Chapter 8: The Structure of Forwards & Futures Markets KEY CONCEPTS

Explanations of the Basics of Forward and Futures Contracts More EVIL is More Beautiful Terms and Conditions of Futures Contracts Margins, Daily Settlements, Price Limits and Delivery Futures Traders and Trading Styles Reading Price Quotes

Futures Contracts
Chicago Board of Trade (CBOT)
Grains, Treasury bond futures

Chicago Mercantile Exchange (CME)

Foreign currencies, Stock Index futures, livestock futures, Eurodollar futures

New York Mercantile Exchange (NYMEX)

Crude oil, gasoline, heating oil futures

Development of new contracts

Futures exchanges look to develop new contracts that will generate significant trading volume

Futures
f0 =100, f1 = 105, f2= 103, f4= 110 In Margin Account f0 =100 +5 f1 = 105 -2 f2 = 103 +7 f4= 110

Long Futures Paid -110+7-2+5 = -100 = -f0 to Get One Underlying Asset

Contract's Terms: (see p. 260-262)

1. Size (see p. 261) 2. Grade, Quotation Unit 3. Delivery Months, 3,6,9,12 3rd Friday is the Last Trading day 4. Minimum Price Change (e.g., 1/32 of 1 %, ex. .0003125x $100,000 = $31.25 for T-Bond Futures) 5. Delivery Terms: Delivery date(s), Delivery Procedure, Expiration Months, Final Trading Day, First Delivery day (see p. 261-262) 6. Daily Price Limits & Trading Halts (see p. 262) 7. Margin

Futures Traders:Commission Brokers & Locals Hedger, Speculator, Spreader (Long One & Short One), Arbitrageur. [ by Trading Strategy] Trading Styles (Techniques): Scalper: Holds a Few Minutes Day Trader; Hold No More Than The Trading Day Position Trader Cost of Seats Fig 1(p.266), Seat can be leased monthly @1%-1.5%of Seat price. CBT has 1402 Full members, & Memberships (p.266) Forward Market Traders: Banks & Firms

Order (same as options)

Stop Loss Order Limit Orders Good-Till-Canceled Day Orders.

Trading Procedure: (see Fig. 2, p. 270) Buyer

Margin

Buyers Broker

Buyers Brokers Commission Broker

Exchange
(Trade)
Margin

Clearinghouse
(Record)

Margin: (p. 270-272, Table 2)

A:Initial Margin = m + 3d (m = the average of the daily absolute changes in the dollar value of a futures contract, d = the standard deviation, measured over some time period in the recent past). Initial margin is used to cover all likely changes in the value of a futures contract. B: Maintenance Margin: Equity position must be > Maintenance margin or get a margin call must deposit new $ (i.e., variation margin) up to IM before the market opens on the next trading day. Ex. p. 272

 Open Interest: Delivery & Cash Settlement(p. 272) Futures Price Quotation (see p.271, 274-275)

T-Bond: $100,000 (face Value in CBT), $50,000 (Face Value in CME), Future Price =(1/32) %xFace Value, Ex. 102 3/32 is $102,093.75 in CBT
T-Bill: futures price per $100 = 100 - (100-IMM Index)x (90/360), Face value = $1 MM, Ex. Dec. 94.95 by IMM, the Actual futures price = [100-(100-94.95)(90/360)] x$1MM/100= $987,375 (will be used Chapters 11) Note: IMM quotes based on a 90-day T-bill w/360-day year. $1 MM Face Value, Interest Rate Is Discount Rate

1. Last Trading Date:The Business Day Prior to the Date of Issue of T-bills in the Third week of the Month 2. Delivery Day: a) Any Business Day After the Last Trading Date (During the Expiration Month) .b) First Business Day of Month, c) Cash settlement 4. If Seller elects to Deliver a 91 or 92 days TBill, then Replace 90 by 91 or 92 in the Formula in p. 373, f = 100 - (100-IMM Index)(90/360)

T-Bond Futures: Based on 8% Coupon & 15 Yrs'

Maturity T-Bond (Face Value $100,000)

Quoted in Dollar & 1/32 of par value of $100. Ex. 111-17 is 111 17/32 = 111.53125, or $111,531.25 Expiration: March, June, Sept, Dec. Last trading Day: the Business Day Prior to the Last seven days of the expiration month. The First Delivery Day = The First Business Day of the Month T-Notes Futures: Same As T-Bond Except the maturity w/2 , 5 and 10 years T-Notes

Other Futures
Agricultural Commodity Futures Stock Indices Futures Natural Resources Futures Miscellaneous Commodities Futures Foreign Currency Futures (Euro , , etc.) T-Bills & Euro$s (the most active in US) Futures T-Notes & T-Bonds Futures Index Futures (i.e., Equities Futures) Managed Futures: Futures Funds (Commodity Funds), Private Pools, Specialized Contract Hedge Funds Option on Futures Transaction Cost: Commission, Bid-Ask Spread, Delivery Cost

Chapter 9: Pinciples of Forward & Futures Pricing KEY CONCEPTS

Difference Between Price and Value of Forward and Futures Contracts Rationale for a Difference Between Forward and Futures Prices Cost of Carry Futures Pricing Model Convenience Yield, Backwardation and Contango Risk Premium/Controversy Role of Coupon Interest/Dividends in Futures Pricing Put-Call Forward/Futures Parity Pricing Options on Futures

Comparison of Forward and Futures Contracts

Forward Futures Private contract betweenTraded on an exchange two parties Not standardized Standardized contract Usually one specified Range of delivery dates delivery date Settled at end of contract Settled daily Delivery or final cash Contract usually closed out settlement usually takes prior to maturity place

Forward Price & Futures Price

Price vs. Value Is Price = Value True for Futures or Forwards? Ans. No, why? Price = Value (from efficient market) F = forward price today ft f f = futures price today t Ft = forward price written at time t 0 F Ft ft = futures price written at time t Vt = value at time t of a forward contract written today = St - F(1+r)-(T-t) @ time t

