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F520 – Futures 1 Introduction to Financial Futures Markets F520 Asset Valuation and Strategy

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Introduction to Financial Futures Markets. F520 Asset Valuation and Strategy. Derivatives and Spot Prices. Derivative A security whose value depends on the values of other “underlying” securities (also know as “contingent claims”) - PowerPoint PPT Presentation

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F520 – Futures 1

Introduction to Financial Futures Markets

F520 Asset Valuation and Strategy

F520 – Futures 2

Derivatives and Spot Prices

• DerivativeA security whose value depends on the values of other “underlying” securities (also know as “contingent claims”)

• Spot PriceRate or price quoted for delivery in one or two business days from the date of the transaction

F520 – Futures 3

Derivative Securities

• Forward Contracts -- A forward market is a market in which a commodity/exchange rate for a future exchange of commodities or financial contracts is fixed today.

• Futures Contracts -- An agreement reached at one point in time calling for the delivery of some commodity at a specified later date at a price established at the time of contracting.

• Options Contracts -- The right (but not the obligation) to buy or sell a particular good at a specified price

• Swap Contract – An agreement where two parties agree to exchange periodic cash flows.

F520 – Futures 4

Roles of Derivative Markets • Risk management and risk transference: Firms can take on

projects which otherwise might be rejected due to their high levels of risk – Examples are expansion of facilities in other countries, your

choice of obtaining a fixed or adjustable rate mortgage, ect.– Due to the existence of speculators risk averse individuals are able

to transfer their risk more easily through a more active market • Derivatives provide another market that investors can use

to alter their risk exposure to an asset when new information is acquired. Competition between markets should increase efficiency of the financial markets

• Trading financial derivatives generates publicly observable prices

F520 – Futures 5

Hedging versus Speculating • Speculating -- In contrast to hedging, the purpose of speculation

is to profit from a change in a future rate or price. Speculating involves the assumption of additional risk

• Hedging -- Hedging is typically defined as utilizing financial instruments or contracts to reduce or eliminate the risk from future changes in rates or prices. The purpose of hedging a transaction is to replace an uncertain future cash flow, rate, or price, with a fixed and certain cash flow, rate, or price – Microhedging -- Using futures (forward) contract to hedge a

specific asset or liability

– Macrohedging -- Hedging the entire exposure of an FI

– Routine Hedging versus Selective Hedging • Routine Hedge -- Seeking to hedge all exposure

• Selective Hedge -- Only partially hedging the gap or hedging occasionally

F520 – Futures 6

Forward Contracts

• An agreement to buy or sell an asset at a specified future time at a specified price

• The specified price is the delivery price and it stays fixed

• The party which agrees to buy has a “long position”; the seller has a “short position”

• A rise in the spot price generates a profit for those holding a long position and a loss for those holding a short position. The net effect is a “zero sum” game.

• Cash flows are exchanged only on the maturity date.

F520 – Futures 7

0 1 2 3 Months

Spot

Price agreed / paidBetween buyer / sellerCommodity Delivered

0 1 2 3 Months

Forward

Price agreed between buyer / sellerTime of delivery / payment Agreed between buyer / seller(3 months)

Buyer pays forwardprice / seller delivers commodity

F520 – Futures 8

Key Elements of Forward Contracts

• Forward contracts involve no exchange of cash initially

• Forward contracts cannot be traded on an exchange

• Forward contracts typically are used in foreign exchange markets, but there is also a large forward market now in interest-rate contracts 

• Forwards have credit risk and are illiquid (do not trade frequently)

F520 – Futures 9

Pricing Forwards

• Risk-Free Arbitrage Opportunity arises when an investment is identified that requires no initial outlays yet guarantees nonnegative payoffs in the future

– Zero investment

– Zero risk

– Guaranteed return

F520 – Futures 10

Given information

• Following are current prices and information

– In the cash market Asset XYZ is selling for $100

– Asset XYZ pays the holder (with certainty) $12 per year in four quarterly payments of $3, and the next quarterly payment is 3 months from now.

– The forward contract requires delivery 3 months from now.

– The current three month interest rate at which funds can be loaned or borrowed is 8% per year (2 percent quarterly).

F520 – Futures 11

Assume the forward price is 107. Is this a fair price?

F520 – Futures 12

Assume the forward price is 107. Is this a fair price?

