Subject 5B: Workshop 1 PART 1: FORWARDS AND FUTURES (reading: Hull 6th or 7th edition chapters 1-3 and

d 5) A financial derivative is a financial instrument whose value depends on or is derived from the values of other financial instruments or other more basic underlying variables (such as commodity prices, exchange rates, share prices, interest rates etc). These contracts range from very simple to very complex. Exchange Traded Markets A derivative exchange is a market where individuals trade in standardized contracts that have been defined by the exchange. The CBOT was established in 1848 to bring farmers and merchants together and initially its task was to standardize the quantities and qualities of the grains traded there. Futures type contracts were developed within a few years and speculators soon became interested in it. Many market participants found trading the futures contract to be a good alternative to trading the grain itself. Most exchanges have organized arrangements so as to almost eliminate counterparty credit risk from trading. This is the risk that the person you are dealing with defaults on their obligations. Over the counter markets Not all trading is done on exchanges such as the ASX, SFE, CBOT. A significant amount of trading is done directly between buyer and seller instead of via an exchange. With trades on an exchange there is usually an intermediary involved (e.g. a broker) and both buyer and seller deal with each other via the intermediary. With OTC markets the deal is done directly between the 2 parties. Another feature of the OTC markets is that the contract details (quantity and quality and other features) are not standardized but are individually negotiated. However the degree of counterparty credit risk is higher.

Spot vs Forward contracts A spot contract is an agreement to buy or sell an asset today: the exchange of money for the instrument concerned happens immediately (the same day). A forward contract is an agreement to buy or sell some asset at a certain future time at a certain future price. These are very common in the foreign exchange market. Broker vs. Market Maker A broker is a market participant who acts as an intermediary to a transaction. The role of broker is to match up the buyer and the seller. They charge both parties a fee for this service. In the share market, the market arrangements require investors to use the services of brokers to buy or sell their shares. You have to use a broker whether you want to or not. The broker does not own the stock themselves, and they are not exposed to risk of the price of the stock changing. The same applies in the futures exchanges (e.g. the SFE) and options exchanges: you have to deal via a broker. A real estate agent is the equivalent of a broker for the real estate market. They match buyer and seller and charge a fee to the seller for selling the property. The seller pays for it out of the price paid by the buyer. The agent does not actually have ownership of the property being sold. A Market Maker is another type of market participant who gets involved in transactions in securities. The difference is that a market maker actually owns the security being traded and is exposed to the risk that prices move in an unfavourable direction.

Bid and Offer Prices A market maker is someone who offers to both buy and sell the security concerned. They will quote a 2 way price to the market. The bid price is the price at which they offer to buy the stock from you. The offer price is the price at which they are willing to sell the stock to you. The offer price is always higher than the bid price. The difference between the offer price and the bid price is called the bid offer spread. The size of the bid offer spread reflects the transaction costs involved for the dealer, as well as the liquidity of the market. A large bid offer spread indicates either a very illiquid market or a high level of risk for the dealer or a lack of competition. A low bid offer spread indicates a very active and liquid market with lots of competition. Banks are market makers in the foreign exchange market Example: table 1.1 spot and forward quotes for the USD-GBP exchange rate bid spot 1.4452 1-month forward 1.4435 3-month forward 1.4402 6-month forward 1.4353 1-year forward 1.4262 offer 1.4456 1.4440 1.4407 1.4359 1.4268

This table shows the quotes on the exchange rate of the british pound (GBP) for the US dollar (USD) by a large international bank on 16 aug 2001. The quote means the number of units of the USD for 1 unit of the GBP. The bid rate means the number of USD the bank is prepared to pay to buy 1 GBP. The offer rate means the number of USD the bank is prepared to sell 1 GBP for.