Ex. p.290, F=100,r=10%, T=45 days, after 20days, S=102, the value of Forward w/25 days = 102100(1.10)-25/365=2.65

 Note: (E=F=S(1+r)T @ time 0, p. 290) Value of Futures @ T = vT = fT - ST 0 Value of Futures @ t = vt = ft - ft-1 (before marked-to-mkt) & vt 0 once marked-to-mkt

Forward vs. Futures Prices (p. 292-295)

(The effect of daily settlement on forward and futures prices) (if r is certain or uncorrelated to f) Example: (A Two-Period Model) A. One day prior to expiration ( p. 292) Buy a forward @ Ft and sell a future @ ft The profit = (-Ft +fT) + (ft - fT) = ft - Ft 0-investment & 0 risk @ t => ft = Ft

B. Two days prior to expiration (interest rate r is constant for two periods, or uncorrelated to futures price) (p. 293) Buy a forward @ F and sell (1+r)-(T-t) futures @ f At time t, the profit = (f-ft)(1+r)-(T-t) invest in risk-free bonds. This close the futures position. Now, sell a new futures @ ft @ T, T = (ft -fT) + [(f-ft)(1+r)-(T-t)(1+r)(T-t)] + (fT-F) = f - F = 0 ( $0 investment & risk-free) f > (<) F if futures prices & interest rates are positively (negatively) correlated (p. 294)

The Effect of Intermediate Cash Flows on Futures Price

Long a Stock S and Short a Futures at f S 0 S S = (DT + f)(1+r)-T Or f = S(1+r)T - DT Ex. S = $100, DT = $2, r = 6%, T = .25, then f = 100(1.06).25-2 = $99.47 ST + DT f-fT = f - ST DT+f

f = S(1+r)T - Dt(1+r)(T-t) = S(1+r)T - DT = Future Spot Price - FV(D) (see p.295) = [S - PV(D)](1+r)T = S + For Continuous Dividends: f = Se(rc-)T = [S-PV(D)]ercT = S + (where is the continuous dividend yield), rc = continuously compound risk-free rate.

Ex1. S = 85, = 8%, rc = 10%, T = 90 day = 0.246575yr, f = 85e(0.1-.08)0.246575 Ex2. S0=50, T=60/365, rc=8%, =6%, f0=S0e(.08-.06)60/365 =49.92 (p. 297). Vt(0,T)=St-Dt,T-F(1+r)-(T-t) for the value of Forward Vt(0,T)=Ste-(T-t) Ferc(T-t) for continuous.

Interest Rate Parity: F=S(1+r)T/(1+)T

1+ S=Spot Exchange Rate/$ US =Risk-Free Rate in US F S r=Foreign Risk-Free Rate F=Forward Exchange Rate/$ UK 1+r $(1+ )F=$S(1+r) Deposit US$ in USs Bank Us Forward Rate to Lock in and then Convert to Foreign Currency = Convert in to Foreign Currency and Deposit in Foreign Bank. Example: S=0.7908/$, = 5.84%, r=3.59%, T=90/365, F= 0.7908(1.0584)-90/365 (1.0359)90/365 = 0.7866 Arbitrage Opp. Exists If Parity is Violated (chapter 10)

Commodities w/Storage Cost: f=S(1+r)T+s ( p. 300) Spot Prices, Risk Premiums, & Cost of Cary 1. Risk Neutral:
A. Buy Now ($) (Paid) (1) Spot Price, S0 (2) Storage Cost, s (3) Interest Foregone, iS0 B. Buy Later:(Paid) (1) Expected Future Spot Price E(ST). In Equilibrium, A = B, or

S0 + s + iS0 = E(ST), I.e., S0=E(ST)-s-iS0

2. Risk Aversion:(in terms of $)

Add Risk Premium E( ) to A. S0 + s + iS0 + E( ) = E(ST) S0=E(ST) -s - iS0 - E( )

Cost of Carry s + iS0=

Under no margin, mark-to-the-market etc. In Spot Market : S0 = E(ST) - - E( ) , where, = Cost of Carry = s(Storage cost) + iS0 (Opp. Cost of Money), E( ) = Risk Premium(Insurance)

The Cost of Carry Futures Pricing Model (Theoretical Fair Price) (p.302)
Consider buy a spot commodity @ S and sell a futures contract @ f. At time T, Closing both position and the profit is (ST-S0-s-iS0) + (f - ST) = = f-S0- (risk-free) = 0 ? Futures Price = Spot Price + Cost of Carry

Quasi Arbitrage: Asset owner sell his Asset and Buy a Futures if f < S+ to take the Arbitrage Opp. Arbitrage Opp. Exists if f S+

Definition: Basis Cash price S - Futures Price f

1. If Futures Prices f < Cash Spot Prices S => Backwardation (or Inverted) Market 2. If futures Prices f > Cash Prices S=> Contango Market 3. Convenience Yield c: f = S + - c

Risk Premium Controversy (mixed in empirical studies)

1. f = E(ST) [No Risk Premium] 2. f < E(fT) = E(ST) = S + + E( ) = f + E( ) Example. p. 309 Normal Contango: E(ST) < f Normal Backwardation: f < E(S )

Put-Call Forward/Futures Parity

Relationship between the prices of Put, Call, and Futures on Asset (i.e, Options & Futures Expire on the Same Time: A Special Case) P=C-S+PV(E) P-C-P on Spot Option P=C+PV(E)-PV(f) P-C-Forward Parity Or P(S,E,T)=C(S,E,T)+PV(E-f) Spot Price @ T vs. Exercise Price E for Options on the Spot

Put-Call-Futures Parity
T=0 Sell a Futures But a Put 0 P(S,T, E) @T ST< E ST-f E-ST 0 E-f @T ST>E ST-f 0

Buy a Call C(S,T,E) Deposit PV(E-f) PV(E-f)

ST-E E-f

P=C+PV(E-f)

E-f

ST-f

Option on the Futures

Basic Characteristics of Options on Futures Intrinsic Values, Lower Bounds & Put-Call Parity of Options on Futures Why Both Calls & Puts Might Be Exercised Early Black & Binomial Option on Futures Pricing Models Trading Strategies for Options on Futures Difference Between Options on the Spot & Options on Futures

Options on Futures: Underlying Asset is Futures

To give the buyer the right to buy (or sell) a futures contract @ a fixed price (E) up to a specified expiration date (Option expiration Date T). (Commodity Options or Futures Option) Call & Put Options Intrinsic Value of an American Option on Futures
= Max(0,f-E) for Call. = Max(0,E-f) for Put.

