Futures and Forward Markets

1
Chapter 19
Futures and Forward Markets
2
Chapter Summary

• Objective To describe the workings of futures
  markets and the mechanics of trading in these
  markets.
• Trading mechanics
• Futures pricing
• Different types of futures contracts
• Swaps

3
Futures and Forwards

• 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

4
Key Terms for Futures Contracts

• 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

5
Profits Futures Buyers and Call Buyers
Futures Buyer
Profit
Call Buyer
0
Price
Fo
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Profits Futures Sellers and Put Buyers
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Types of Contracts

• Agricultural commodities
• Metals and minerals (including energy contracts)
• Foreign currencies
• Financial futures
• Interest rate futures
• Stock index futures

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Summary Reminder

• Objective To describe the workings of futures
  markets and the mechanics of trading in these
  markets.
• Trading mechanics
• Futures pricing
• Different types of futures contracts
• Swaps

9
Trading Mechanics

• 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

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Margin and Trading Arrangements

• 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 traders margin may not fall.

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Margin and Trading Arrangements

• 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

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Trading Strategies

• 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

13
Basis and Basis Risk

• 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

14
Summary Reminder

• Objective To describe the workings of futures
  markets and the mechanics of trading in these
  markets.
• Trading mechanics
• Futures pricing
• Different types of futures contracts
• Swaps

15
Futures Pricing

• 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

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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

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Hedge Example(text, pp.731-732)

• Investor owns an SP/TSE 60 fund that has a
  current value equal to the index of 400
• Assume dividends of 5 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 408
• Assume the investor hedges by selling or shorting
  one contract

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Hedge Example -Outcomes
Value of ST 380 405 420 Payoff on Short
(408 - ST) 28 3 -12 Dividend Income
5 5 5 Total 413 413 413
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Rate of Return for the Hedge
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General Spot-Futures Parity
Rearranging terms
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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 risk-free rate
• If the futures price is too low, go long futures,
  short the stock and invest the proceeds at the
  risk-free rate

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Commodity Futures Pricing
General principles that apply to stock apply to
commodities Carrying costs are more for
commodities Spoilage is a concern
Where F0 futures price P0 cash price
of the asset C Carrying cost c C/P0
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Futures Price versusExpected Spot Price Theories

• Expectations
• Normal Backwardation
• Contango

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Futures Price versusExpected Spot Price Theories
25
Summary Reminder

• Objective To describe the workings of futures
  markets and the mechanics of trading in these
  markets.
• Trading mechanics
• Futures pricing
• Different types of futures contracts
• Swaps

26
Stock Index Contracts

• 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

27
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

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Pricing on Stock Index Contracts

• The spot-futures price parity is given as

• Empirical investigations have shown that the
  actual pricing relationship on index contracts
  follows the spot-futures relationship

29
Index Arbitrage

• 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

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Index Arbitrage and Program Trading

• 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

31
Foreign Exchange Futures

• Futures markets
• Chicago Mercantile (International Monetary
  Market)
• London International Financial Futures Exchange
• MidAmerica Commodity Exchange
• Active forward market
• Differences between futures and forward markets

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Pricing on Foreign Exchange Futures

• Interest rate parity theorem
• Developed using the US Dollar and British Pound

where, F0 is the forward price E0 is the current
exchange rate
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Text Pricing Example
rCAN 6 ruk 5 T 1 yr E0 1.60 per
pound

• If the futures price varies from 2.12 per pound
  arbitrage opportunities will be present

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Interest Rate Futures

• Domestic interest rate contracts
• T-bills, notes and bonds
• municipal bonds
• International contracts
• Eurodollar
• Hedging
• Underwriters
• Firms issuing debt

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Hedging Interest Rate Risk

• 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

36
Summary Reminder

• Objective To describe the workings of futures
  markets and the mechanics of trading in these
  markets.
• Trading mechanics
• Futures pricing
• Different types of futures contracts
• Swaps

37
Swaps

• Interest rate swap
• Foreign exchange swap
• Credit risk on swaps
• Swap Variations
• Interest rate cap
• Interest rate floor
• Collars
• Swaptions

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Pricing on Swap Contracts

• 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