 Correlations Among Major US Stock Market Indexes17-28Creating Synthetic Stock PositionsSynthetic stock purchasePurchase of the stock index instead of actual Purchase of the stock index instead of actual shares of stockshares of stockCreation of a synthetic T-bill plus index futures that duplicates the payoff of the stock index contractShift between Treasury bills and broad-based Shift between Treasury bills and broad-based stock market holdingsstock market holdings17-29Index Arbitrage Exploiting mispricing between underlying stocks Exploiting mispricing between underlying stocks and the futures index contractand the futures index contractFutures Price too high-short the future and buy Futures Price too high-short the future and buy the underlying stocksthe underlying stocksFutures price too low-long the future and short Futures price too low-long the future and short sell the underlying stockssell the underlying stocks Difficult to do in practice Difficult to do in practiceTransactions costs are often too largeTransactions costs are often too largeTrades cannot be done simultaneouslyTrades cannot be done simultaneously17-30Additional Financial Futures ContractsForeign CurrencyForwards versus futuresForwards versus futuresInterest Rate Futures17-31Figure 17.7 U.S.Dollar Foreign-Exchange Rates17-3217.6 SWAPS17-33SwapsLarge component of derivatives marketOver$200 trillion outstandingOver$200 trillion outstandingInterest Rate SwapsInterest Rate SwapsCurrency SwapsCurrency SwapsInterest rate swaps are based on LIBOR17-34Figure 17.8 Interest Rate Swap