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Instructor Notes.doc.doc Instructor Notes.doc.doc Document Transcript

  • Chapter 16 Futures Contracts Slides 16-1 Fundamentals of Investments 16-2 Futures Contracts 16-3 Futures Contracts Basics 16-4 Futures Contracts Basics 16-5 Futures Contracts Basics 16-6 Futures Contracts Basics 16-7 Futures Contracts Basics 16-8 Futures Contracts Basics 16-9 Work the Web 16-10 Work the Web 16-11 Why Futures? 16-12 Speculating with Futures 16-13 Hedging with Futures 16-14 Work the Web 16-15 Futures Trading Accounts 16-16 Futures Trading Accounts 16-17 Work the Web 16-18 Cash Prices 16-19 Cash Prices 16-20 Cash Prices 16-21 Cash-Futures Arbitrage 16-22 Cash-Futures Arbitrage 16-23 Spot-Futures Parity 16-24 More on Spot-Futures Parity 16-25 Stock Index Futures 16-26 Index Arbitrage 16-27 Index Arbitrage 16-28 Work the Web 16-29 Hedging Stock Market Risk with Futures 16-30 Hedging Stock Market Risk with Futures 16-31 Hedging Interest Rate Risk with Futures 16-32 Hedging Interest Rate Risk with Futures 16-33 Hedging Interest Rate Risk with Futures 16-34 Futures Contract Delivery Options 16-35 Chapter Review 16-36 Chapter Review 16-37 Chapter Review
  • A-135 Chapter 16 Chapter Organization 16.1 Futures Contracts Basics A. Modern History of Futures Trading B. Futures Contract Features C. Futures Prices 16.2 Why Futures? A. Speculating with Futures B. Hedging with Futures 16.3 Futures Trading Accounts 16.4 Cash Prices versus Futures Prices A. Cash Prices B. Cash-Futures Arbitrage C. Spot-Futures Parity D. More on Spot-Futures Parity 16.5 Stock Index Futures A. Basics of Stock Index Futures B. Index Arbitrage C. Hedging Stock Market Risk with Futures D. Hedging Interest Rate Risk with Futures E. Futures Contract Delivery Options 16.6 Summary and Conclusions Selected Web Sites http://www.cbot.com http://www.nymex.com http://www.cme.com http://www.kcbt.com http://www.nybot.com http://www.futuresworld.com http://futures.pcquote.com http://www.thefinancials.com http://www.futurewisetrading.com http://www.usafutures.com http://www.investorlinks.com http://www.programtrading.com
  • Futures Contracts A-136 Annotated Chapter Outline 16.1 Futures Contracts Basics Forward Contract: Agreement between a buyer and a seller, who both commit to a transaction at a future date at a price set by negotiation today. Futures Contract: Contract between a seller and a buyer specifying a commodity or financial instrument to be delivered and paid for at contract maturity. Futures contracts are managed through an organized futures exchange. Futures Price: Price negotiated by buyer and seller at which the underlying commodity or financial instrument will be delivered and paid for to fulfill the obligations of a futures contract. While a forward contract can be struck between any two parties, a futures contract must be managed through an organized futures exchange. A. Modern History of Futures Trading Futures trading dates back to 17th century Japan, where rice futures were traded. The CBOT is the oldest U.S. exchange, established in 1848. Only commodity futures were traded for over 100 years, until financial futures appeared in the 1970s. The first were currency contracts, followed by interest rate futures, and then stock index futures. Financial futures now constitute the bulk of all futures trading. Current Topics: "CBOT Votes to Link with Electronic Rival Eurex," by Peter A. McKay, The Wall Street Journal, June 25, 1999. After much discussion, the CBOT overwhelmingly approved linking with the rival electronic commodities exchange Eurex. The CBOT view this as "a step into a new era of electronic trading." CBOT and Eurex contracts will begin trading on the same screens around the middle of 2000. Several CBOT members said they reluctantly supported the vote because they needed to develop an electronic strategy to quickly counter competitors' efforts. Brokers stated, even though open outcry will go away completely, electronic trading is going to be the wave of the future. Current Topics: "Average Lease Price of a CBOT Seat Hit Record of $10,355 a Month in June," by Peter A. McKay, The Wall Street Journal, July 6, 1999. The average lease price for a seat on the CBOT hit a new high of $10,355 a month. The price of owning a seat at $620,000, remained well below it's peak of $857,500. An interesting twist is that CBOT seats carry CBOE trading rights, and it’s the CBOE where the profit opportunities currently exist. In fact, in the past, "seat arbitrage" took place, where option traders would sell CBOE seats to buy
