Chapter 25 Hedging with Financial Derivatives. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25-2 Chapter Preview We examine how markets

Chapter 25

Hedging with Financial Derivatives

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25-2

Chapter Preview

• We examine how markets for derivatives work and how the products are used by financial managers to reduce risk. Topics include:

– Hedging

– Forward Markets

– Financial Futures Markets

– Stock Index Futures

– Predicting the Fed Funds Rate


Hedging

• Hedging involves engaging in a financial transaction to offset an existing position to reduces or eliminate risk.

• Definitions– long position: an asset which is purchased

or owned

– short position: an asset which must be delivered at a future date, or an asset which is borrowed and sold, but must be replaced in the future


Forward Markets

• Forward contracts are agreements by two parties to engage in a financial transaction at a future point in time.

• The contract usually includes:

– The exact assets to be delivered by one party, including the location of delivery

– The price paid for the assets by the other party

– The date when the assets and cash will be exchanged


Forward Markets

• An Example of an Interest-Rate Contract– First National Bank agrees to deliver $5 million

in face value of 6% Treasury bonds maturing in 2027

– Rock Solid Insurance Company agrees to pay $5 million for the bonds

– FNB and Rock Solid agree to complete the transaction one year from today at the FNB headquarters in town.


Hedging— Long or Short?

• Quiz: Suppose you work for a business whose expects to receive $15 million from a client next year. You are worried that interest rates are going to fall next year as the US economy slows.

• How would you hedge against the interest rate risk your company faces?


Hedging— Long or Short?

A: You take a long position in bonds to offset your existing long position in cash—engage in a Forward Contract to buy $15 million in bonds at a fixed price.


Forward Markets

• Long Position– Agree to accept delivery of securities at future date

subject to terms of forward contract.

– Hedges by locking in future interest rate of funds coming in future, avoiding rate decreases.

• Short Position– Agree to deliver securities at future date subject to

terms of forward contract

– Hedges by reducing price risk from increases in interest rates if holding bonds.


Forward Markets

• Pros 1. Flexible

• Cons1. Lack of liquidity: hard to find a counter-party and thin

or non-existent secondary market

2. Subject to default risk—requires information to screen good from bad risk

3. Adverse selection and moral hazard problems.


Financial Futures Markets

Financial futures contracts are highly standardized forward contracts traded on organized exchanges subject to specific rules.

Traded on Exchanges– Developed by Chicago Board of Trade in 1975 to

solve liquidity and default problems of forward contracts. Global competition Regulated by CFTC.

Commodity Futures Options Trading, Inc. home page

http://www.cbot.com

http://www.cbot.com/



• Financial Futures Contracts Specify1. Type of security to be traded

2. Delivery Location

3. Amount to be Delivered

4. Date

5. Price

• Success of FFC

1. FFC are more liquid: standardized contracts that can be traded

2. Delivery of range of securities reduces the chance of corner.

3. Mark to market daily: avoids default risk

4. Don't have to deliver: cash netting of positions

http://www.cmegroup.com/trading/interest-rates/files/CL-100_TFDPBrochureFINAL.pdf

http://www.cbot.com/cbot/pub/page/0,3181,1059,00.html#M



• Delivery?1. If the position remains open until the delivery date, then shorts

must deliver and longs must accept delivery of underlying asset.

2. But before the delivery date, positions can be closed by taking the opposite position.

Delivery occurs in about 3% of T-bond and T-note contracts.

• Profit or Loss—note that when the price of the futures contract rises, investors with a long position gain, and short positions loose.

Commodity Futures Options Trading, Inc. home page

http://www.cbot.com

http://www.cbot.com/


30 Year U.S. Treasury Bonds Futures

Contract Size One U.S. Treasury bond having a face value at maturity of $100,000 or multiple thereof.

Deliverable Grades U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a maturity of at least 15 years from the first day

of the delivery month. The invoice price based on 6% standard.

Price Quote Points ($1,000) and thirty-seconds of a point; for example, 80-16 equals 80 16/32

Contract Months Mar, Jun, Sep, Dec

Last Trading Day Seventh business day preceding the last business day of the delivery month. Trading in expiring contracts closes at noon, Chicago time, on the last trading day.

Last Delivery Day Last business day of the delivery month.

Trading Hours Open Auction: 7:20 am - 2:00 pm, Chicago time, Monday - FridayElectronic: 6:00 pm - 4:00 pm, Chicago time, Sunday - FridayTrading in expiring contracts closes at noon, Chicago time, on the last trading day

Ticker Symbols Open Auction: US; Electronic: ZB

Daily Price Limit None

Margin Information Find information on margins requirements for the 30 Year U.S. Treasury Bond



• Trading– Your broker contacts floor trader who executes purchase or

sale of futures contract

– Trades are effectively with the exchange's clearinghouse acting as a counterparty in each trade. There must be a short position for each long position.

– All trades require a Margin Deposit.• Initial Margin is set by the exchange for each contract type

• End of trading day settlement price on contract is determined

• Each open account is marked to market. If P , long position profits and short position loses.