Cash-and-Carry Arbitrage TransactionPrices for Analysis

Spot price of asset 100 PForward price of asset 107 FFinancing Rate 2% rCash Flow Yield 3% y

t=0 Borrow $100 for one year at 2% 100 +PBuy one asset in the spot market -100 -PSell a forward contract for delivery of asset 0

Total Cash Flow 0

t=1 Receive cash flow 3 +yPDeliver the asset against the forward contract 107 +FRepay loan, including interest -102 -P(1+r)

Total Cash Flow 8 F-P(1+r-y)In equilibrium this will equal 0, not 8. F=P+P(r-y)

F520 – Futures 13

Assume the forward price is $92.Is this a fair price?

14

Assume the forward price is $92.Is this a fair price?

Cash-and-Carry Arbitrage TransactionPrices for Analysis

Spot price of asset 100 PForward price of asset 92 FFinancing Rate 2% rCash flow yield 3% y

t=0 Borrow $100 for one year at 2% 100 +PBuy asset in the spot market -100 -PSell a forward contract for delivery of asset 0

Total Cash Flow 0

t=1 Receive cash flow on asset 3 +yPDeliver share of asset against the forward contract 92 +FRepay loan, including interest -102 -P(1+r)

Total Cash Flow -7 F-P(1+r-y)In equilibrium this will equal 0, not -7. F=P+P(r-y)

F520 – Futures 15

What is the fair price?

• F = P + P(r - y)

• F = $100 + $100(0.02 - 0.03) = $99P is the current spot price r is the finance rate, risk-free ratey is the cash yield, such as dividends

F520 – Futures 16

Using a Forward Price of 99, we obtain the fair price.

Cash-and-Carry Stock Arbitrage TransactionPrices for Analysis

Spot price of asset 100 PForward price of asset 99 FFinancing Rate 2% rCash flow yield 3% y

t=0 Sell the asset and receive 100 +PInvest the proceeds in an interest bearing account -100 -PBuy a forward contract for delivery of asset 0

Total Cash Flow 0

t=1 Pay cash flow to person that we sold asset to -3 -yPBuy asset at the forward price -99 -FInterest earned plus original principal 102 +P(1+r)

Total Cash Flow 0 -F+P(1+r-y)In equilibrium this will equal 0. F=P+P(r-y)

F520 – Futures 17

F520 – Cha Futures 18

Besides interest, what factors should be considered in our carrying costs?

• Financing/Investment costs may differ (rb and rl)

Range of Prices

F = P + P(rb - y)

F = P + P(rl - y)

• Costs as a percent are deducted from y or added to r. Most common for commoditiesTransaction costsStorage cost Insurance costsTransportation costs

Range of Prices

Costs as a percent are deducted from y or added to r. Most common for commodities

F520 – Futures 19

What market imperfections cause our arbitrage pricing model to break down and provide us a range

of prices that we should consider? • Interim cash flows are not considered (not important for

commodities, but are for dividend paying stocks)

• Differences between the borrowing and lending rate

• Proceeds from short selling may not be available

• Deliverable asset and settlement date may be unknown (contract may be contingent or allow for a range of dates or more than one type of asset is allowed for delivery)

• Deliverable asset may be a basket of securities which may be difficult to track

• Differences in the tax treatment of securities and forwards/futures

F520 – Futures 20

Futures Contracts

• Like forwards, a financial futures contract is an agreement to buy or sell an asset at a specified time at a specified price

• But Futures are:– “Standardized” contracts

– Traded on an organized exchange which “guarantees” performance

– “Marked” to market daily

– Supported by a “margin account” (performance bond)

– Only rarely do buyers and sellers of futures contracts accept or make delivery. Most futures contracts are “offset” by taking an opposite position.

F520 – Futures 21

0 1 2 3 Months

Forward

Forward price agreed between buyer / sellerTime of delivery / payment agreed between buyer / seller(3 months)

Buyer pays forwardprice / seller delivers commodity

0 1 2 3 Months

Futures

Futures price agreed between buyer / sellerTime of delivery / payment agreed between buyer / seller(3 months)

Buyer pays futuresprice / seller delivers commodity

Marking to Market Daily

22

Net Payoff of a Futures Contract

Net Payoff

X–futures price

Pa

yoff

of F

utu

re (

$)

Security Price

0

Long Position in Futures Contract

Xfutures price

Pa

yoff

of F

utu

re (

$)

0

Security Price

Net Payoff

Short Position in Futures Contract

23

Exchange vs. Over-the-Counter Markets • Exchange Market is a market with a centralized exchange

and trading floor. Each futures exchange has a clearinghouse which guarantees contract performance to both parties

– Major products sold on Exchanges • Options

• Futures

• Over-the-Counter market is a market with out a centralized exchange or trading floor

– Major products sold Over-the-Counter • Options

• Forwards

• Swaps

F520 – Futures 24

Advantages of Over-the-Counter markets (relative to Exchanges)

• Exchange products may lack flexibility in the variety of instruments available and the horizon over which they trade.