  • A-137 Chapter 16 less expensive CBOT seats. Also, the leasing, rather than purchasing, may represent a "wait-and-see" attitude about the CBOT's future. B. Futures Contract Features Futures contracts are derivative securities and are a zero-sum game. Futures contracts must stipulate the following five contract terms: ♦ The identity of the underlying commodity or financial instrument. ♦ The futures contract size. ♦ The futures maturity date, also called the expiration date. ♦ The delivery or settlement procedure. ♦ The futures price. Specific delivery procedures are set by the futures exchange and may vary, but normally the delivery procedures are selected for convenience and low cost. C. Futures Prices The largest volume of futures trading in the U.S. takes place at the CBOT, about 1/2 of all domestic futures trading. Four of the six contract terms are specified in the WSJ futures price listing: identity of commodity or financial instrument, contract size, maturity date, and futures price. 16.2Why Futures? Futures contracts are used for hedging and speculation. Hedgers transfer price risk to speculators, while speculators absorb price risk. Hedging and speculation are complimentary activities. D. Speculating with Futures Long Position: In futures jargon, refers to the contract buyer. A long position profits from a futures price increase. Short Position: In futures jargon, refers to the seller. A short position profits from a futures price decrease. Speculator: Trader who accepts price risk by going long or short to bet on the future direction of prices. If you think the price of a commodity or financial instrument is priced too low relative to what they will be in the future, then you can speculate by buying the futures. If you think it is priced too high, then you can speculate by selling the futures. A speculator accepts price risk in order to bet on the direction of prices by going long or short.
  • Futures Contracts A-138 E. Hedging with Futures Hedger: Trader who seeks to transfer price risk by taking a futures position opposite to an existing position in the underlying commodity or financial instrument. Short Hedge: Sale of futures to offset potential losses from falling prices. Long Hedge: Purchase of futures to offset potential losses from rising prices. As a hedger, one seeks to transfer price risk by taking a futures position opposite to an existing position in the underlying commodity or financial instrument. If you are long in the underlying commodity (because you own it); you offset the risk in your long position with a short position in futures. If prices rise, you have a gain on the underlying commodity and a loss in the futures position. If prices decrease, you have a loss in the underlying commodity and a gain in the futures position. The gains and losses offset each other and you have greatly reduced or eliminated the possibility of a loss in the underlying commodity position. The trade-off is that if prices rise, you have given up the gain in the commodity by taking a loss in futures. This is an example of a short hedge. If you do not own the underlying commodity, but need to acquire it in the future, you can lock in the price you will pay in the future by buying the futures contract. You are short the underlying commodity because you must buy it in the future, so you offset the short position with a long position in futures. This is an example of a long hedge. 16.3Futures Trading Accounts Futures Margin: Deposit of funds in a futures trading account dedicated to covering potential losses from an outstanding futures position. Initial Margin: Amount required when a futures contract is first bought or sold. Initial margin varies with the type and size of a contract, but it is the same for long and short futures positions. Marking-to-Market: In futures trading accounts, the process whereby gains and losses on outstanding futures positions are recognized on a daily basis. Maintenance Margin: The minimum margin level required in a futures trading account at all times. Margin Call: Notification to increase the margin level in a trading account.
  • A-139 Chapter 16 Reverse Trade: A trade that closes out a previously established futures position by taking the opposite position. A futures exchange allows only exchange members to trade on the exchange. Members may be firms, or individuals trading for their own accounts, or they may be brokerage firms handling trades for customers. The three essential things to know about a futures trading account are: ♦ Margin is required. ♦ Futures accounts are market-to-market daily. ♦ A futures position can be closed out any time by a reverse trade. 16.4Cash Prices versus Futures Prices A. Cash Prices Cash Price: Price of a commodity or financial instrument for current delivery. Also called the spot price. Cash Market: Market in which commodities or financial instruments are traded for essentially immediate delivery. Also called the spot market. B. Cash-Futures Arbitrage Cash-Futures Arbitrage: Strategy for earning risk-free profits from an unusually large difference between cash and futures prices. Basis: The difference between the cash price and the futures price for a commodity, i.e., basis = cash price - futures price. Carrying-Charge Market: The case where the futures price is greater than the cash price; i.e., the basis is negative. Inverted Market: The case where the futures price is less than the cash price; i.e., the basis is positive. Earning risk-free profits from an unusual difference between cash and futures prices is called cash-futures arbitrage. In a competitive market, cash-futures arbitrage yields very slim profits, if any at all. The difference between the cash price and the futures price is the basis. There are several economic factors that justify the basis, including storage costs, transportation costs, and seasonal price fluctuations. C. Spot-Futures Parity Spot-Futures Parity: The relationship between spot prices and futures prices that holds in the absence of arbitrage opportunities.
