Capital Markets

Salaar - Finance

Capital MarketsCapital Markets

Spring Semester 2010Spring Semester 2010

Lahore School of EconomicsLahore School of Economics

Salaar farooq – Assistant Professor

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Lecture

Derivatives:Derivatives:FuturesFutures

Chapter 20 Chapter 20

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Futures - Ch 20Learning Objectives

Understanding Futures Contracts

Forwards contracts

Structure of Futures Markets

Mechanics of trading

Using Futures for Hedging & Speculation

Futures pricing

Summary

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Derivative: Futures ContractWhat is it?….

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Derivative: FuturesWhat is it?….

An agreement which requires the parties to buy/sell an asset…

at a specified price… a specified amount…

at a specified date in the future.

It creates an OBLIGATION for both parties to deliver!

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FuturesPurpose….

Powerful tool for…?

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FuturesPurpose….

Powerful tool for…

Hedging (shifting) – Price Risk

Speculation

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FuturesTypes….

2 Major categories…

Commodity Futures?

Financial Futures

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FuturesTypes….

Commodity Futures…

Agricultural commodities (grains, livestock, corn)

Imported foodstuff (sugar, coffee)

Industrial (uranium, gold)

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FuturesTypes….

2 Major categories…

Commodity Futures

Financial Futures?

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FuturesTypes….

Financial Futures…

Based on a financial instrument or index

1. Stock index futures

2. Interest rate futures

3. Currency futures

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FuturesMechanics of Trading Futures….

A contract between a Buyer/seller & an established exchange where the buyer agrees to TAKE OR a seller agrees to MAKE delivery of something at a fixed price & date & amount

Futures Price

Price at which the agreement is made

Settlement/delivery date

Date at which the parties must transact in the future

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FuturesMechanics of Trading Futures….

Example:

Suppose a Futures contract on 1 unit of asset A trades on an exchange, with a 3 months settlement from now.

Faraz buys this contract & Kashif sells this contract at a price of $100.

At the settlement ?

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FuturesMechanics of Trading Futures….

Example:

Suppose a Futures contract on 1 unit of asset A trades on an exchange, with a 3 months settlement from now.

Faraz buys this contract & Kashif sells this contract at a price of $100.

At the settlement date after 3 months, Kashif will deliver asset A to Faraz. Faraz at this time will pay Kashif $100.

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FuturesLiquidating positions….

Most futures have settlements in 3 months standardized for…

1. March

2. June

3. September

4. December

This is when the contract stops trading. (usually 3rd wed)

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FuturesTo Settle a future….

The party has 2 choices

?

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FuturesTo Settle a future….

The party has 2 choices

Liquidating prior to settlement date

Done by taking an off-setting position in same contract

Buyer = sells, & seller = buys

Waiting till settlement date

Taking or making delivery of the underlying

CASH: settling with cash (ED)

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Futures Exchange Clearinghouse….

2 main Purposes

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FuturesExchange Clearinghouse….

2 main Purposes

1. Guarantees performance of parties

Done by the exchange taking an opposite position.

After the deal, exchange becomes the buyer or seller in ALL transactions

2. Allows & Manages contracts settlement prior to expiration

Contract farthest away from settlement

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FuturesMargin Requirements….

Initial Margin

Maintenance Margin

Variation Margin

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FuturesMargin Requirements….

Initial Margin

Exchange requires a minimum deposit per contract

Maintenance Margin

Minimum level of equity required by the investor at all times

Variation Margin

Amount necessary to bring the equity back to initial margin

NOTE: after 24 Hours, position is closed if investor fails to fulfill variation margin

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FuturesMargin difference b/w….

Securities & Futures

Securities

Futures

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FuturesDaily price Limits

?

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FuturesDaily price Limits

Futures is a future price

Based on expectations of future

New info released can cause huge volatility

The exchange has the right to set daily price limits (min & max) to promote price stability – so information can be absorbed

Trading does not stop – just continues within the limit!

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FuturesFutures VS Forwards

Forward?

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FuturesFutures VS Forwards

Forward

Similar to future contract:

Agreement to buy/sell an asset at a specified price, amount and time period

Difference (forwards)?

