Chapter 20 Futures Forwards and Swap Markets 2015

Chapter 20 Futures, Forwards, and Swap Markets © 2015 Mc. Graw-Hill Ryerson Limited

Chapter Summary • Objective: To describe the workings of futures markets and the mechanics of trading in these markets. • • Trading mechanics Futures pricing Different types of futures contracts Swaps © 2015 Mc. Graw-Hill Ryerson Limited 20 -2

Futures and Forwards • • • Forward - an agreement calling for a future delivery of an asset at an agreed-upon price Futures - similar to forward but feature formalized and standardized characteristics Key difference in futures • • Secondary trading - liquidity Marked to market Standardized contract units Clearinghouse warrants performance © 2015 Mc. Graw-Hill Ryerson Limited 20 -3

Key Terms for Futures Contracts • • Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot © 2015 Mc. Graw-Hill Ryerson Limited 20 -4

Figure 20. 1 Prices for Canadian Commodity Futures, June 6, 2013 © 2015 Mc. Graw-Hill Ryerson Limited 20 -5

Figure 20. 2 Profits to Buyers and Sellers of Futures and Option Contracts © 2015 Mc. Graw-Hill Ryerson Limited 20 -6

Types of Contracts • • Agricultural commodities Metals and minerals (including energy contracts) Foreign currencies Financial futures Interest rate futures Stock index futures © 2015 Mc. Graw-Hill Ryerson Limited 20 -7

Table 20. 1 Sample of Future Contracts © 2015 Mc. Graw-Hill Ryerson Limited 20 -8

Summary Reminder • Objective: To describe the workings of futures markets and the mechanics of trading in these markets. • • Trading mechanics Futures pricing Different types of futures contracts Swaps © 2015 Mc. Graw-Hill Ryerson Limited 20 -9

Trading Mechanics • Clearinghouse - acts as a party to all buyers and sellers. • • Obligated to deliver or supply delivery Closing out positions • • • Reversing the trade Take or make delivery Most trades are reversed and do not involve actual delivery © 2015 Mc. Graw-Hill Ryerson Limited 20 -10

Figure 20. 3 Panel A: Trading without a Clearinghouse, Panel B: Trading with a Clearinghouse © 2015 Mc. Graw-Hill Ryerson Limited 20 -11

Margin and Trading Arrangements • • • Initial Margin - funds deposited to provide capital to absorb losses Marking to Market - each day the profits or losses from the new futures price are reflected in the account. Maintenance or variation margin - an established value below which a trader’s margin may not fall. © 2015 Mc. Graw-Hill Ryerson Limited 20 -12

Margin and Trading Arrangements • • Margin call - when the maintenance margin is reached, broker will ask for additional margin funds Convergence of Price - as maturity approaches the spot and futures price converge Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets © 2015 Mc. Graw-Hill Ryerson Limited 20 -13

Trading Strategies • Speculation • • • short - believe price will fall long - believe price will rise Hedging • • long hedge - protecting against a rise in price short hedge - protecting against a fall in price © 2015 Mc. Graw-Hill Ryerson Limited 20 -14

Basis and Basis Risk • Basis - the difference between the futures price and the spot price • • over time the basis will likely change and will eventually converge Basis Risk - the variability in the basis that will affect profits and/or hedging performance © 2015 Mc. Graw-Hill Ryerson Limited 20 -15

Summary Reminder • Objective: To describe the workings of futures markets and the mechanics of trading in these markets. ü Trading mechanics • • • Futures pricing Different types of futures contracts Swaps © 2015 Mc. Graw-Hill Ryerson Limited 20 -16

Futures Pricing • • Spot-futures parity theorem - two ways to acquire an asset for some date in the future Purchase it now and store it Take a long position in futures These two strategies must have the same market determined costs © 2015 Mc. Graw-Hill Ryerson Limited 20 -17