  • Futures Contracts A-140 The futures price is simply the future value of the spot price, compounded at the risk-free rate. It is shown as: F = S(1 + r)T D. More on Spot-Futures Parity The previous spot-futures parity assumed no dividends. If we include dividends and denote the dividend yield by d, we have: F = S(1 + r - d)T 16.5 Stock Index Futures A. Basics of Stock Index Futures The buyer of a stock index futures contract has agreed to purchase the index at the futures price, and the seller has agreed to sell the index at the futures price. The futures price is normally 100 times the index, although the S&P 500 is 250 times the index. If the price rises, the buyer profits from the increase and the seller loses money. If the price goes down, the reverse occurs. A. Index Arbitrage Index Arbitrage: Strategy of monitoring the futures price on a stock index and the level of the underlying index to exploit deviations from parity. Program Trading: Computer-assisted monitoring of relative prices of financial assets; it sometimes includes computer submission of buy and sell orders to exploit perceived arbitrage opportunities. Spot-futures parity is the basis for index arbitrage—monitoring the futures price on a stock index along with the level of the underlying index. The trader attempts to take advantage of violations of parity. If the trader sees the futures price is too low, he/she sells the index and buys the futures contract. Many times program trading is used to take advantage of index arbitrage. Computers are used to spot the arbitrage opportunities, and then computers again quickly submit the buy and sell orders. Program trading accounts for about 15% of all NYSE trading volume, and 20% of all program trading involves stock- index arbitrage. The NYSE defines program trading as the simultaneous purchase or sale of at least 15 stocks with a total value of $1 million or more. Related to index arbitrage and futures and options trading is the triple witching hour. This is when S&P 500 futures contracts, options on the S&P index, and
  • A-141 Chapter 16 various stock options all expire at the same time, four months a year on the third Friday of the month. Since all three types of contracts expire at the same time, unusual price behavior sometimes occurs. Enormous buying and selling occur as large positions are closed out due to large-scale index arbitrage and program trading. Large price swings and increased volatility are common, so several exchange rules have been adopted to control this problem. B. Hedging Stock Market Risk with Futures Cross-Hedge: Hedging a particular spot position with futures contracts on a related—but not identical—commodity or financial instrument. A portfolio manager may want to protect the value of a portfolio from the risk of an adverse movement of the market. To do this the manager would establish a short hedge using futures to protect the portfolio against a fall in prices during the life of the futures contract. There are three basic inputs required to calculate the number of stock index futures contracts needed to hedge a stock portfolio: ♦ The current value of your stock portfolio. ♦ The beta of your stock portfolio. ♦ The contract value of the index futures contract used for hedging. To calculate: Number of contracts = (ßp x Vp) / VF C. Hedging Interest Rate Risk with Futures Hedging a bond portfolio is similar to a stock portfolio, but the goal is to protect against changing interest rates. To protect against rising interest rates (and a fall in the value of the bond portfolio), establish a short hedge in futures. The formula is: DP x VP No. of contracts = DF x VF To estimate the duration of the futures contract: DF = DU + MF D. Futures Contract Delivery Options Cheapest-to-Deliver Option: Seller's option to deliver the cheapest instrument when a futures contract allows several instruments for delivery. For example, U.S. Treasury note futures allow delivery of any Treasury note with a maturity between 6½ and 10 years.
  • Futures Contracts A-142 Many futures contracts have a delivery option whereby the seller can choose among several different grades of the underlying commodity or instrument when fulfilling delivery requirements. The cheapest to deliver option, or quality option, allows the seller to deliver the cheapest instrument among the specified alternatives. A hedge will have to be monitored regularly to ensure it reflects the issue most likely to be delivered. 16.6 Summary and Conclusions Lecture Tip: Like options, futures contracts is a topic that tends to greatly interest students. The Stock-Trak exercises are one way to allow students to trade futures and become more familiar with their characteristics. Another project is to have students select a futures contract in each of three areas: commodity, stock index futures, and an interest rate futures. Have them predict the direction of pricing for each of these futures and buy and/or sell the futures contract, speculating on the direction of the price movements. Alternatively, have the instructor set up initial stock and bond portfolios. Then require students to set up a hedge, using futures contracts for each of the portfolios. Do this early enough in the semester so that the students can track the progress of their hedge on the changing value of the portfolios. This will give them a "real-life" example of how difficult actual hedging can be.