Ex.

Options On Futures
Call Option On Futures C(f, T,E)=IV+TV IVC=Max(0, ft-E) for Call at time t, IVP=Max(0, E-ft) for Put at time t Lower Bound for American & European Options (see P. 311 &312) Ex . See p.313 Buy (in April) a July call futures on Gold(100 ounces) w/E= $1000. Exercise Decision in May 5: If July gold futures price is $1040 and the most recent settlement price(i.e., the last trading futures price on May 4)=$1038. The Investor receive a long Gold Futures Contract + a Cash of $3,800 [i.e., (1038-1000)x100]. If Investor Decides to close out the long futures for a gain of (1040-1038)x100=$200. Total Payoff from the Decision of Exercise is $4,000. (ft-E)x100=$4,000

Put-Call Parity Ce(f,T,E) = Pe(f,T,E) + (f-E)(1+r)-T

Ex. Pe(f,T,E) = 7.45, f = 320, E=315, r = 5.46%, T = .25, then Ce(f,T,E) = 7.45 + 5(1.0546)-.25 = 12.52 Example See p.317

Put-Call Parity of Option on Futures:

Pe = Ce + (E-f)(1+r)-T vs. Pe = Ce -S + E(1+r)-T
Current Date PV Buy a Put P Buy a Futures 0 Buy a Call Buy a Bond w/ PV(E-f) C PV(E-f) Expiration Date fT E E- fT fT-f E-f 0 E-f E-f fT E 0 fT -f fT -f fT -E E-f fT -f

Put-Call Parity of Options on Futures: P(f,T,E) = C(f,T,E)+PV(E-f)

Exercise of the option gives holder a position of Futures Contract Early Exercise of Call & Put Options on Futures? (Textbook: Possible for Both Call & Put, p.315)

B/S Option On Futures Pricing Model (p. 319)

C(f,T,E)=PV[fN(d1)-EN(d2)] Where d1= ln(f/E)+2T/2 T d2= d1- T = the volatility of the futures price

Black Option on Futures Pricing Model

C(f,T,2,E, r) = e-rcT[fN(d1) - EN(d2)]

where, d1 = [ln(f/E) + .52T]/T d2 = d1 - Ex

Chapter 10: Futures Arbitrage Strategies KEY CONCEPTS

Cash and Carry Arbitrage Implied Repo Rate Delivery Option Imbedded in the T-Bond Futures Contracts Rationale for Spread Strategies Stock Index Futures Arbitrage and Program Trading

Short-term Interest Rate Futures Strategies T-Bill Cash & Carry/Implied Repo Implied Repo Rate r f/S - 1 = /S ,[f - S = ] r=(f/S)1/t -1 = the return implied by the cost of carry relationship between spot & futures prices
Sell a Futures Contracts Buy a Spot Borrow S (use Spot as Collateral) Net Cash 0 r is the repo Repo is an insured loan f-ST
ST

-S(1+r) f-S(1+r)=0

Repo: Federal Funds Futures Carry Arbitrage Federal Funds futures contract size: $5MM Quote: at 100-(daily overnight rate)
3/1 4/1 LIBOR1=5.5%, LIBOR2=6% Repay borrowing $5MM April f=93.75. Borrow PV= Buy a futures to closed out 5MM @1 month and lend all $ @ 2 months LIBOR PV(5MM)=$4,977,187.89 Sell one April futures @93.75 Loan Balance on 5/1=PV(5MM)(1+6%(60/360))=$5,026,959.77 Assume 1-month LIBOR=7.25% on 4/1, PV of LB2 on 4/1 is LB2/(1+7.25%(30/360))=$4,996,770.94. Under no basis risk (so Futures price on 4/1 is 100-7.25=92.75. The gain from futures is $4,166.67=(93.75-92.75)x5MM(30/360)/100. Repo is [($4,99,770.94+4,166.67)/$(PV(5MM))-1]360/30= 5.73%>5.50%

T-Bill and Euro$ Futures Price Determination

T-Bill: f utures price per $100 = 100 - (100-IMM Index)x (90/360), Face value = $1 MM, Ex. Dec. 94.95 by IMM, the Actual futures price = [100(100-94.95)(90/360)] x$1MM/100= $987,375 Note: IMM quotes based on a 90-day T-bill w/360day year. $1 MM Face Value, Interest Rate Is Discount Rate

Euro$ Futures: $1MM Face Value, Based on LIBOR

Interest Rate of Euro$ is Called LIBOR Note: T-bill is a discount instrument, and Euro$ is an addon instrument.

Ex. 10% quote rate on T-bill & Euro$ (Spot Market) Pay 100-10(90/360)=97.5 & get 100 par in 90 days Yield = (100/97.5)365/90 -1 = 10.81% for T-bill. Pay 97.5 get back 97.5(.1)(90/365)=2.44 interest + 97.5 principle Yield = (1+2.4/97.5)365/90 -1 =10.36% for Euro$

Euro$ Futures Price Same as T-bill Futures Price Calculation

Futures price per $100 = 100 - (100-IMM Index)x (90/360), Face value = $1 MM, Ex. Dec. 94.46 by IMM, the Actual futures price = [100-(100-94.46) (90/360)] x$1MM/100= $986,150 Note: IMM quotes based on a 3-month LIBOR w/360-day year. Expiration months: March, June, Sept, Dec. Last Trading Date: Second London Business Day before the third Wed. of the Month First Delivery Day: Cash Settled on Last Trading Day.