• Exchanges are regulated by the government. While providing some benefits, it also restricts the kinds of trading that can be conducted.

• Complying with exchange rules and regulations may increase the cost of trading on exchanges

F520 – Futures 25

Disadvantages of Over-the-Counter Markets (relative to Exchanges)

• Credit risk -- both parties must trust each other to complete the contract as promised.

• Difficulty of finding a trading partner -- It may be difficult to find a counter party willing to buy (sell) a commodity at a specific day in the future

• Difficulty of fulfilling an obligation without actually completing delivery

26

Why Hedges are Imperfect • Amount -- Since exchange traded derivatives have specified contract

amounts, if the amount that we wish to hedge is not exactly equal to some multiple of the contract size, we must choose to either under-hedge or over-hedge.

• Delivery Date -- If the date of our future transaction does not perfectly match with the derivative delivery date, we must choose a contract with a longer delivery date and close it (Future and spot rates converge as they get closer to maturity, therefore the correlation between the future and spot rate is not equal to 1.) out early or an earlier delivery date and remain unhedged for a period of time.

• Basis Risk – When price movements on the futures contract and the underlying asset are not perfectly correlated, an imperfect hedge results, even though they are the same asset. This risk can be estimated by obtaining the correlation between the two prices from past price movements.

27

Why Hedges are Imperfect (cont.)• Cross-hedging Risk -- When we try to hedge an asset with a

similar, but not identical asset. For example, hedge platinum with a gold futures contract. While historically highly correlated, there is the risk that these past price patterns may not continue.Maturity of Contract Security -- For interest rate derivatives, if the item we are hedging does not have the same maturity of the item that we are using to hedge the instrument, we are exposed to risk. For short-term financial contracts we estimate the number of contracts needed as

$ amt. of security duration of asset.# of Contracts = ------------------ X ------------------------

$ amt. of contract dur of derivative sec

• Transaction Costs -- Commissions and margin requirements take up cash and make it difficult to get a perfect hedge.

F520 – Futures 28

Hedging Illustration

• Page 175 of text Assume that a gold mining company expects to sell 1,000 ounces of gold one week from now and that the management of a jewelry company plans to purchase 1,000 ounces of gold one week from now. The managers of both the gold mining company and the jewelry company want to lock in today’s price – that is, they both want to eliminate the price risk associated with gold one week from now. The cash price for gold is currently $352.40 per ounce. The cash price is also called the spot price. The futures price for gold is currently $397.80 per ounce. Each futures contract is for 100 ounces.

F520 – Futures 29

Devise the appropriate hedge

30

TABLE 10-2: How well did your hedge fair? Assume the following prices in one week – cash $304.20 and futures $349.60.Information at time of hedge (t=0)Cash Price 352.40$ Futures Price 397.80$ Number of ounces to hedge 1000Number of ounces per futures contract 100Number of futures contracts used 10 calcInformation at end of hedge (t=1 week)Cash Price 304.20$ Futures Price 349.60$

Short (Sell) Hedge by Gold Mining Company

Cash Market Futures Market BasisAt time hedge is placedValue of 1000 oz. @ spot Sell 10 futures contracts S 352.40$

1,000 * 352.40$ 352,400$ 10*100* 397.80$ 397,800$ F 397.80$ Basis (45.40)$

At time hedge is LiftedValue of 1000 oz. @ spot Buy 10 futures contracts S 304.20$

1,000 * 304.20$ 304,200$ +10*100* 349.60$ 349,600$ F 349.60$ Basis (45.40)$

Summary Gain (Loss) Cash Mkt. (48,200)$ Gain (Loss) Futures 48,200$

Net Position $0

31

TABLE 10-3: How well did your hedge fair? Assume the following prices in one week – cash $392.50 and futures $437.90.Information at time of hedge (t=0)Cash Price 352.40$ Futures Price 397.80$ Number of ounces to hedge 1000Number of ounces per futures contract 100Number of futures contracts used 10 calcInformation at end of hedge (t=1 week)Cash Price 392.50$ Futures Price 437.90$