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FuturesFutures VS Forwards

Forward

Similar to future contract:

Agreement to buy/sell an asset at a specified price, amount and time period

Difference (forwards)

1. Non-standardized (OTC)

2. No clearinghouse involved

3. No secondary markets

4. Intended for actual delivery (futures only have approx 2% delivery rate)

5. Not Marked to Market (no margin required)

6. Exposed to CREDIT RISK b/w parties

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FuturesRisk & Return Characteristics

Long Futures

Short Futures

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FuturesRisk & Return Characteristics

Long Futures

When an investor buys a futures contract: profits if Px rises

Short Futures

When an investor sells a futures contract: profits if Px declines

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FuturesLeveraging aspects of Futures

To take a position in Futures

Only initial margin is required: creates leverage

P/L

Is based on the contract size causing magnified P & L

Why leverage?

Otherwise cost to hedge against price risk would be too high!

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing FuturesStarts with an investor making DECISION

b/w

LONG NOW? (SPOT)

OR

LONG LATER? (FUTURES)

• Based on C/F impact of decision• Assumes no arbitrage

Commodities Pricing

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

IF,

»Future Price = Spot Price

Fo = So

Then,

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

If Fo = So

+Fo

+So

TVM Lost

TVM Gain

Therefore,

Arbitrage possible

C/F Now

C/F Later

Better Off

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

We ADD Time Value of Money to Futures Price

Expressed as,

Fo = So + TVM,

Same as:

Fo = So . ( 1+r)n

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

Now if:

Fo = So + TVM,

Or

Fo = So . ( 1+r)n

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

Now if: Fo = So + TVM, Fo = So . ( 1+r)n

+Fo

+So

TVM Lost

TVM Gain

Storage paid

NO Storage paid

C/F OUT

NO C/F

Arbitrage possibleStillBetter Off

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

We ADD Storage costs to Futures Price

Expressed as,

Fo = So + TVM + Storage costs

Same as:

Fo = So . ( 1+r)n + q

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

Also called Cost of Carry

Fo = So + TVM + Storage costs

Future price,

Fo = So . ( 1+r)n + q

TVM + Storage costs = Cost of carry

Center for Research in Economics and BusinessCenter for Research in Economics and Business

Pricing Futures

NOTE: Other costs may be added as appropriate(e.g Gold Khi Landed)

Fo = So . ( 1+r)n + q + … +

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FuturesPrice Convergence at Delivery

At the Delivery date:

Futures price MUST = Cash Mkt price

Thus,

As delivery date approaches…

Futures Px converges to the cash price

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FuturesHedging with Futures

Hedging

Using futures as a substitute for a transaction in cash market

1. Hedge position LOCKS in a value for cash position

2. Loss in one is offset by gain in the other

NOTE:

When the P&L are equal, its called a PERFECT HEDGE

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FuturesRisks associated with Hedging

Basis Risk

Basis = Cash Px – Futures Price

The difference b/w the Cash Px & Futures Px.

As long as they move together, there is no basis risk.

But if the Basis changes after initiating a Hedge, the position is exposed to a Basis Risk.

Thus…

a hedge becomes a substitute for basis risk instead of price risk!

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FuturesRisks associated with Hedging

Basis Risk

Basis = Cash Px – Futures Price

This difference should equal the “Carry”

So, if carry changes, basis also changes & hedge is affected!

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FuturesHedging

Short Hedge

Used to protect against a decline in future cash Price of asset

The hedger sells a futures contract (agrees to MAKE delivery)

also called Sell Hedge

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FuturesHedging

Long Hedge

Used to protect against a Rise in future cash price of asset

The hedger buys a futures contract (agrees to TAKE delivery)

also called Buy Hedge

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FuturesRole of Futures in Financial Mkts

1. Allows price risk transfer

2. Allows an alternative to cash markets (for taking positions)

3. Allows portfolio changes with lower costs

4. Improves liquidity

5. Improves efficiency

6. Allows leverage ability

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Futures - Ch 10Learning Summary

Understanding Futures Contracts (price risk transfer)

Forwards contracts (OTC like futures)

Structure of Futures Markets (Floor brokers, locals)

Mechanics of trading

Using Futures for Hedging & Speculation

Futures pricing (cash px, cash yield & carry)

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Finished: Futures