Euro$ Arbitrage: (Cost of Carry relation is Violated

Between Euro$ Futures & Spot) (Table 2, p. 332) EX: On 9/16, a London bank needs either to issue $10MM of 180 day Euro$ CD @ 8.75 or to issue a 90-day CD @ 8.25 and selling a Euro$ futures contract expiring in 3 months of IMM index of 91.37. (Table 2, p. 332) If 180-day Euro$CD is issued, then paid $10,437,500 = $10MM[1+.0875(180)/360], or 9.07% If 90-day CD is issued @ 8.25 and sell 10 Euro$ futures @ 91.37, then need to pay 10MM [1+.0825(90/360)] on 12/16 and get 10*978,425 from futures pay 10*980,100 to close the futures (loss $16,750). The firm needs to issue $10MM x(1+ .0825/4) + $16,750 = $10,223,000 on 12/6 and pays $10,233,000 (1+.0796/4) = $10,426,438 or 8.84% < 9.07%

Return on futures 2.1575% Synthetic 180-Day CD 3 months return on CD 2.0625% =[(100-91.37)/100]/4 Current Date: 90- Owe 10MM(1+8.25/4) Owe 10,223,000x day CD Rate 8.25 =$10,206,250 (1+7.96/4)= New 90-day CD Rate Issue 90 day CD 10,426,438 7.96. IMM= 92.04=> for $10MM get $10MM f= 98.01. Issue new IMM 91.37/Dec the cost of 90-day CD for Sell 10 Futures 10,206,250 + (978425- debt 8.84% at $978,425 each 980100)x10 Annual Return from 90-day CD & Furures = 8.84% 180 Days 180-day CD Rate 8.75. Owe $10MM(1+8.75x180/360) or the cost of debt 9.07% > 8.84%

Long-term Interest Rate (T-Bond Futures) Arbitrage

Which Date & Which Bond to Delivery in Delivery Month? Maturity (of the bond time remaining from the 1st day of delivery month to bond maturity ) & Coupon Rate Conversion Factor is $1 bond w/coupon & maturity = Deliverable bond on Bond Futures Contract with 6% Coupon Rate Invoice Price = futures price x CF+AI

Conversion Factor (see p. 353) :

Ex. Find CF for delivery of the 5 1/2 of August 15, 2028, on the March 2006 T-bond future contract (for Short March futures contract). Decided to deliver on 4/7/2006 On the March 7, 2006 the bond's remaining life is 22 yrs, 5 months. Rounding down to 0 (0,3,6,9). CF0 = (.055/2)[1-1.03-2*22]/.03 + 1.03-2*22 = 0.939364 CF3=CF0+0.055/2)(1.03)-0.5 -0.055/4=0.938929718 The Invoice price = Settlement Price on position day * CF + Accrued interest If the settlement price on March 7 is $112 and the Accrued interest = $303.87, then Invoice price = $112,000*0.9389 + $303.87 = $105,460.67 (Formula for CF see p.353)

 The cheapest-to-deliver bond, among all deliverable bonds, is the bond that is most profitable to deliver. Note: profit is measured by: [The FV of net cash flow by Selling a futures & Buying a Spot @ time t ] (see Table 4, p. 334-6) f(CF) + AIT - [(B+AIt)(1+r)T-t - FV of Coupon at T], where, AIT is the accrued interest on the bond at T, the delivery date, AIt is the accrued interest on the bond at time t (i.e., today), r = risk-free rate, B = bond price

Example:Given Current date 12/15, Delivery Date 6/11,

Repo Rate 2.62%, Future Price 112.65625 A: 12.5% Coupon, Mature on 8/15/09, CF = 1.4022 2/15 8/15 13+31+30+31+30+31+15 =181 days 2/15 6/11 4/15 13+31+15=59 15+31+11=57 AIt =6.25x59/181=2.04 on 4/15, AIT =6.25x(59+57)/181= 4.01 from 2/15 to 6/11. Bond price is Quoted 160.125(ask price). The Invoice Price =f(CF) + AIT=112.65625(1.4122)+4.01=161.98 on 6/11 (B+AIt)(1+r)T-t = (160.125+2.04)(1.0262)57/365=162.82 f(CF) + AIT - [(B+AIt)(1+r)T-t]=161.98-162.82= -.84

Example: Continue B: 8.125% Coupon, Mature on 5/15/21, CF = 1.0137, B = 116.21875, r = 2.62% 4/15 5/15 6/11 30 27days days 11/15 184 Days

AIt = 4.0625(181-30)/181= 3.39 on 4/15 from 11/15 to 4/15 AIT = 4.0625(27/184) = 0.60 on 6/11 from 5/15 to 6/11 FV(4.0625)=4.0625(1.0262)27/365 =4.07 on 6/11 from 5/15-6/11 f(CF) + AIT - [(B+AIt)(1+r)T-t - FV of Coupon at T] = 112.65625(1.0137)+0.6 - [(116.21875+3.39) (1.0262)57/365-4.07 =-1.22, 12.5% Coupon is Cheapter-t-D Bond than 8.125%

Rules (Determining the Quoted Futures Price)

1. Find the Cash Spot Price (Cheapest-to-deliver Bond) from Quoted Price 2. Find Futures Price based on on f = [S-PV(D)]er(T-t) 3. Find Quoted Futures Price from the Cash Futures Price 4. Divide the Quoted Futures Price by Conversion Factor to Allow the difference Between the C-t-D Bond & 15Yrs 8%
Coupon Payment 60 Days Current Time 122 Days Coupon Payment 148 Days Maturity Of Futures Coupon Payment