Short (Sell) Hedge by Gold Mining Company

Cash Market Futures Market BasisAt time hedge is placedValue of 1000 oz. @ spot Sell 10 futures contracts S 352.40$

1,000 * 352.40$ 352,400$ 10*100* 397.80$ 397,800$ F 397.80$ Basis (45.40)$

At time hedge is LiftedValue of 1000 oz. @ spot Buy 10 futures contracts S 392.50$

1,000 * 392.50$ 392,500$ +10*100* 437.90$ 437,900$ F 437.90$ Basis (45.40)$

Summary Gain (Loss) Cash Mkt. 40,100$ Gain (Loss) Futures (40,100)$

Net Position $0

32

TABLE 10-4 (Basis Widens): How well did your hedge fair? Assume the following prices in one week – cash $304.20 and futures $385.80.Information at time of hedge (t=0)Cash Price 352.40$ Futures Price 397.80$ Number of ounces to hedge 1000Number of ounces per futures contract 100Number of futures contracts used 10 calcInformation at end of hedge (t=1 week)Cash Price 304.20$ Futures Price 385.80$

Short (Sell) Hedge by Gold Mining Company

Cash Market Futures Market BasisAt time hedge is placedValue of 1000 oz. @ spot Sell 10 futures contracts S 352.40$

1,000 * 352.40$ 352,400$ 10*100* 397.80$ 397,800$ F 397.80$ Basis (45.40)$

At time hedge is LiftedValue of 1000 oz. @ spot Buy 10 futures contracts S 304.20$

1,000 * 304.20$ 304,200$ +10*100* 385.80$ 385,800$ F 385.80$ Basis (81.60)$

Summary Gain (Loss) Cash Mkt. (48,200)$ Gain (Loss) Futures 12,000$

Net Position ($36,200)

33

TABLE 10-5 (Basis Widens): How well did your hedge fair? Assume the following prices in one week – cash $392.50 and futures $474.10.Information at time of hedge (t=0)Cash Price 352.40$ Futures Price 397.80$ Number of ounces to hedge 1000Number of ounces per futures contract 100Number of futures contracts used 10 calcInformation at end of hedge (t=1 week)Cash Price 392.50$ Futures Price 474.10$

Short (Sell) Hedge by Gold Mining Company

Cash Market Futures Market BasisAt time hedge is placedValue of 1000 oz. @ spot Sell 10 futures contracts S 352.40$

1,000 * 352.40$ 352,400$ 10*100* 397.80$ 397,800$ F 397.80$ Basis (45.40)$

At time hedge is LiftedValue of 1000 oz. @ spot Buy 10 futures contracts S 392.50$

1,000 * 392.50$ 392,500$ +10*100* 474.10$ 474,100$ F 474.10$ Basis (81.60)$

Summary Gain (Loss) Cash Mkt. 40,100$ Gain (Loss) Futures (76,300)$

Net Position ($36,200)

F520 – Futures 34

What would the hedge look like if we entered a forward contract?

Assume a forward price of $370 per ounce

F520 – Futures 35

Cross-Hedging Illustration

• Page 178 of textSuppose that a mining company on a far-away planet plans to sell 2,500 ounces of kryptonite one week from now and that a jewelry company plans to purchase the same amount of kryptonite in one week. Both parties want to hedge against price risk. However, kryptonite futures contracts are not currently traded. Both parties believe that there is a close relationship between the price of kryptonite and the price of gold. Specifically, both parties believe that the cash price of kryptonite will remain at 40% of the cash price of gold. The cash price of kryptonite is currently $140.96 per ounce and the cash price of gold is currently $352.40 per ounce. The futures price of gold is currently $397.80 per ounce.

F520 – Futures 36

Devise the appropriate cross-hedge

37

TABLE 10-6 (Basis&Ratio Stable): How well did your hedge fair?