 Note that the offer rate is above the bid rate (otherwise the bank would lose money and banks are in the business of making money not of losing it). The spot bid quote means that the bank will buy 1 GBP from the customer in exchange for 1.4452 US dollars for immediate delivery. (buy GBP & Sell USD). The spot ask quote means that the bank is willing to sell GBP to the customer in exchange for 1.4456 USD (sell GBP / but USD) for immediate delivery. The 6-month forward exchange rate quotes mean that the bank is willing to enter a deal to buy 1 GBP for 1.4353 USD in six months time (both amounts to be exchanged in the future, not now) the bank is willing to enter a deal to sell 1GBP for 1.4359 USD in six months time. Forward Contracts The simplest type of financial derivative contract is the forward contract. A forward contract is an agreement (betweeen 2 parties) made today to purchase some instrument on some future date for a price that is agreed upon today. Note that a forward contract is an over the counter transaction (not exchange traded). The date on which the exchange of money in return for the instrument is called the delivery date or the maturity date or the expiry date. T is our notation for the delivery date. The asset which is being bought is called the underlying asset or sometimes just the underlying. We will use S to denote the value of the underlying asset and the subscript t to denote the time. ST is the value of the underlying asset on the maturity date of the forward contract. The amount of money which will change hands on the delivery date is called the delivery price which we will denote by X

When the forward contract is entered into the delivery price is set at a level such that there is no need to have any exchange of money between the 2 parties. The only exchange of money occurs on the delivery date. One party to the contract is obligated to buy the underlying asset on the maturity date and to pay an amount X for it. This applies regardless of the market value of that asset at the time. The other party is obligated to sell the asset on the maturity date in return for a payment of X. Both sides are locked into the deal. It is a zero sum game and if the contract is making a profit for one party it is making a loss of the same magnitude for the other party. This means if you have a forward contract in place which is of positive value, it is of negative value for the other party (called the counterparty. The counterparty could default on their obligations under the contract, and this is one of the risks of forward contracts. The party who is obligated to buy the asset is said to have a LONG POSITION The party who is obligated to sell the asset is said to have a SHORT POSITION The payoff to the party with the long position is, on the maturity date of the contract, payoff = ( ST X ) . The payoff to the holder of the short position is 1 times this, which is payoff = ( X ST ) . The value of the asset on the maturity date cannot be known with certainty, it is a random variable.

Investment vs Consumption Assets Investment Asset: one that is held for investment purposes by a significant number of investors e.g. bonds, shares, gold, silver consumption asset: one that is held primarily for consumption: e.g. copper, oil, pork bellies (bacon) We can use arbitrage type arguments to produce valuation formulae for forward and futures contracts over investment assets. This is not possible for forwards and futures defined over consumption assets. Short Selling: An important concept in the valuation of options and forward and futures contracts is that of short selling of an asset. Short selling means selling something you do not own. This often causes confusion how can you sell something you do not own? For most physical assets we use in our daily lives you cannot do this. If you sell your neighbours car it would be illegal. But with financial assets you can. The way it works is this you borrow the asset (say NAB shares) from another investor (often a broker) who does own them, but you promise to give it back at a later date you then sell them in the market for the then current market price you use the sale proceeds for whatever purpose you had in mind later on you have to buy the asset back in the market for the price prevailing on the day you buy it back you then give it back to the party you borrowed it from you may have to pay a fee and compensation for any income on the asset during the term of the arrangement Doing this will deliver a profit to the investor if the price of the asset falls but deliver a loss if the price of the asset increases. Short selling can and does happen in financial markets. There are some restrictions on short selling but we will assume there are no such restrictions.