36 Days

Suppose C-t-D T-Bond is 12%, Conversion Factor 1.4 & Futures is 270 days to mature, Coupon Pay Semiannual, Interest rate is 10% & Current Quoted Bond Price is $120

Example: Continue
1. The Cash Price = Quoted Bond Price + Accured Interest 120 + 6x[60/180] = 121.978, The PV ($6) in 122 days (0.3342 yr) = $5.803 2. The Futures Price for 270 days (0.7397 yr) is (121.978 - 5.803)e0.7397x0.1 = 125.094 At Delivery, There are 148 Days of Accured Interest, The Quoted Futures Price Under 12% Coupon is 3. 125.094-6x148/183 = 120.242 The Quoted Futures Price under 8% should be 4. 120.242/1.4 = 85.887

Delivery Options: 1. Wild Card Option: if B5 < f3*CF [note: issue notice of intention to deliver at 9pm to clearinghouse] 2.Quality (or Switching) Option:(switching to favorable B) 3. The-end-of-the-month Option: (same as Wild Card Option, there are 7 Business Days in the expiration month) 4. Timing Option(in one month; financing cost vs coupon) Implied Repo/Cost of Carry (T-B Futures) f(CF) + AIT = $ received for Delivery = $ paid for Bond + Cost of Carry = (B+AI)(1+r)T r = [(f(CF) + AIT)/(B+AI)]1/T - 1

Implied Repo/Cost of Carry Repo

Current Date Expiration Date Buy a Bond -(B+AI) BT+AIT Borrow B+AI -(B+AI)(1+r)T Sell a T-Bond Futures f(CF)+AIT - (BT +AIT) Net Cash Flow 0 f(CF)+AIT -(B+AI)(1+r)T 0 Investment 0 risk r = [(f(CF)+AIT)/(B+AI)]1/T -1 11/15 12/2/05 95 Days 3/7/06 2/15
$ $ On 12/2/05, p.398. Given B=136.12695,8.125% coupon of mature on 5/15/2021, Deliver on 3/7,AI =.38 , CF=1.2083, f=112, AIT =2.51 =8.125(95/365), r = 3.89%, T=95/365,

T-Bond Futures Spread: Long & Short a T-B Futures

w/ Different Expiration Dates Ex. to speculate r , if r will in short period then Sell a shorter maturity futures & Buy a longer maturity futures

T-Bond Futures Spread & the Implied Repo Rate

0

t Buy

Sell @ Time t, Get T-Bond & Pay ft(CFt)+AIt ,Finance By Repo Rate r. @ Time T, Deliver T-Bond & Get fT(CFT)+AIT. 0 Net Cash Flow @ Time 0 & t & 0 risk at Time T (ft (CFt) +AIt)(1+r)T-t = fT(CFT)+AIT, or r=[(fT(CFT)+AIT)/(ft(CFt)+AIt)]1/(T-t)-1. If r forward rate,

Ex. (T-Bond Futures Spread/ Implied Repo Rate)

On 11/13/09, 6 3/4s T-Bond Maturing on 8/15/26 is the C-TD Bond, March-June Spread & Given AI =.40, CFM=1.0798, CFJ=1.0792, fM=116, fJ=115, AIM =.35, AIJ =2.16 =>(implied repo rate from 3/13-6/11) r = [(115(1.0792)+2.16)/(116(1.0798)+.40 )]365/90 -1 = 1.99 % (ex. P. 343)

11/13 fM=116 fJ=115

3/13 Delivery Date For March futures

6/11 Delivery Date for June

Turtle Trade: Implied Repo Rate on T-Bond Spread vs. Implied Rate on Fed Funds Futures

Stock Index Futures Strategies

Stock Index Arbitrage: when f = Se(rc-)T is Violated Then Buy Low Sell High, See Ex: p. 344, & Table 5

Program Trading
At least $1MM mkt Value & At least 15 Stocks transaction

Exchange Rate Arbitrage: Interest Rate Parity is Violated Assume Forward price=futures price Interest Rate Parity: f(1+r)=S(1+r$), or in Continuous-time f=Se(r$-r)T Ex: S=0.7908/$, r$=5.84%, r=3.59%, T=90/365=0.2466 By Interest Rate Parity, f(1.0584)=0.7908(1.0359), f= 0.7866/$ If F0.7866/$, the Arbitrage Exists Buy Low Sell High This Arbitrage is called Covered Interest Arbitrage

Chapter 11: Forward and Futures Hedging, You will Spread, and Target Strategies
KEY CONCEPTS Why Hedge

Get Rich Quick

Hedging concepts Factors involved when constructing a hedge Difference Between a Short Hedge and a Long Hedge and When to Use Each Appropriate Hedging Contract to Use in a Given Situation Optimal Hedge Ratios Analysis of Specific Hedge

Why Hedge?
The value of the firm may not be independent of financial decisions because
Shareholders might be unaware of the firms risks. Shareholders might not be able to identify the correct number of futures contracts necessary to hedge. Shareholders might have higher transaction costs of hedging than the firm. There may be tax advantages to a firm hedging. Hedging reduces bankruptcy costs.

Managers may be reducing their own risk. Hedging may send a positive signal to creditors. Dealers hedge so as to make a market in derivatives.

Why Hedge? (continued)

Reasons not to hedge
Hedging can give a misleading impression of the amount of risk reduced Hedging eliminates the opportunity to take advantage of favorable market conditions There is no such thing as a hedge. Any hedge is an act of taking a position that an adverse market movement will occur. This, itself, is a form of speculation.

Hedging Concepts
Short Hedge and Long Hedge
Short (long) hedge means to hedge by a short (long) position in futures Short hedges can occur because
The hedger owns an asset and plans to sell it later. The hedger plans to issue a liability later

Long hedges can occur because

The hedger plans to purchase an asset later. The hedger may be short an asset.