Information at time of hedge (t=0) Information at end of hedge (t=1 week)Cash Price Kryptonite 140.96$ Cash Price Kryptonite 121.68$ Cash Price Gold 352.40$ Cash Price Gold 304.20$ Futures Price Gold 397.80$ Futures Price 349.60$ Number of ounces Kryptonite hedged 2500Number of ounces per futures contract 100 Ratio (t=0) Ratio (t=1)Number of futures contracts used 10 calc 40.00% 40.00%

Short (Sell) Hedge by Gold Mining Company

Cash Market Futures Market BasisAt time hedge is placedValue of 2500 oz. @ spot Sell 10 futures contracts S 352.40$

2,500 * 140.96$ 352,400$ 10*100* 397.80$ 397,800$ F 397.80$ Basis (45.40)$

At time hedge is LiftedValue of 2500 oz. @ spot Buy 10 futures contracts S 304.20$

2,500 * 121.68$ 304,200$ +10*100* 349.60$ 349,600$ F 349.60$ Basis (45.40)$

Summary Gain (Loss) Cash Mkt. (48,200)$ Gain (Loss) Futures 48,200$

Net Position $0

38

TABLE 10-7 (Basis Stable, Ratio Changes):How well did your hedge fair?

Information at time of hedge (t=0) Information at end of hedge (t=1 week)Cash Price Kryptonite 140.96$ Cash Price Kryptonite 112.00$ Cash Price Gold 352.40$ Cash Price Gold 304.20$ Futures Price Gold 397.80$ Futures Price 349.60$ Number of ounces Kryptonite hedged 2500Number of ounces per futures contract 100 Ratio (t=0) Ratio (t=1)Number of futures contracts used 10 calc 40.00% 36.82%

Short (Sell) Hedge by Gold Mining Company

Cash Market Futures Market BasisAt time hedge is placedValue of 2500 oz. @ spot Sell 10 futures contracts S 352.40$

2,500 * 140.96$ 352,400$ 10*100* 397.80$ 397,800$ F 397.80$ Basis (45.40)$

At time hedge is LiftedValue of 2500 oz. @ spot Buy 10 futures contracts S 304.20$

2,500 * 112.00$ 280,000$ +10*100* 349.60$ 349,600$ F 349.60$ Basis (45.40)$

Summary Gain (Loss) Cash Mkt. (72,400)$ Gain (Loss) Futures 48,200$

Net Position ($24,200)

39

TABLE 10-8 (Basis Stable, Ratio Changes):How well did your hedge fair?

Information at time of hedge (t=0) Information at end of hedge (t=1 week)Cash Price Kryptonite 140.96$ Cash Price Kryptonite 121.68$ Cash Price Gold 352.40$ Cash Price Gold 392.50$ Futures Price Gold 397.80$ Futures Price 437.90$ Number of ounces Kryptonite hedged 2500Number of ounces per futures contract 100 Ratio (t=0) Ratio (t=1)Number of futures contracts used 10 calc 40.00% 31.00%

Short (Sell) Hedge by Gold Mining Company

Cash Market Futures Market BasisAt time hedge is placedValue of 1000 oz. @ spot Sell 10 futures contracts S 352.40$

2,500 * 140.96$ 352,400$ 10*100* 397.80$ 397,800$ F 397.80$ Basis (45.40)$

At time hedge is LiftedValue of 1000 oz. @ spot Buy 10 futures contracts S 392.50$

2,500 * 121.68$ 304,200$ +10*100* 437.90$ 437,900$ F 437.90$ Basis (45.40)$

Summary Gain (Loss) Cash Mkt. (48,200)$ Gain (Loss) Futures (40,100)$

Net Position ($88,300)

F520 – Futures 40

COPPER 2,204.60 lbs per metric tonne

Cash Buyer 7,028.00 $3.19 price per pound

Cash Seller & Settlement

7,028.50 $3.19

3-months Buyer 7,059.50 $3.203-months Seller 7,060.00 $3.2015-months Buyer 7,235.00 $3.2815-months Seller 7,245.00 $3.29

Copper Cash and Forward PricesLME Official Prices (US$/tonne) for 13 September 2013

http://www.lme.com/metals/non-ferrous/copper/

F520 – Futures 41

|

http://www.cmegroup.com/trading/metals/base/copper_quotes_settlements_futures.html

Copper Futures, price per pound, 25,000 pounds per contractDaily Settlements for Copper Future Futures (FINAL) - Trade Date: 09/13/2013