Spot-Futures Parity Theorem • • • With a perfect hedge the futures payoff is certain - there is no risk A perfect hedge should return the riskless rate of return This relationship can be used to develop futures pricing relationship © 2015 Mc. Graw-Hill Ryerson Limited 20 -18

Hedge: Text Example • • Investor owns an S&P/TSX 60 fund that has a current value equal to the index of $800 Assume dividends of $10 will be paid on the index at the end of the year Assume futures contract that calls for delivery in one year is available for $816 Assume the investor hedges by selling or shorting one contract © 2015 Mc. Graw-Hill Ryerson Limited 20 -19

Hedge Example - Outcomes Value of ST 760 810 840 ($816 - ST) 56 6 -24 Dividend Income 10 10 10 Payoff on Short Total © 2015 Mc. Graw-Hill Ryerson Limited 826 826 20 -20

Rate of Return for the Hedge © 2015 Mc. Graw-Hill Ryerson Limited 20 -21

General Spot-Futures Parity Rearranging terms: © 2015 Mc. Graw-Hill Ryerson Limited 20 -22

Figure 20. 4 S&P 500 Monthly Dividend Yield © 2015 Mc. Graw-Hill Ryerson Limited 20 -23

Arbitrage Possibilities • • • If spot-futures parity is not observed, then arbitrage is possible If the futures price is too high, short the futures and acquire the stock by borrowing the money at the risk-free rate If the futures price is too low, go long futures, short the stock and invest the proceeds at the risk-free rate © 2015 Mc. Graw-Hill Ryerson Limited 20 -24

Spread Pricing: Parity for Spreads © 2015 Mc. Graw-Hill Ryerson Limited 20 -25

Figure 20. 5 Gold Futures Prices © 2015 Mc. Graw-Hill Ryerson Limited 20 -26

Summary Reminder • Objective: To describe the workings of futures markets and the mechanics of trading in these markets. ü Trading mechanics ü Futures pricing • • Different types of futures contracts Swaps © 2015 Mc. Graw-Hill Ryerson Limited 20 -27

Commodity Futures Pricing General principles that apply to stock apply to commodities Carrying costs are more for commodities Spoilage is a concern Where; © 2015 Mc. Graw-Hill Ryerson Limited F 0 = futures price P 0 = cash price of the asset C = Carrying cost c = C/P 0 20 -28

Figure 20. 6 Typical Commodity Price Pattern over the Season © 2015 Mc. Graw-Hill Ryerson Limited 20 -29

Discounted Cash Flow Analysis • • • The modern approach to commodity futures prices as estimates of future commodity prices uses portfolio theory Current prices are expected future prices discounted at a risk adjusted discount rate This rate is estimated from commodity betas © 2015 Mc. Graw-Hill Ryerson Limited 20 -30

Table 20. 2 Commodity Betas © 2015 Mc. Graw-Hill Ryerson Limited 20 -31

Futures Price versus Expected Spot Price: Theories • • • © 2015 Mc. Graw-Hill Ryerson Limited Expectations Normal Backwardation Contango 20 -32

Figure 20. 7 Futures Price Over Time in the Special Case that the Expected Spot Price Remains Unchanged © 2015 Mc. Graw-Hill Ryerson Limited 20 -33

Stock Index Contracts • • Available on both domestic and international stocks Advantages over direct stock purchase • • • lower transaction costs better for timing or allocation strategies takes less time to acquire the portfolio © 2015 Mc. Graw-Hill Ryerson Limited 20 -34

Table 20. 3 Major Stock-Index Futures © 2015 Mc. Graw-Hill Ryerson Limited 20 -35

Table 20. 4 Correlations among Major U. S. Stock Market Indexes © 2015 Mc. Graw-Hill Ryerson Limited 20 -36

Using Stock Index Contracts to Create Synthetic Positions • Synthetic stock purchase • • Purchase of the stock index instead of actual shares of stock Creation of a synthetic T-bill plus index futures that duplicates the payoff of the stock index contract © 2015 Mc. Graw-Hill Ryerson Limited 20 -37