An anticipatory hedge is a hedge of a transaction that is expected to occur in the future.

See Table 11.1, p. 358 for hedging situations.

 The Basis
Basis = spot price - futures price. Hedging and the Basis
(short hedge) = ST - S0 (from spot market) - (fT - f0) (from futures market) (long hedge) = -ST + S0 (from spot market) + (fT - f0) (from futures market) If hedge is closed prior to expiration, (short hedge) = St - S0 - (ft - f0) (long hedge) = -(St - S0 )+ ft - f0 If hedge is held to expiration, =S0 f0 .

Spread Basis: b0 S - f (initial basis) Spot bt St - ft (basis @ t) bT ST - fT (basis @ expiration) futures t= (Short hedge)= bt - b0, If Position closed outT@ t time t. Profit from Hedge Strategy : T Profit of long spot and short future(i.e.,Short Hedge) = (ST - S) + (f - fT) = f - S = - b0 (Buy @ S and Sell @ f) T (Long Hedge) = b0

Example. S = 95, f = 97, ST = x, T (Short Hedge) = $2 (why?) t = (St - S) + (f - ft) = (St-ft) - (S-f) = S-f = bt- b0.

bt - b0 Is Stochastic S > f Strengthening Basis for Short Hedger S < f Weakening basis for Short Hedger If closed out before expiration date at time t
@t, St = 92, ft = 90, Given S = 95, f = 97,

then t(Short Hedge) = (92-90)-(95-97) = 2-(-2)=4

 The Basis (continued)

This is the change in the basis and illustrates the principle of basis risk. Hedging attempts to lock in the future price of an asset today, which will be f0 + (St - ft)-S0. A perfect hedge is practically non-existent. Short hedges benefit from a strengthening basis. Everything we have said here reverses for a long hedge. See Table 11.2, p. 361 for hedging profitability and the basis.

 The Basis (continued) (p.361) Example: March 30. Spot gold $1087.15. June futures $1088.60. Buy spot, sell futures. Note: b0 = 1087.15 - 1088.60 = -1.45. If held to expiration, profit should be change in basis or 1.45. At expiration, let ST = $1108.50. Sell gold in spot for $1108.50, a profit of 21.35. Buy back futures at $1108.50, a profit of -19.90. Net gain =1.45 or $145 on 100 oz. of gold.

Example: (continued) Instead, close out prior to expiration when St = $1077.52 and ft = $1078.63. Profit on spot = -9.63. Profit on futures = 9.97. Net gain = .34 or $34 on 100 oz. Note that change in basis was bt - b0 or -1.11 - (-1.45) = .34. Behavior of the Basis. See Figure 10.1, p. 362.

Two risks exist in Hedge: 1. Cross Hedge (commodity is not the same as the underlying commodity of futures) 2. Quantity Risk: Size

Contract Choice Rule #1: Which futures commodity?

One that is most highly correlated with spot A contract that is favorably priced

Rule #2: Which expiration?

The futures whose maturity is closest to but after the hedge termination date subject to the suggestion not to be in the contract in its expiration month (i.e., Expiration Date of Contract is Over and Close to the Hedge Termination Date) See Table 10.3, p. 364 for example of recommended contracts for T-bond hedge Concept of rolling the hedge forward

 Contract Choice (continued)

Rule #3: Long or short? A critical decision! No room for mistakes. If Positive Correlated => One Long and One Short , If Negative Correlated => Both are Long or Short Three methods to answer the question.
(See Table 10.4, p. 363)

a) worst case scenario method b) current spot position method c) anticipated future spot transaction method

Margin Requirements and Marking to Market

low margin requirements on futures, but cash will be required for margin calls

Determination of the Hedge Ratio

Hedge ratio: The number of futures contracts to hedge a particular exposure Nave hedge ratio (Spot asset value/futures price)

Appropriate Nave hedge ratio Nf should be such that some goal can achieve
Portfolio consists of a long S and Nf of Futures (H=S+ Nff , vs. H=hS-C in Option)) = S + Nff = 0 => Nf = -S/f

Note that this ratio Nf = - S/f must be estimated.

Hedge Ratios
A. Minimum Variance Hedge Ratio B. Price Sensitivity Hedge Ratio C. Stock Index Futures Hedge

A. Minimum Variance Hedge Ratio (p.368) Profit from short hedge = S + fNf Variance of Profit 2 = 2S + N2f 2f + 2NfSf Minimizing 2 => Nf = - Sf/ 2f = - in the regression of S on f Effectiveness of Hedge e* = (2S - 2)/2S = N2f 2f /2S Consider: S = + f + , Then The Effectiveness of the Minimum Variance Hedge
2 2 2 2

A. Minimum Variance Hedge Ratio (continued) Hedging effectiveness is

e* = (risk of unhedged position - risk of hedged position)/risk of unhedged position This is coefficient of determination from regression.

B. Price Sensitivity Hedge Ratio

H/r = S/r + ff/r, Portfolio H = S + ff = (S/ys)(ys/r) + f(f/yf)(yf/r) = 0 => Nf = - (S/ys)/(f/yf) if ys/r = yf/r or Nf= - (S/ys)/(f/yf)

Price Sensitivity Hedge Ratio

This applies to hedges of interest sensitive securities (e.g.,T-Bond, T-Notes). First we introduce the concept of duration. We start with a bond priced at B:
C t P B= +) y t= ( 1 1
T t

where CPt is the cash payment at time t and y is the yield (IRR), or discount rate. 1% = 100 base points