Types of market participant: Hedgers: traders who want to protect themselves from financial loss by entering into a transaction. For example, if you are an importer, you are exposed to the risk of the local currency falling in value relative to the currency of the country you import goods from. You can protect yourself against this risk by entering into a forward foreign exchange transaction. Speculators: traders who want to make short term profits by entering into a transaction, by taking a bet on which way market prices are going to change. For example, you may have the opinion that defence related stocks are going to go up in value next week due to a new war breaking out in central asia this is likely to increase demand for the goods and services produced by the defence industry. If you buy now and sell next week you may make a substantial profit (assuming your guess about the war was correct). Arbitrageurs: traders who engage in arbitrage. This means making a series of transactions simultaneously in 2 or more markets in such a way as to make a riskless profit. For instance some stocks are traded in both New York and London. If a particular stock is trading for USD152 in New York and for GBP100 in London at a time when the exchange rate is 1GBP = 1.55USD, then a trader could do the following 2 deals: (i) buy 10000 shares in New York for $US1,520,000 (ii) sell 10000 shares in London for $US1,550,000 = GBP 1,000,000 1.55 (iii) get a risk free profit of $30,000 in USD In practice there are transactions costs involved in doing this: there are transactions costs involved in buying the stock, in selling the stock and in converting one currency to another. For small investors these transaction costs tend to be large ( as a proportion of the profits) but for big investors such as banks they are much lower. The actions of investors to buy the cheap version (in New York) and sell the expensive version (in London) of the same asset will tend to make the 2 prices converge: the cheap one gets more expensive and the expensive one gets cheaper until there is no profit to be made from arbitrage.
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Relationship between spot and forward prices Notation and assumptions no transaction costs market participants have same tax rate all market participants can borrow or lend any amount of money at the same risk free interest rate (for both borrowing and lending) market participants can exploit arbitrage opportunities as they occur these assumptions apply (at least approximately) to a few key market participants such as large investment banks T = time until delivery (maturity) in a forward / futures contract S0 = price of the underlying asset today F0 = futures price today for a futures contract maturing at time T r = risk free interest rate (usually taken to be libor) Forward Price for an investment asset The easiest type of forward contract to value is one where the underlying asset pays no income during the term of the contract: zero coupon bonds and non dividend paying stocks are examples of this type of asset. Suppose that a forward contract that matures at time T over the asset S has delivery price K. How should the delivery price K be chosen? Suppose that the underlying asset is a stock with initial price S0 = 40 and the term of the contract is T = 0.25 years (i.e. 3 months), and that the risk free interest rate is r = 0.05 continuously compounded. Q: What would happen if the delivery price were K = 43? Under this scenario, an arbitrageur could Now: borrow $40 for 3 months at 5% buy the stock for $40 short the forward contract (agree to sell the stock at time 3 months for a price of $43 Wait till the end of 3 months: sell the stock and receive $43, pay back the loan with interest for 40.50 = 40 e0.050.25 keep the profit of $2.50
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What would happen if the delivery price were K = $39? Under this scenario, an arbitrageur could Now: short sell the stock for $40 now, agreeing to give it back to the person the stock was borrowed from (by purchasing it in the open market in 3 months time for its price at that time) invest the $40 for 3 months at 5% (i.e. lend risk free for 3 months) go long in the forward contract (agree to buy the stock at time 3 months for a price of $39) wait till the end of 3 months: buy the stock and pay $39, give back the stock to the person you borrowed it from under the short selling arrangement Receive the proceeds of our risk free investment which is 40.50 = 40 e0.050.25 keep the profit of $1.50 = 40.50 - 39.00 The only delivery price which does not permit an arbitrageur to make a profit from doing one of the above strategies is K = $40.50. This value of K is denoted by F and is called the arbitrage free forward price. The mathematical formula for what K should be is:
F0 = S0 .e rT

Short selling: what if we cant do this?

Actually it does not matter if short selling cant be done (e.g. because it is illegal it used to be illegal in australia). If it is an investment asset then a lot of people hold the asset for investment purposes and are willing to sell if the price is right. If the forward price is too low, then an arbitrageur (who holds the asset) can sell the asset and go long in a forward contract.
F0 = S0 .e rT is the arbitrage free forward price
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If the delivery price K for a forward contract is K > F0 then the arbitrageurs strategy is: Now borrow S0 for term T at rate r buy the asset and pay S0 for it enter a short forward contract to sell S at time T for amount K Intermediate hold this position to time T At time T pay back loan with interest for amount F0 = S0 .erT sell the asset and get K for it profit at time T = K F0 > 0

The combination of borrowing and buying the asset as above, creates what is called a synthetic long forward position in the asset. The payoff at maturity from creating this synthetic long forward contract is payoff1 = ( ST F0 ) The payoff from the short forward contract with delivery price K is payoff 2 = ( K ST ) The overall payoff is the sum of these 2 payoffs: this is payoff = ( ST F0 ) + ( K ST ) = K F0

