Chapter 17 - futures markets and risk management Flashcards
forward contract
An arrangement calling for future delivery of an asset at an agreed-upon price
futures makets
Establish contract size, acceptable grade of commodity, contract delivery dates, etc.
Key differences between futures and forwards:
- futures contracts are standardized, traded on organized exchanges, and settled on a daily basis
- forward contracts are customized, traded over the counter, and settled at the expiration of the contract
basics of futures contracts
- Calls for delivery of a commodity at a specified delivery date, for an agreed-upon price
- Place and means of delivery are specified
- Parties to the contract much more commonly close out their positions before contract maturity
- Taking gains/losses in cash
futures price
The agreed-upon price to be paid on a futures contract at maturity
long position of futures
- The futures trader who commits to purchasing the asset
- Profit = spot price and maturity - original futures price
short position in futures
- The futures trader who commits to delivering the asset
- Profit: original futures price - spot price and maturity
“zero-sum game” of futures
losses/gains to all positions netting out to 0
futures categories
agricultural, metals/minerals (includes energy), foreign currencies, and financial (fixed-income and equities)
single stock futures
A futures contract on the shares of an individual company
clearing house
- Established by exchanges to facilitate trading, an intermediary between two traders
- The only party that can be hurt by the failure of any trader to honor the obligations of the contract
open interest
- the number of contracts outstanding
- long/short position are not counted separately
- Can be defined as the number of long or short contracts outstanding
marking to market
- The daily settlement of obligations on futures positions
- E.x. Clearinghouse credits/debits the accounts of the long/short position of the futures price rises
margin
a security account consisting of cash/equivalents (such as T-bills) that ensures the trader will be able to satisfy the obligations of the futures contract
maintenance margin
- An established value below which a trader’s margin may not fall
- Reaching the maintenance margin triggers a margin call
margin call
requires the margin account be replenished or the position be reduced to a size commensurate with remaining funds
convergence property
The convergence of futures prices and spot prices at the maturity of the futures contract
cash settlement
The cash value of the underlying asset (rather than the asset itself) is delivered to satisfy the contract
federal commodity futures trading commission (CFTC)
- regulates futures markets
- Sets capital requirements for member firms, authorizes trading in new contracts, and oversees the maintenance of daily trading records
general rule of capital gains
60% of futures gains/losses are treated as long-term cap gains and 40% as short term
speculator
uses a contract to profit from movements in futures prices
hedger
uses a contract to protect against price movements
short hedge
taking a short futures position to offset risk in the sales price of an asset
why futures?
- Transaction costs are far small in futures markets
- Leverage because of margin
cross-hedging
hedging a position using futures on another asset
basis
The difference between the futures price and the spot price
basis risk
Risk attributable to uncertain movements in the spread between a futures price and a spot price
futures spread
taking a long position in a futures contract of one maturity and a short position in a contract with a different maturity
Spot-futures parity (cost-of-carry relationship)
- Describes the theoretically correct relationship between spot and futures prices
- Violation of the parity relationship gives rise to arbitrage opportunities
- F0 = S0(1+rf)^T
- S0 = F0/(1+rf)^T
spot-futures parity (cost-of-carry relationship) if there is a dividend
- F0 = S0(1 + rf - d)^T
- If d < rf, the futures price will exceed the spot price and by greater amounts for longer times to contract maturity
- If d > rf, the income yield on the stock actually exceeds the forgone (risk-free) interest that could be earned on the money invested
- The futures price will be less than the spot price and by greater amounts for a longer time to contract maturity
contract size
the multiplier used to calculate contract settlements
synthetic stock positions
Index futures let investors participate in broad market movements without actually buying/selling a large number of stocks
timers
- Attempt to shift from bills intro the market before market upturns and shift back into bills to avoid market downturns
- Using futures contracts makes trading costs much lower
index arbitrage
- Strategy that exploits divergences between actual futures prices and their theoretically correct parity values to make a riskless profit
- If the futures price is too high, short the futures contract and buy the stocks in the index
- If too low, buy futures and short the stocks
program trading
Coordinated buy orders and sell orders of entire portfolios, often to achieve index arbitrage objectives
hedging foreign exchange risk and Ex
- can be hedged through currency futures or forward markets
- E.x. if you know you will receive £100,000 in 60 days, you can sell those pounds forward today in the forward market and lock in an exchange rate equal to today’s forward price
direct quotes
the number of US dollars required to purchase some unit of foreign currency
direct quotes
the number of US dollars required to purchase some unit of foreign currency
indirect quotes
the amount of foreign currency needed to purchase $1
Major US interest rate contracts
- Eurodollars, Tbills, Tnotes, and Tbonds
interest rate futures
Allow traders to hedge against interest raet risk in a wide spectrum of maturities
treasury contracts
- call for delivery of a T-bond, bill, or note
- If interest rates rise, the MV of the security at delivery will be less than the original futures price, and the deliverer will profit
- The short position in the interest rate futures contract gains when interest rates rise and bond prices fall
Price value of a basis point (PVBP)
- The change in the value of a fixed-income security resulting from a one-basis-point change in its yield to maturity
- PVBP = change in portfolio value / predicted change in yield
hedge ratio (H) =
= PVBP of portfolio / PVBP of hedge vehicle
cross-hedging
Hedging a position in one asset by establishing an offsetting position in a related, but different asset
swaps
Multiperiod extensions of forward contracts
foreign exchange swaps
- An agreement to exchange a sequence of payments denominated in one currency for payments in another currency at an exchange rate agreed to today
- Exchange of currencies on several dates
interest rate swap
Contracts between two parties to trade cash flows corresponding to different interest rates
notional principal
Principal amount used to calculate swap payments
swap dealer
- Typically a financial intermediary such as a bank
- Finds people looking to take opposite sides of a swap so its preposition is effectively neutral
- Charges a bid-ask spread on the transaction
