Futures and Swaps

1
Futures and Swaps

• An Application of Arbitrage

2
Hedging with Forwards and Futures

• Business has risk
• Business Risk - variable costs
• Financial Risk - Interest rate changes
• Goal - Eliminate risk
• HOW?
• Hedging Forward Contracts

3

• Ex - Kellogg produces cereal. A major component
  and cost factor is sugar.
• Forecasted income sales volume is set by using
  a fixed selling price.
• Changes in cost can impact these forecasts.
• To fix your sugar costs, you would ideally like
  to purchase all your sugar today, since you like
  todays price, and made your forecasts based on
  it. But, you can not.
• You can, however, sign a contract to purchase
  sugar at various points in the future for a price
  negotiated today.
• This contract is called a Futures Contract.
• This technique of managing your sugar costs is
  called Hedging.

4
1- Spot Contract - A contract for immediate sale
delivery of an asset. 2- Forward Contract - A
contract between two people for the delivery of
an asset at a negotiated price on a set date in
the future. 3- Futures Contract - A contract
similar to a forward contract, except there is an
intermediary that creates a standardized
contract. Thus, the two parties do not have to
negotiate the terms of the contract. The
intermediary is the Commodity Clearing Corp
(CCC). The CCC guarantees all trades provides
a secondary market for the speculation of
Futures.
5
Types of Futures
Commodity Futures -Sugar -Corn -OJ -Wheat -Soy
beans -Pork bellies Financial Futures -Tbills -Y
en -GNMA -Stocks -Eurodollars Index Futures
-SP 500 -Value Line Index -Vanguard Index
SUGAR
6
Futures Contract Concepts

• Not an actual sale
• Always a winner a loser (unlike stocks)
• Contracts (K) are settled every day. (Marked to
  Market)
• Hedge - K used to eliminate risk by locking in
  prices
• Speculation - K used to gamble
• Margin - not a sale - post partial amount
• Hog K 30,000 lbs
• Tbill K 1.0 mil
• Value line Index K index x 500

7
Futures and Spot Contracts
The basic relationship between futures prices and
spot prices for equity securities.
8
Futures and Spot Contracts

• Example
• The DAX spot price is 3,970.22. The interest
  rate is 3.5 and the dividend yield on the DAX
  index is 2.0. What is the expected price of the
  6 month DAX futures contract?

9
Futures and Spot Contracts
The basic relationship between futures prices and
spot prices for commodities.
10
Futures and Spot Contracts

• Example
• In July the spot price for coffee was .7310 per
  pound. The interest rate was 1.5 per year. The
  net convenience yield was -12.2. What was the
  price of the 10 month futures contract?

11
Homemade Forward Rate Contracts
12
A Simple Example of Arbitrage
Cost Payoff Security A 0.90 1.00 Secur
ity B 0.95 1.00 Buy the cheaper security
and and finance the transaction by selling the
expensive one.
13
A Slightly More Complicated Example
Long-Term Capital (and Solomon before) found a
common mispricing in the long-term, 30-year
U.S. Treasury Bond Market. When the Treasury
issues new 30-year T-Bonds (called on the run),
there is a very active market for the bonds. But
the older 30-year T-Bonds, say 29 ½ -year bonds
(called off the run), seem to have less activity
and are harder to trade. Long-Term noticed (in
1994) that February 1993 issue of 30-year bond
traded to yield 7.36 August 1993 issue of
30-year bond traded to yield 7.34 What do you
do with the 12 basis point difference?
14
What is a Swap?
An interest rate swap is an agreement between two
parties in which each party makes a series of
interest payments to the other at pre-determined
dates at different rates. One set of rates is
variable or floating. Firm XYZ is currently
borrowing at floating rate LIBOR but would prefer
to borrow at a fixed rate of 7.5 for one
year. It contacts a swap dealer ABSwaps to
arrange a swap based on 100 million notational
principal. The fixed-rate payer, floating-rate
receiver has a cash flow at each interest payment
date of (Notational principal)(LIBOR Fixed
Rate)(Days/360) Thus, from the perspective of
XYZ, the cash flow on a payment date is
(100,000,000)(LIBOR - .075)(Days/360)
15
(No Transcript)
16
(No Transcript)
17
Transactions Equivalent to Interest Rate Swaps
XYZ entered into a one-year swap in which it
made a series of quarterly payments at a rate of
7.5 and received a series of quarterly payments
at a rate of LIBOR. Suppose XYZ had (1) issued a
100 million one-year fixed rate note with
quarterly payments at 7.5 and used the money
to (2) Purchase a 100 million one-year floating
rate note that would pay interest at LIBOR each
quarter. These two transactions are equivalent
to the SWAP!
18
Swap-Spread Example
February 8, 1997, T-Bonds with 20-year maturity
had yield of 6.77. Swaps of similar duration
were quoted at 6.94 versus LIBOR. Swap Spread
6.94 - 6.77 17 basis points (historical
range was 17-32 basis points) A repurchase
agreement or repo is an arrangement with a
financial institution in which the owner of a
security sells that security to the financial
institution with an agreement to buy it back,
usually a day later (overnight repo), or longer
term (term repo). The difference between
six-month LIBOR and repo rate was 20 basis
points. Is there a profit opportunity here of 3
basis points (20-17)?
19
Arbitrage Opportunity

• Transactions
• Purchase 250 million of 20-year T-bonds, 100
  financed at the repo rate.
• Enter into a 20-year interest-rate swap agreement
  to pay 6.94 and receive six-month LIBOR with a
  notional amount of 250 million.
• What is the cash flow to a hedge fund taking
  advantage of this opportunity?
• No cash outlay because T Bond is100 financed
  and swaps have 0 cost.
• T-bond pays 6.77 less borrowing at repo rate.
• Swap receives LIBOR and pays 6.94 fixed.

20
Net Cash Flow to Arbitrage
Flow Flow (T-Bond investment) Flow (Swap
investment) Flow (6.77 - repo rate) (LIBOR
6.94) (LIBOR repo rate)
(6.94-6.77) (LIBOR (LIBOR-20) -
17 20 basis pts 17 basis pts
3 basis points on 250 million or 75,000
per annum