Duration = D = Weighted Average Maturity of

Bond D = -(B/B)/[y/(1+y)] B/B -D[y/(1+y/n)], n = # of Interest Payment/yr

Example: Given B = PV(ci) + PV(P) D = i[PV(ci)]/B, 3 years 10% Coupon Bond w/face Value $100, y= 12%, paid semiannual:
Time 0.5 1.0 1.5 2.0 2.5 3.0 Total Payment 5 5 5 5 5 105 130 PV(ci) 4.717 4.450 4.198 3.960 3.736 74.021 95.082 Weight 0.0496 0.0468 0.0442 0.0416 0.0393 0.7785 1.0000 Time x Weight 0.0248 0.0468 0.0663 0.0832 0.0983 2.3355

2.6549= D

Price Sensitivity Hedge Ratio (continued)

An approximation to the change in price for a yield change is B = B DUR B (y)
1+ y

with DURB being the bonds duration, which is a weighted-average of the times to each cash payment date on the bond, and represents the change in the bond price or yield. Duration has many weaknesses but is widely used as a measure of the sensitivity of a bonds price to its yield. Modified Duration MD: MD= DUR/(1+y)

Price Sensitivity Hedge Ratio (continued) The hedge ratio is as follows

DUR B B 1 + y f MD B B N f = DUR f 1 + y = MD f f B f

Technically, the hedge ratio will change continuously like an options delta and, like delta, it will not capture the risk of large moves.

Price Sensitivity Hedge Ratio (continued)

Alternatively, Nf = -(Yield beta)PVBPB/PVBPf where Yield beta y is the beta from a regression of spot yields yb on futures implied yields and PVBPB, PVBPf is the present value of a basis point change in the spot and futures prices. That is, PVBPB= B/yb=MDBB
MD B B N f = MD f yieldbeta f

C. Stock Index Futures Hedging (Price sensitivity is not applicable to Stock Index) From the Minimum Variance Hedge, given S = rsS, f = rff , an appropriate hedge ratio is Nf = - s(S/f), where s is obtained by regression of rs = + srf + (Mkt Model)

Hedging Strategies: Applications

1. Currency Hedges

2. Intermediate & Long-term Interest Rate

Futures Hedges

3. Stock Market Hedges

3 Most Actively Traded Currency Futures

1. Euro with size of 125,000 2 British Pound with size of 62,500 3 Japanese Yen with size of 12,500,000 In US, Futures Prices Are Stated in $. EX. $.8310 for is 12,500,000x$.008310/ =$103,875/Futures

Long Currency Hedge: A/P in

On 7/1, Car Dealer in US buys 20 British Car of 35,000/car, A/P on 11/1.
Date
7/1

Spot Mkt $1.319/, F=$1.306/ Forward Cost =20(35000)x1.306 =$914,200 Forward H

S=$1.442/, Total Cost in $ $700,000(1.442)=$1.009,400

Futures Mkt fD=$1.278/, #of Contract= Nave hedge 20(35,000)/62,500=11.2 Buy 11 Currency Futures
fD=$1.4375/, Sell 11 Contracts

11/1

Cost $1,009,400-$914,200=$95,200 for No hedge than Forward $1,009,200-11[(1.4375-1.2780)x62,500]=$1,009,200-109,656.25 = $899,743.75 by Futures Hedge

Short Hedge: Convert to $ in the Future

On 6/29, CFO in UK will Transfer 10MM to NY on 9/28 (Forward Hedge)
Date Spot Mkt Forward Mkt Sell 10MM Forward Currency @$1.357/
Exercise Forward Paid 10MM & Get $13.57MM 6/29 S=$1.362/,F=$1.357/

9/28 S=$1.2375/

Paid 10MM & Get $12.375MM for No Hedge Paid 10MM & Get $13.57MM by Forwards Hedge

Strip Hedge & Rolling Strip Hedge

On 1/2, ABC to Borrow $ at 3/1 $15MM 6/1 45 Strip: On 1/2 :Sell 15 March , 45 June, 20 Sep and 10 Dec contracts. On 3/1 Buy 15 Futures On 6/1 Buy 45 Futures On 9/1 Buy 20 Futures On 12/1 Buy 10 Futures

9/1
12/1

20 10

Rolling Hedge Strip: On 1/2 Sell 90 March Futures On 3/1 Buy 90 March Futures and Sell 75 June Futures On 6/1 Buy 75 June Futures and Sell 30 Sep Futures On 9/1 Buy 30 Sep Futures and Sell 10 Dec Futures On 12/1 Buy 10 Dec Futures

2. Intermediate & Long-term Interest Rate Futures Hedge

Intermediate and Long-Term Interest Rate Futures Hedges First let us look at the T-note and bond contracts T-bonds: must be a T-bond with at least 15 years to maturity or first call date T-note: three contracts (2-, 5-, and 10-year) A bond of any coupon can be delivered but the standard is a 6% coupon. Adjustments, explained in Chapter 10, are made to reflect other coupons. Price is quoted in units and 32nds, relative to $100 par, e.g., 93 14/32 is 93.4375. Contract size is $100,000 face value so price is $93,437.50

Ex. Hedging a Long Position in a Gov't Bond (Table 7, p.378) Hold $1MM of Gov't Bond Today. If bond prices (interest rate ), then futures on T-Bond will So, you should sell T. bond future today to Hedge the Risk.
3/28

T-Bond f=$66,718.75=$66 23/32 B=101,MDs =7.83, ,B=95.6875 Sold $1MM Gov't Bond get MDf =7.2, f=70.5 $956,875,(Loss $53,125 w/o Hedge) =>Nf =-15.6, Sell w/Hedge:Closed out Futures Position at 16 T-Bond Futures $66,718.75, f=70.5-66.71875=3.78125 Today @ $70,500 per $100f, f =16xfx1000 =$60,500 Nf =1,010MDs / [T-bond futures $100,000/Contract] 70.5MDf=15.6 Net = $956,875 +60,500=$1,017,375

2/25

Hedging a Future Purchase of a T-Notes (p. 379)