Month Open High Low Last Change SettleEstimatedVolume

Prior DayOpen Interest

SEP 13 3.2010 3.2300 3.1950 3.2100 -.0055 3.2070 597 2,244

OCT 13 3.2060 3.2255 3.1905 3.2040 -.0060 3.2030 366 2,086

NOV 13 3.2015 3.2200 3.1910 - -.0065 3.2035 138 1,577

DEC 13 3.2000 3.2270 3.1905 3.2070 -.0065 3.2035 39,396 106,197

JAN 14 3.2030 3.2100 3.1980 - -.0065 3.2075 24 1,619

FEB 14 3.2090 3.2120 3.2020 - -.0060 3.2110 30 1,108

MAR 14 3.2350 3.2355 3.2040 3.2040 -.0070 3.2150 3,979 25,423

APR 14 3.2115 3.2115 3.2115 - -.0070 3.2190 4 553

MAY 14 3.2255 3.2255 3.2150 - -.0065 3.2230 238 2,739

JUN 14 3.2200 3.2200 3.2200 - -.0065 3.2275 4 620

JLY 14 - 3.2505B - - -.0065 3.2315 27 1,628

AUG 14 - - - - -.0065 3.2360 1 649

SEP 14 3.2405 3.2475 3.2405 - -.0065 3.2405 6 1,195

F520 – Futures 42

Contract Month

Product Code

First TradeLast Trade

Settlement

First HoldingLast Holding

First PositionLast Position

First NoticeLast Notice

First DeliveryLast Delivery

SEP 2013 HGU1309/20/201009/26/2013

09/26/2013--

08/29/201309/27/2013

08/30/201309/27/2013

09/03/201309/30/2013

OCT 2013 HGV1310/31/201110/29/2013

10/29/2013--

09/27/201310/30/2013

09/30/201310/30/2013

10/01/201310/31/2013

NOV 2013 HGX1311/30/201111/26/2013

11/26/2013--

10/30/201311/27/2013

10/31/201311/27/2013

11/01/201311/29/2013

DEC 2013 HGZ1309/20/201012/27/2013

12/27/2013--

11/27/201312/30/2013

11/29/201312/30/2013

12/02/201312/31/2013

Product Calendar for Copper Futures

F520 – Futures 43

What is the estimated forward price?• Dividend: 0.00% on a commodity

• Rate: 0.00% to 0.30% for 3 month to 1 year ratehttp://finance.yahoo.com/bonds

• F = P + P(r - y)

• F = 3.19 + 3.19 (r - 0.00)*(month/12)

Rate = 0.00% Rate = 0.30%Forward Months Forward Months Forward Months Forward Months

3.19 1 3.19 7 3.19 1 3.20 73.19 2 3.19 8 3.19 2 3.20 83.19 3 3.19 9 3.19 3 3.20 93.19 4 3.19 10 3.19 4 3.20 103.19 5 3.19 11 3.19 5 3.20 113.19 6 3.19 12 3.19 6 3.20 12

F520 – Futures 44

Using Futures to Replicate the Returns of a Portfolio

• Futures Price is for delivery in 1 year

• F = P + P(r - y)P is the current spot price –

Assume S&P500 is 1,000and I buy 1000 contracts (my total exposure is $1 million)

r is the finance rate, risk-free rate of 4%y is the cash yield, such as dividends of 2%

• Futures Price (based on fair value formula)F = $1,000 + $1,000(0.04 - 0.02)

= $1,020

F520 – Futures 45

S&P500 Stocks

• Assume I buy the stocks representing the S&P500 Index and hold it to its delivery date in 1 year. What is my dollar return if in 1 year the spot price is $1100? Note that the spot price and futures price should converge on the delivery date since both have 2 days to settlement.(P1 - P0 + D) ($1.1m-$1m+$1m*.02) = $120,000

F520 - Futures 46

S&P500 Futures• How many Futures contracts do I need

Information from earlier

– Current spot price – on S&P500 is $1,000

– Current futures price _ S&P futures is $1,020an emini S&P futures controls 50 S&P indexesa S&P futures controls 250 S&P indexes

– The total exposure I want is $1 million

• The calculation for the number of contracts is similar to a cross-hedge. # futures = Market value of portfolio / Cash Value of 1 future# futures = $1 mil / $1000*50 using the emini# futures = 20 contracts

47

• Assume I buy 20 Futures contract and hold them till the delivery date in 1 year. What is my return if on the date of delivery the futures price is $1100?(P1 - P0) ($1100-$1020)*50*20 = $80,000

• How can the return on a futures replicate the return on holding the S&P 500 contract?