Pricing on Stock Index Contracts • The spot-futures price parity is given as: • Empirical investigations have shown that the actual pricing relationship on index contracts follows the spot-futures relationship © 2015 Mc. Graw-Hill Ryerson Limited 20 -38

Index Arbitrage • • • Exploiting mispricing between underlying stocks and the futures index contract Futures Price too high - short the future and buy the underlying stocks Futures price too low - long the future and short sell the underlying stocks © 2015 Mc. Graw-Hill Ryerson Limited 20 -39

Index Arbitrage and Program Trading • Difficult to implement in practice • • • Transactions costs are often too large Trades cannot be done simultaneously Development of Program Trading • • Used by arbitrageurs to perform index arbitrage Permits acquisition of securities quickly © 2015 Mc. Graw-Hill Ryerson Limited 20 -40

Foreign Exchange Futures • Futures markets • • Chicago Mercantile (International Monetary Market) London International Financial Futures Exchange Active forward market Differences between futures and forward markets © 2015 Mc. Graw-Hill Ryerson Limited 20 -41

Figure 20. 8 A: Foreign Exchange Listing, Cross Rates, July 19, 2013 © 2015 Mc. Graw-Hill Ryerson Limited 20 -42

Figure 20. 8 B: Canadian Dollar Forward Rates, July 19, 2013 © 2015 Mc. Graw-Hill Ryerson Limited 20 -43

Figure 20. 9 Canadian Dollar Futures in the CME, July 20, 2013 © 2015 Mc. Graw-Hill Ryerson Limited 20 -44

Pricing on Foreign Exchange Futures • • Interest rate parity theorem Developed using the Canadian Dollar and British Pound where, F 0 is the forward price E 0 is the current exchange rate © 2015 Mc. Graw-Hill Ryerson Limited 20 -45

Text Pricing Example r. CAN = 6% ruk = 5% E 0 = $1. 60 per pound • T = 1 yr If the futures price varies from $2. 12 per pound arbitrage opportunities will be present © 2015 Mc. Graw-Hill Ryerson Limited 20 -46

Interest Rate Futures • Domestic interest rate contracts • • • International contracts • • Bankers’ Acceptances (BAX) Canada bonds Eurodollar Hedging • • Underwriters Firms issuing debt © 2015 Mc. Graw-Hill Ryerson Limited 20 -47

Hedging Interest Rate Risk • • Owners of fixed-income portfolios protecting against a rise in rates Corporations planning to issue debt securities protecting against a rise in rates Investor hedging against a decline in rates for a planned future investment Exposure for a fixed-income portfolio is proportional to modified duration © 2015 Mc. Graw-Hill Ryerson Limited 20 -48

Summary Reminder • Objective: To describe the workings of futures markets and the mechanics of trading in these markets. ü Trading mechanics ü Futures pricing ü Different types of futures contracts • © 2015 Mc. Graw-Hill Ryerson Limited Swaps 20 -49

Swaps • • • © 2015 Mc. Graw-Hill Ryerson Limited Interest rate swap Foreign exchange swap Credit risk on swaps 20 -50

Figure 20. 10 Interest Rate Swap © 2015 Mc. Graw-Hill Ryerson Limited 20 -51

Figure 20. 11 Interest Rate Futures © 2015 Mc. Graw-Hill Ryerson Limited 20 -52

Pricing on Swap Contracts • • • Swaps are essentially a series of forward contracts One difference is that the swap is usually structured with the same payment each period while the forward rate would be different each period Using a foreign exchange swap as an example, the swap pricing would be described by the following formula © 2015 Mc. Graw-Hill Ryerson Limited 20 -53

Figure 20. 12 Forward Contracts versus Swaps Panel A: Two forward contracts, each priced independently Panel B: Two-year swap agreement © 2015 Mc. Graw-Hill Ryerson Limited 20 -54