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If the delivery price K is K < F0 then the strategy (for a holder of the asset) is: Now sell the asset for amount S0 invest / lend the proceeds S0 for term T at rate r enter a long forward contract to buy the asset at time T for amount K Intermediate hold this position to time T At time T loan matures with interest for amount F0 = S0 .e rT buy the asset and pay K for it payoff at time T = ST K + F0 Alternatively the investor who owns the asset could have decided not to sell the asset and instead hold it and wait till time T. In this case the payoff at time T (value of the position) would be just ST The profit to be had from deciding to adopt the sell / lend / long forward strategy instead of deciding to hold is ( ST K + F0 ) ST = ( F0 K ) . If this is positive we prefer to follow the above strategy instead of holding onto the asset. The combination of selling the asset and lending the sale proceeds at the risk free rate for term T creates what is called a synthetic short forward position in the asset. The payoff at maturity from doing this is payoff1 = ( F0 ST ) The payoff from the long forward contract with delivery price K is payoff 2 = ( ST K ) The overall payoff is the sum of these 2 payoffs: this is payoff = ( F0 ST ) + ( ST K ) = F0 K
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Forward Contract when the asset provides a known income

Suppose the underlying asset provides a perfectly predictable cash income to the holder during the term of the forward contract. In this case the formula for the arbitrage free forward price is
F0 = ( S0 I ) .e rT

where I is the present value (at the risk free rate) of the income produced by the asset during the term of the forward contract.
Numerical Example:

we have a 10 month forward contract on a stock with initial price S0 = 50 the risk free interest rate is 8% pa continuously compounded the stock pays a dividend of $0.75 every 3 months, the first due in exactly 3 months.

The present value of the income paid during the term of the forward contract is I = 0.75 ( e 0.080.25 + e 0.080.50 + e 0.080.75 ) = 2.162 The forward price is
F0 = ( S0 I ) .e = ( 50.000 2.162 ) e
rT 10 0.08 12

= 51.13584

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If the delivery price K is K > F0 then the strategy is: Now borrow S0 for term T at rate r buy the asset and pay S0 for it the income stream provided by the asset has PV of I enter a short forward contract to sell S at time T for amount K Intermediate hold this position to time T reinvest any income as it is received at the risk free rate of interest At time T the reinvested income will have accumulated to an amount I .e rT pay back loan with interest for amount S0 .e rT sell the asset and get K for it profit at time T = K S0 e rT + N Ie rT = K ( S0 I ) erT = K F0 > 0 N N accumulated sale
proceeds loan maturity ' payment reinvested income

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If the delivery price K is K < F0 then the strategy for a holder of the asset is (if short selling is not allowed): Now: sell the asset and get S0 for it lend the proceeds of S0 for term T at rate r enter a long forward contract to buy S at time T for amount K Intermediate: hold this position to time T At time T: the loan matures and we receive amount S0 .erT buy the asset and pay K for it payoff at time T = S0 e rT K + ST N N
loan maturity ' payment value of asset

Alternatively the investor could have held on to the asset instead of selling it. The income provided by the asset could have been reinvested at the risk free interest rate up to time T. The time T payoff provided by this alternative strategy would have been ST + N I .e rT N accumulated
value at maturity reinvested income

The extra benefit provided by selling the asset, lending the proceeds and going long a forward, instead of just holding the asset, is the difference between these 2 payoffs: this is ( S0erT K + ST ) ( ST + I .erT ) = ( S0 I ) erT K = F0 K > 0

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if short selling is allowed and if K < F0 then the strategy to make an arbitrage profit is:

Now short sell the asset and get S0 for it (this involves borrowing the asset and compensating the lender for any income foregone during the term of the short selling arrangement) lend the proceeds of S0 for term T at rate r enter a long forward contract to sell S at time T for amount K Intermediate: hold this position to time T At time T the loan matures and we receive amount S0 .e rT buy the asset and pay K for it to the counterparty of the forward contract give the asset (worth ST ) back to the person you borrowed it from under the short selling arrangement pay compensation (to the person who lent you the asset for the I .e rT short selling) for the income foregone of amount N payoff = S0 e rT K N I .e rT = ( S0 I ) erT K = F0 K > 0 N accumulated
loan maturity ' payment reinvested income
accumulated reinvested income

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Forward Contract when the asset provides a known income yield