• What were the cash outflows on the futures contract at t=0?Nothing!

So what should I do with the money? So far I have nothing invested in the futures contract. Remember a margin simply means I have funds accessible to my broker in a liquid account (assume a money market earning the risk-free return) Invest the full $1 million in the risk-free rate (this is far more than I need for the margin), earning 4% in our example.

Assume I have the same $1 million that I assumed for the spot purchase.$1 mil *.04 = $40,000 return on investment in risk-free rate(This underestimates my return since I did not take into account that the futures price is increasing and marking to market will add to the amount of funds in my investment account that earns the risk-free rate.)

So what is my return on the Futures in the S&P500 and the risk free portfolio?$40,000 + $80,000 = $120,000 on my original $1 million of investment or 12%

• Note, both made $120,000 on my investment. Both required $1 million as the initial investment. Therefore, the futures portfolio can replicate the expected return in the underlying asset.

F520 – Futures 48

Adjusting for the Hedge Ratio

• What would I do if the portfolio had a beta of 1.2. This is greater risk than the S&P500 contract. How could I mimic the expected return on this portfolio?

# futures = ($1 mil / $1000*50 using the emini)*1.2 # futures = 20*1.2 = 24 contracts

• Our expected dollar return(P1 - P0) ($1100-$1020)*50*24 = $96,000 from the futures $1 mil *.04 = $40,000 from the risk free return $40,000 + $96,000 = $136,000

• Since this is a cross-hedge (portfolio beta of 1.2 and S&P500 futures beta of 1.0) the hedge will not be perfect. This is an approximate number of contracts.

F520 – Futures 49

http://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500_quotes_settlements_futures.html

S&P 500 (^GSPC)-SNP 1,687.99 4.57(0.27%) Sep 13, 2013

http://finance.yahoo.com/q?s=^GSPC&ql=1

Month Open High Low Last Change SettleEstimatedVolume

Prior DayOpen Interest

SEP 13 1684.75 1690.50 1680.50 1689.50 +3.50 1688.50 756,480 2,261,091

DEC 13 1678.25 1683.75 1674.00 1682.75 +3.75 1682.00 1,162,403 837,087

MAR 14 1669.00 1676.75B 1668.00A 1676.50A +3.75 1675.50 105 2,953

JUN 14 1665.00 1668.75B 1661.50 1668.75B +3.75 1669.25 8 441

SEP 14 - 1658.75B 1656.75A 1658.75B +3.75 1662.25 0 6

Total 1,918,996 3,101,578

Daily Settlements for E-mini S&P 500 Future Futures (FINAL) Trade Date: 09/13/2013

F520 – Futures 50

What is the estimated forward price?• Dividend: 2.04%

http://finance.yahoo.com/q?s=SPY&ql=0

• Rate: 0.00%http://finance.yahoo.com/bonds

• F = P + P(r - y)

• F = 1,687.99 + 1,687.99 (0.00 - 0.0204)*(month/12)

Rate = 0.00% Rate = 0.30%Forward Months Forward Months Forward Months Forward Months1,685.12 1 1,667.90 7 1,685.54 1 1,670.86 71,682.25 2 1,665.03 8 1,683.09 2 1,668.41 81,679.38 3 1,662.16 9 1,680.65 3 1,665.96 91,676.51 4 1,659.29 10 1,678.20 4 1,663.51 101,673.64 5 1,656.42 11 1,675.75 5 1,661.07 111,670.77 6 1,653.56 12 1,673.30 6 1,658.62 12

F520 – Futures 51

US Treasury Bonds Rates http://finance.yahoo.com/bondsMaturity Yield Yesterday Last Week Last Month3 Month 0.00 0.00 0.00 0.02 6 Month 0.01 0.01 0.04 0.05 2 Year 0.43 0.44 0.45 0.32 3 Year 0.86 0.88 0.88 0.67 5 Year 1.69 1.71 1.75 1.47 10 Year 2.88 2.90 2.93 2.71 30 Year 3.83 3.85 3.86 3.75

Category: Large Blend

Fund Family: SPDR State Street Global AdvisorsNet Assets: 135.73BYield: 2.04%Fund Inception Date: Jan 22, 1993Legal Type: Exchange Traded Fund

http://finance.yahoo.com/q/pr?s=SPY+Profile

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