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Capital Markets. Spring Semester 2010 Lahore School of Economics. Salaar farooq – Assistant Professor. Derivatives: Futures Chapter 20. Lecture. Futures - Ch 20 Learning Objectives. Understanding Futures Contracts Forwards contracts Structure of Futures Markets Mechanics of trading - PowerPoint PPT PresentationTRANSCRIPT
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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
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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