Salaar Finance Capital Markets Spring Semester 2010 Lahore

Salaar - Finance Capital Markets Spring Semester 2010 Lahore School of Economics Salaar farooq – Assistant Professor

Salaar - Finance Derivatives: Futures Chapter 20 Lecture

Salaar - Finance Futures - Ch 20 Learning Objectives n Understanding Futures Contracts n Forwards contracts n Structure of Futures Markets n Mechanics of trading n Using Futures for Hedging & Speculation n Futures pricing n Summary

Salaar - Finance Derivative: Futures Contract What is it? ….

Salaar - Finance Derivative: Futures What is it? …. n 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. n It creates an OBLIGATION for both parties to deliver!

Salaar - Finance Futures Purpose…. Powerful tool for…?

Salaar - Finance Futures Purpose…. Powerful tool for… n Hedging (shifting) – Price Risk n Speculation

Salaar - Finance Futures Types…. 2 Major categories… n Commodity Futures? n Financial Futures

Salaar - Finance Futures Types…. Commodity Futures… Agricultural commodities (grains, livestock, corn) Imported foodstuff (sugar, coffee) Industrial (uranium, gold)

Salaar - Finance Futures Types…. 2 Major categories… n Commodity Futures n Financial Futures?

Salaar - Finance Futures Types…. Financial Futures… Based on a financial instrument or index 1. Stock index futures 2. Interest rate futures 3. Currency futures

Salaar - Finance Futures Mechanics 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 at which the agreement is made Settlement/delivery date Date at which the parties must transact in the future

Salaar - Finance Futures Mechanics 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 ?

Salaar - Finance Futures Mechanics 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 at this time will pay Kashif $100.

Salaar - Finance Futures Liquidating positions…. Most futures have settlements in 3 months standardized for… 1. March 2. June 3. September 4. December n This is when the contract stops trading. (usually 3 rd wed)

Salaar - Finance Futures To Settle a future…. The party has 2 choices ?

Salaar - Finance Futures To 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)

Salaar - Finance Futures Exchange Clearinghouse…. 2 main Purposes

Salaar - Finance Futures Exchange 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

Salaar - Finance Futures Margin Requirements…. Initial Margin Maintenance Margin Variation Margin

Salaar - Finance Futures Margin 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

Salaar - Finance Futures Margin difference b/w…. Securities & Futures Securities Futures

Salaar - Finance Futures Daily price Limits ?

Salaar - Finance Futures Daily price Limits Futures is a future price n Based on expectations of future n 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!

Salaar - Finance Futures VS Forwards Forward?

Salaar - Finance Futures VS Forwards Forward Similar to future contract: Agreement to buy/sell an asset at a specified price, amount and time period Difference (forwards)?

Salaar - Finance Futures 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

Salaar - Finance Futures Risk & Return Characteristics Long Futures Short Futures

Salaar - Finance Futures Risk & 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

Salaar - Finance Futures Leveraging 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 Business Pricing Futures Starts with an investor making DECISION b/w LONG NOW? (SPOT) Commodities Pricing OR LONG LATER? (FUTURES) • Based on C/F impact of decision • Assumes no arbitrage

Center for Research in Economics and Business Pricing Futures IF, » Future Price = Spot Price Fo = So Then,

Center for Research in Economics and Business Pricing Futures If Fo = So TVM Gain Better Off +Fo C/F Later Arbitrage possible TVM Lost +So Therefore, C/F Now

Center 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 Business Pricing Futures Now if: Fo = So + TVM, Or Fo = So. ( 1+r)n

Center for Research in Economics and Business Pricing Futures Now if: Fo = So + TVM, Fo = So. ( 1+r)n NO Storage paid NO C/F Still Better Off TVM Gain +Fo Arbitrage possible Storage paid C/F OUT +So TVM Lost

Center 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 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 Business Pricing Futures NOTE: Other costs may be added as appropriate (e. g Gold Khi Landed) Fo = So. ( 1+r)n + q + … +

Salaar - Finance Futures Price Convergence at Delivery At the Delivery date: n Futures price MUST = Cash Mkt price Thus, n As delivery date approaches… Futures Px converges to the cash price

Salaar - Finance Futures Hedging 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

Salaar - Finance Futures Risks 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!

Salaar - Finance Futures Risks 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!

Salaar - Finance Futures Hedging 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

Salaar - Finance Futures Hedging 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

Salaar - Finance Futures Role 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

Salaar - Finance Futures - Ch 10 Learning Summary n Understanding Futures Contracts (price risk transfer) n Forwards contracts (OTC like futures) n Structure of Futures Markets (Floor brokers, locals) n Mechanics of trading n Using Futures for Hedging & Speculation n Futures pricing (cash px, cash yield & carry)

Salaar - Finance Finished: Futures