3/29, manager will have $1MM A/R on 7/15 and decides to buy 11 5/8 T-notes (9 yrs) w/5.6 modified duration & yield 12.02%. Given Forward price of notes is 97 28/32. Buy Tnote futures to hedge (why?). 3/29
F=97 28/32, MDs =5.6, f=78 21/32, MDf =6.2, =>Nf =-11.24, Buy 11 T-Notes Futures Today @ $78 21/32

(i.e.,$78,656.25) Lock-in $978,750 978,750MDs/78,65 6.25MDf=11.24

7/15, S=107 19/32 f=86 6/32 or $86,187.5 W/O hedge, $1MM face value T-note is $1,075,937.5, Loss $978,750$1,075,937= ($97,187.5) W/Hedge:11($86,187.5-78,656.25) = $82,843.75 from futures, Net = $1,075,937.5-$82,843.75 = $993,093.75 paid for $1MM T-Note for 11.75%

Ex. Hedging a Corporate Bond Issue (21 years maturity)

Sell T-bond futures (why?). Nf = -MDsS/MDff. (Table 9, p. 380)

On 2/24, a Company decides to issue $5MM face value of bond on 5/24 expected yS=13.76% coupon& price at par w/20 yrs maturity and MDS=7..22 duration. T-bond futures are at 68 11/32 (=$68,343.75), MDf=7.88

Nf = -MDsS/MDff=-7.22(5MM)/7.88(68,343.75)=67.0. Sell 67 T-Bond Futures. On 5/24 y=15.25%, w/13.76% coupon is priced at $907.4638/$1000, or $4,537,319 for $5MM Bond f=60 25/32 (=$60,781.25). W/O hedge, loss $4,537,319-$5MM=$462,681 W/Hedge, 67(68,343.75-60,781.25)=$506,687.5 Gain from futures, Total $ receive=$4,537,319+ $506,687.5 =$5,044,006.5 or Yield of 13.63%

3. Stock Index Futures Hedge (f= CME index*$250)

Note: S&P 500 Index CME = 745.45 on 11/22/0x, f = 745.45*250 = $186,362.5/Dec. index futures Contract Expiration: March, June, Sept, Dec. Last Trading Day: The Thursday before the 3rd Friday of Expiration Month Ex. Stock Portfolio Hedge (Table 10, p 382)

Hold a portfolio. Sell the S&P 500 futures to hedge his portfolio. Nf = -sS/f. Mkt Value weighted betas to get s , Portfolio mkt value = S, Index futures times 250 = f.

Ex. Hedging a Takeover ( Table 11, p. 385, hedging a future purchase of stocks). Buy Nf S&P 500 futures Contracts, Nf = -S/f, = beta in CAPM

Ex. Hedging a Takeover ( Table 11, p. 385, hedging a future purchase of stocks).
On 7/15, a firm decide to buy 100,000 shares of stock to take over another company on 8/15, S=$26.5 w/beta=1.8, Nf = S/f, S&P futures=1,260.5, or x250=$315,125/contract Nf=1.8(2,650,000/315,125)=15.14. Buy 15 futures On 8/15 Stock price=28.75, Cost of shares=28.75x100,000 $2,875,000 (W/O Hedge), additional $225,000 cost more than that from S=$26.5 W/Hedge, f=1,327.2 or x250=$331,800, 15(331,800315,125)= $250,125 gain from futures, Total cost for taking over = $2,875,000-250,125)=$2,625,000, or 26.25/share

Chapter 12: Swaps

Key Concepts
Interest Rate Swaps (pricing, Applications, Termination) Forward Rate Agreements & Similarity to Swaps Interest Rate Options Use & Pricing Caps, Floors, Collars Use & Pricing The Derivative Intermediary The Nature of Credit Risk & How It Is Managed General Awareness of Accounting, Regulatory & Tax Issues

Basic Concepts
Swaps = Privated Agreements Between 2 Parties to Exchange Cash Flows In the Future According to a Prearranged Formula = Portfolio of Forwards Contracts Comparative Advantage : Borrowing Fixed When it Wants Floating or Vice Versa Prime Rate (Reference Rate of Interest for Domestic Financial Mkt) LIBOR (Reference Rate for International Financial Mkts)

Example
Borrowing Rate:

Fixed
10% 11.2%

Floating
6-month LIBOR +0.3% 6-month LIBOR +1%

Company A Company B

B pays 1.2% more than A in Fixed & Only .7% in Floating B has Comparative Advantage in Floating Rate Mkt, A has Comparative Advantage in Fixed Rate Mkt 9.95% A Swap is Created: A B
10%

A pays 10%/year to Outside Lender, Receive 9.95%/year from B, Pays LIBOR to B

LIBOR B Borrows @ LIBOR+1% A Borrows @ Fixed 10% & Then Enter a Swap to Ensure that A Ends Up Floating Rate

LIBOR+1%

Example:

Company B Cash Flow: 1. Pay LIBOR+1% to Outside Lender 2. Receive LIBOR from A 3. Pays 9.95% to A Company A Net Cash Flow with Swap -10%+9.95%-(LIBOR) = -(LIBOR+0.05%) Without Swap, Company A Pays LIBOR+0.3%, Save 0.25% Company B Net Cash Flow with Swap -(LIBOR+1%)-9.95%+[LIBOR] = -10.95% Without Swap, Company A Pays 11.2%, Save 0.25% The Total Gain = [11.2%-10%] - [(LIBOR+1%) - (LIBOR+ 0.3% )] = 0.5%.

Role of Financial Intermediary (Net 0.1%) A: Cash Flow: (Net = LIBOR+0.1%, Save 0.2% ) Pay 10% to outside Lenders Receive 9.9%/annum from Financial Intermediary Pay LIBOR to Financial Intermediary
10% A 9.9%
LIBOR

Financial Institution

10.0%

B
LIBOR

LIBOR + 1%

B: Cash Flow: (Net = 11%, Save 0.2%) Pay LIBOR + 1% to Outside Lenders Receive LIBOR from Financial Intermediary Pay 10%/annum to Financial Intermediary