By income yield we mean the ratio of the income to the value of the asset. Income yields are usually taken to mean continuous income yields. This is analogous to continuously compounded interest rates. Suppose the underlying asset provides a constant income yield at rate y p.a. to the holder during the term of the forward contract. This means that during a small time interval ( t , t + t ) , the amount of income paid on the asset is y.t.St +t , which is proportional to the asset value at the time of payment. An example of an asset that behaves like this is a holding of a foreign currency in a foreign bank account which pays interest at a fixed rate but on a daily basis. Suppose you have USD1m in a US bank account which pays interest at 6% p.a. on a daily basis. The interest earned is added to the account balance every day. When converted into AUD, the interest income is proportional to the amount of the account. In this case the formula for the arbitrage free forward price is given by the r y T formula F0 = S0 .e( ) In deriving this forward price we make the assumption that the income received on the asset can be reinvested back into the asset. For instance in the case of shares, the dividends could be used to purchase more shares. If we hold one unit of the asset at time t=0, at a price of S0 and if we reinvest any income back into more units of the asset, then by time T we will hold e yT units of the asset and these are worth ST per unit.

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Numerical Example:

Problem

The dividend yield on an asset is 4% p.a. convertible half yearly, and the risk free rate is 10% p.a. with continuous compounding. The asset price is initially $25. What is the forward price for a forward contract maturing in 6 months?
Solution: First we need to convert the dividend yield to an equivalent continuous yield. This is y = ln(1.022 ) = 2 ln(1.02) = 0.0396

From the information given we have

S0 = 25.00 T = 0.50 r = 0.10 y = 0.0396 F0 = S0 e
( r t )T ( 0.100.0396 )
1 2

= 25 e

= $25.77

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Valuation of forward contracts:

It is normal market practice with forward contracts to set the forward price to be the arbitrage free forward price when the contract is first set up. This means that when the contract is initiated, it is designed so that there is no exchange of cash for the asset, and the exchange happens only at the maturity date. As at the inception date, the value of the contract is zero to both sides of the deal. Later on, after the contract has been set up, market conditions will probably change 0from what they were initially. Consequently the value of the contract will also change and it is unlikely to stay at zero. We shall consider the value of the contract from the perspective of the holder of the long position. This value can change from positive to negative and back again during the life of the contract. Consider a forward contract over some asset S, written at some previous time let K be the delivery price of the forward contract Let the term to maturity be T Let F0 be the forward price of the asset S for delivery at time T for a new forward contract written today Let f be the market value today of the forward contract which matures at time T with delivery price K
Then the market value of the forward contract is f = ( F0 K ) e rT

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Proof:

If we have a long position in a forward contract with maturity T and exercise price K then we can at zero cost, also enter into a short forward contract with maturity T and delivery price F0 This combination of forward contracts has a payoff which is risk free and is independent of the stock price at maturity, ST The payoff from this combination is payoff = ( ST K ) + ( F0 ST ) = F0 K The present value of this payoff is ( F0 K ) e rT The present value of the payoff ( F0 ST ) is zero by design

Hence the present value of the payoff ( ST K ) is ( F0 K ) e rT

Note: (i) for an investment asset that pays no income during the term of the forward contract we have F0 = S0 erT so that the value of a forward contract with delivery price K is f = ( F0 K ) e rT = ( S0 erT K ) e rT = S0 Ke rT
(ii)

if F0 = ( S0 I ) e rT then f = S0 I Ke rT

(iii) if F0 = S0 e( r y )T then f = S0 e yT Ke rT Numerical example of valuation of a forward contract:

Scenario: Six months ago you entered into a long forward contract for a term of 12 months. Today this forward contract has 6 months remaining to maturity. The delivery price of the contract is X = $24 The current price of the underlying asset is S = 25 The risk free rate of interest is 10% p.a. with continuous compounding The asset pays no income during the remaining term of the contract

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 What is the forward price of the asset for a forward contract written today that matures in 6 months? What is the value of the forward contract with delivery price of $24? What would the value of the contract be if it was a short forward contract instead? Assuming that interest rates 6 months ago were 10% and that $24 was the arbitrage free forward price at that time for a 1 year contract, what was the value of the underlying asset then?
Solution

The forward price of the asset is F0 = S0 e rT = $25.00 e0.100.5 = 26.28 If a new forward contract on the asset were written today, this is what the delivery price would be, and it would be costless to enter into this contract as either the holder of a long or the holder of a short position. To compute the value today of the long forward contract that was written 6 months ago with a delivery price of $24, the valuation formula is f = ( F0 K ) e rT = ( 26.28 24 ) e0.120.5 = 2.17 This is the present value of the payoff that would apply if the price of the underlying asset on the maturity date is equal to the forward price. If the contract were a short forward instead of a long forward then the value of the contract would be of the same magnitude but opposite sign: f = ( K F0 ) e rT = ( 24 26.28 ) e 0.120.5 = 2.17 To back solve for what the share price would have been 6 months ago we solve for S and get F0 = S0 e rT $24.00 = S e0.10 S = 24.00 e 0.10 = 21.72