• Example of long position in January 8 crude oil at $90 per barrel (1,000 barrel contract). http://www.nymex.com/WS_spec.aspx

Date Settlement Price

Mark to Market Deposit or Withdrawl

Margin Balance

Nov. 1 $90 $7,763 $7,763

Nov. 2 $96.0 6.0 $6,000 $13,763

Nov. 3 $86.00 -10.0 -$10,000

+1,987

$3,763

$5,750

Nov. 29 $88.00 +2 $2,000 $7,750

Nov. 29 $88.00 Close with short

-7,750 0



• Pricing—

Arbitrage insures that settlement price on FFC and expected Spot Price should move together.

At Settlement Date, price of contract = price of the underlying asset delivered.


T-Bond Financial Futures

Contract for delivery of $100,000 Face Value of Treasury bond from WSJ 11/30/00. Contract specifies # of years to maturity left on the bond.

Open- opening price, 101*$1000 + (25/32)*$1000 = $101,781.25High/Low, Settle = final price of day.Open Interest = 151,728*$100,000 = $152 billion


Widely Traded Financial Futures Contracts


Widely Traded Financial Futures Contracts

esoteric futures


Predicting Fed Behavior Using Fed Funds Futures

• The Chicago Board of Trade lists future contracts on the Fed Fund rates.

• The long position (agrees to take delivery) will receive the interest that would be paid on $5 million of fed funds held for 30 days. The short position will deliver that amount.

• The price of the contract is 100 minus the average Fed Funds rate during the contract month.

• The Fed funds contract for Dec. (Exp. Date Jan 2, 2008) is currently selling for 95.78, so the average fed funds rate for the month of Dec. is expected to be 100-95.78, or 4.22%.


Fed Funds Futures

Trading Unit $5 million.

Price Quote 100 minus the average daily effective fed funds rate for the delivery month.

Settlement The contract is cash settled against the average daily effective fed funds rate for the delivery month.

Contract Months First 24 consecutive calendar months.

Last Trading Day Last business day of the delivery month.

Ticker Symbols Open Outcry: FF

Daily Price Limit None

Note that during an expiration month, the price for the current contract reflects the weighted average of two key components:

1. The realized overnight effective fed funds rates experienced to date2. The expected effective ffs rates to the end of the month.


Predicting Fed Behavior Using Fed Funds Futures

• The Fed funds contract for Dec. (Exp. Date Jan 2, 2008) is currently selling for 95.78, so the average fed funds rate for the month of Dec. is expected to be 100-95.78, or 4.22%.


Price of Fed Funds Futures

• Futures Price during the current month:

Where Daysn = number of days in the current month

j = number of days passed to date.

FERe is the expected Fed funds effective rate from j+1 to n.


Price of Fed Funds Futures

• Suppose on Nov. 9 the November contract was priced at 95.45, implying a rate of

4.56% = 100 - 95.44

The price of 95.44 reflects the average daily fed effective rate for the first 9 days of November, 4.468, and an implied expected fed effective rate for the remaining 21 days of November of 4.59%.

Current

Fed Funds = 4.56% = (9/30) x 4.468 + (21/30) x ??

Futures Rate


Predicting Fed Funds Rates

• Lets try to figure out the probability for a 50 basis point cut in the fed funds rate.

• The current Fed Fund rate target is 4.5%.

– QUIZ: If the Fed cuts the Fed Funds rate target by 50 basis points at its next meeting (Dec. 11), what would the average fed funds rate be for the month of Dec? What probability does the Fed Funds Mkt assign to a 50 basis point cut?


Predicting Fed Funds RatesLets try to figure out the probabilities for a 50 basis point cut.

• The Current Fed Fund rate targetfft = 4.5%.

• The Fed Funds futures price implies a rate of

iffr = 100 - 95.78 = 4.22%.

– The Implied Fed Funds futures rate (iffr) is what the futures market thinks the fed funds rate will be on average for the month of Dec.

• If the Fed changes the target rate after markets close on Dec. 11-- next FOMC meeting, then the first 11 days of Dec will have a rate of, ffr = fft = 4.5%.

• The last 20 days will have a rate of 4.0% with probability p, and a rate of 4.5% (no change) with probability (1 - p).



So the futures market thinks the average fed funds rate for the month of May will be:

iffr = oldfft x(11/31) + ffrex(20/31)

Where

ffre = newfft x p + oldfft x(1- p)



Prob is aprox (ffir - oldfft)/(newfft - oldfft)

= (4.22 - 4.5)/(4.0 - 4.5)

= (-.28)/(-.5) = 56%

http://stlouisfed.org/education/8fc/FC-econdata.html


Chapter Summary

• Hedging: the basic idea of entering into an offsetting contract to reduce or eliminate some type of risk was presented.

• Forward Markets: the basic idea of contracts in this highly specialized market, as well as a simple example of eliminating risk was presented.


Chapter Summary (cont.)

• Financial Futures Markets: these exchange traded markets were presented, as well as their advantages over forward contacts.

• Stock Index Futures: the specific application of stock index futures was presented, exploring their ability to reduce or eliminate risk for equity portfolios.

Documents

Chapter 25 Hedging with Financial Derivatives. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25-2 Chapter Preview We examine how markets