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Equality of futures and forward prices:

When the risk free interest rate is constant and the same for all maturities, then it can be shown that the forward price and the futures price for a contract with a certain delivery date are the same. The proof (see textbook) can be extended to the situation where the interest rate is not constant but is known with certainty. In the real world, interest rates vary unpredictably, and in these circumstances forward and futures prices are not the same. As explained in the textbook: if the asset price is highly positively correlated with interest rates then futures prices tend to be higher than forward prices (due to the margining systems used by futures exchanges), but if the asset price is highly negatively correlated with interest rates then futures prices tend to be lower than forward prices Some of the other factors that contribute to there being a difference include: Transaction costs Taxes Treatment of margins (dont exist for forwards) Liquidity (usually higher for futures than forwards) Default risk (lower for futures) For most purposes it is reasonable to assume forward and futures prices are the same, especially for short maturity contracts. For longer maturity products (e.g. Eurodollar futures) it is less valid to make this assumption. Empirical studies have been done on this issue: For currencies these studies found few statistically significant differences between futures and forward prices. For commodities (metals) there were statistically significant differences, with futures prices being higher.

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Stock Index Futures

A stock index is an index that measures / reflects the investment performance of a portfolio of stocks. The group of stocks in the portfolio is called the index population. For instance the ASX 200 index population is the top 200 companies measured by market capitalization. In Australia, the stock exchange publishes a variety of different stock indexes: one for the overall stock market, one for industrial companies, another for the mining and oil industry, and various others for specific industries. In Australia these indexes are based on weights proportional to market capitalization (# shares on issue times market price of the shares) in the index population. Some overseas indexes (eg Dow Jones) are based on weights proportional to the stock prices for all stocks in the index population. There are 2 main types of stock index: a price index and an accumulation index. Changes in the level of a price index allow us to measure the change in the value of the portfolio of stocks. It measures the capital gain type return only. An accumulation index is similar except that it is calculated by assuming that any dividend income paid by the portfolio is re-invested back into the portfolio of stocks in proportion to the market values of each stock in the index population. Changes in the level of an accumulation index measure the total return on the portfolio from both capital gains and income. Note that this total return calculation assumes no tax or transaction costs. Stock index futures are futures contracts where the payoff at maturity depends on the value of a stock index. These are usually based on a price index and not on an accumulation index.

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Futures / Forward Prices for Stock Index Futures: The dividend income provided by a portfolio of stock is usually spread more or less uniformly over a year, as different stocks pay dividends on different dates. It is normal practice to treat the dividend income as a dividend yield instead of as a known cash income. In doing this we should estimate the dividend yield y as the average annualized dividend yield during the life of the contract and include those dividends in the calculation for which the ex dividend date occurs during the life of the contract. The formula for the forward price of a stock index for maturity T is r y T F0 = S0 e( ) where y is the dividend yield and S0 is the initial value of the stock index.
Contango and Backwardation:

SP500 index futures as at 16/3/2001 march 01 117330 june 01 118470 sept 01 119640 dec 01 120740 march 02 121790 june 02 123040 These futures prices are increasing with maturity, at approx 3.8% p.a. This is probably because the risk free interest rate is 3.8% above the dividend yield. When futures prices are an increasing function of maturity we say the market is in contango. When the futures prices are a decreasing function of maturity we say the market is in backwardation.

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Index Arbitrage

if F0 > S0 e( r y )T so that the futures price is above the arbitrage free value, then an arbitrage profit can be made by doing the following: buy spot the stocks underlying the index short sell the futures contract this is often done by firms holding short term money market investments if F0 < S0 e( r y )T so that the futures price is below the arbitrage free value, then an arbitrage profit can be made by doing the following: short sell the stocks underlying the index take a long position in the futures contract this is often done by pension funds that hold an index portfolio of stocks These strategies are often implemented by trading a small representative sample of the stocks in the index instead of the whole index population. This is more efficient and avoids excessive transaction costs. Sometimes this is done via computerized systems, known as program trading.
Forward and Futures Contracts on currencies

In our notation for assets, in the context of a foreign currency St means the value at time t of 1 unit of the foreign currency as measured in the local currency. This is what they call a direct quote. For instance if the local currency is AUD and the foreign currency is USD then the exchange rate might be USD 1.00 = AUD 2.00, meaning that the price of 1 unit of the USD will cost 2.00 Australian dollars. We would write that as St =2.00 For many countries that were formerly part of the British Empire, foreign exchange quotes are indirect quotes against the US dollar instead of direct quotes. This means the exchange rate is expressed as the number of US dollars that 1 unit of the local currency would be worth.

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In the above example, 1 unit of AUD would be worth $0.50 US dollars. In 1 our notation this would be St If you are the holder of an amount of foreign currency then you can deposit that money in a foreign bank account and earn the risk free rate of interest that applies in that currency. Notation: r means the domestic risk free interest rate rf means the foreign risk free interest rate Here both rates are taken to be continuously compounded rates and we assume that both the spot and forward prices are direct quotes. The relationship between the spot and forward exchange rates is ( r r )T F0 = S0 e f this relationship is called covered interest parity comments on the formula F0 = S0 e
( r rf )T

if the domestic rate is higher than the foreign rate then the forward price will increase with the term to maturity if the domestic rate is lower than the foreign rate then the forward price will decrease with the term to maturity this formula is really the same as the formula F0 = S0 e( r y )T if y = rf so we can view the foreign interest rate as being like a dividend yield

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Example: 2 year forward exchange rate between the USD and AUD

To see where this relationship comes from we shall consider how to create a synthetic forward exchange rate contract for the following example:

the spot exchange rate is 0.62 USD per 1.00 AUD the 2 year risk free interest rate is 5% in Australia and 7% in the USA because of the way the exchange rate is quoted, we shall treat the USD as the domestic exchange rate and the AUD as the foreign exchange rate, in applying the formula so we have S0 = 0.62 , r = 0.07 , rf = 0.05 , T = 2 ( r r )T 0.07 0.05)2 F0 = S0 e f = 0.62 e( = 0.6453 this means that we can enter a contract today to exchange 1 unit of the AUD for 0.6453 units of the USD in 2 years time
To create a synthetic forward exhange rate contract: Now borrow 1 unit of AUD at 5% for 2 years immediately exchange this 1 unit of AUD for 0.62 units of USD using the spot market invest / lend 0.62 units of the USD in a US bank account or short term investment at a rate of 7% for 2 years net cashflow at time t = 0 is nil Intermediate: our USD asset grows at the USD risk free rate our AUD liability grows at the AUD risk free rate At maturity in 2 years: our AUD borrowing matures for an amount of 1.00 e0.052 = 1.105171 our USD lending matures for an amount of 0.62 e0.072 = 0.713170 we pay back our AUD loan (pay 1.105171 AUD) and receive our USD asset of 0.713170 USD the exchange rate implicit in this transaction (which happens in 2 0.62 e0.072 0.713170 years) is = = 0.645303 1.00 e0.052 1.105171
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This example shows how to create a synthetic forward exchange rate contract:

borrow 1 unit of the foreign currency (financially equivalent to selling a foreign denominated zero coupon bond) at the foreign interest rate for a term equal to that of the forward exchange it at the spot exchange rate for the local currency lend / invest the proceeds (financially equivalent to buying a domestic zero coupon bond) earning interest at the local interest rate for the same term wait till the end of the term of the forward contract: the foreign asset and the domestic liability combination is equivalent to an exchange rate transaction at the time when they both mature

commodity futures and forwards

Some commodities (e.g. gold, silver) are held as investment assets as well as having industrial uses. There are storage costs (including insurance) associated with holding these commodities. Storage costs can be thought of as a negative income. If U is the pv of all storage costs during the term of a forward contract then the forward price for delivery at time T is F0 = ( S0 + U ) .e rT If the storage cost is proportional to the price of the commodity then we can think of it as being like a negative dividend yield. If the storage cost as a proportion of the commodity price is u then the forward price for r +u T delivery at time T is F0 = S0 e( )

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consumption commodities

Some commodities (e.g. sugar) are consumption assets and not investment assets. This means that the motivation for holding these assets is to use them in some industrial process or to consume them. Holding the asset to time T is not the same for them as having a forward contract to buy the asset at time T. A confectionary manufacturer cant use sugar futures to make sweets with but can use physical sugar for this purpose. For consumption commodities the arbitrage arguments used to derive formulae for forward prices as in the case of investment assets dont hold exactly. Suppose that K > F0 = ( S0 + U ) .e rT is the forward price for some commodity. an arbitrageur can borrow ( S0 + U ) at rate r for term T and buy one unit of the commodity and pay storage costs as they occur and short one futures contract At time T this will deliver a profit of ST + ( K ST ) ( S0 + U ) .e rT = K ( S0 + U ) .e rT N   
 

value of holding short futures payoff loan maturity payment

this strategy can be easily implemented for any commodity but the more people do this, the sooner the prices of the commodity and the forward price will change until this inequality no longer holds and it wont be profitable to adopt this strategy

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Suppose that K < F0 = ( S0 + U ) .e rT is the forward price for some commodity. an arbitrageur can sell the commodity and save the storage costs for ( S0 + U ) invest / lend the proceeds at the risk free rate for term T go long in one futures contract At time T this would deliver a profit of = ( S0 + U ) .e rT K This would work ok for an investment asset. But the problem here is that selling the commodity and going long a futures contract is not a perfect substitute for a holding of the commodity if it is a consumption asset. Hence for commodity futures all we can really say is that F0 ( S0 + U ) .e rT if storage costs are proportional to the commodity price then F0 S0 e( r +u )T
Convenience Yields

This is a way of measuring the benefits of holding the physical asset: If U is the pv of all storage costs during the term of a forward contract then the convenience yield yC is defined by the equation
F0 .e yCT = ( S0 + U ) .e rT

If the storage cost as a proportion of the commodity price is u then the convenience yield is defined by the equation r +u yC )T F0 e yCT = S0 e( r +u )T F0 = S0 e( where F0 is the futures price.

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COST OF CARRY

This means the storage cost plus the interest required to finance purchase of the asset less any income on the asset. It is another way to think about the relationship between spot and forward prices. Let c be the cost of carry. For an investment asset the relationship between spot and forward prices is F0 = S0 .ec.T For a consumption asset with a convenience yield we have c y T F0 = S0 e( C ) type of asset zero dividend paying stock stock index foreign currency cost of carry c=r c=ry c = r rf

commodity with storage cost yield c = r + u u

Futures price and expected future spot price

What does the futures price say about the expected spot price on the maturity date? We consider the expected spot price on some future date to be the markets consensus opinion about the spot price on that future date. We mean the average of the markets opinion about this matter. Some people take the view that the best estimate of what the spot price will be at time T in the future is the forward or futures price for delivery at time T the futures price is the best unbiased estimator of the future spot price Economists John Maynard Keynes and John Hicks argued that this may not be true:
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Suppose that hedgers tend to hold short forward positions while speculators tend to hold long forward positions. Then the futures price will be lower than the expected future spot price. The reasoning behind this conclusion is that speculators will only go long the forward if they expect to make money and require compensation for the risks they are taking on. hedgers on the other hand are willing to lose money on the average because they see it as the cost of obtaining protection against price falls. Suppose that hedgers tend to hold long forward positions while speculators tend to hold short forward positions. Then the futures price will be higher than the expected future spot price. The reasoning behind this conclusion is that speculators will only short the forward if they expect to make money and require compensation for the risks they are taking on. hedgers on the other hand are willing to lose money on the average because they see it as the cost of obtaining protection against price increases.
speculating on long futures contracts and risk / return Suppose a speculator goes long a futures contract hoping that it will be profitable at maturity (i.e. that ST > F0 ). The speculator does the following: invests F0 .e rT , the pv of the futures price at the risk free rate for term T at rate r goes long in a futures contract waits till maturity receives F0 , the proceeds from the risk free investment buys the stock for amount F0 sells the stock for its market price of ST the profit at maturity from selling the stock is ST F0
the time 0 cashflow from doing this is F0 .e rT the time T cashflow from doing this is ST = F0 + ( ST F0 )

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the net present value of this proposed strategy is k .T NPV = E ( ST ) e F0 .e rT N 


risk
expected adjusted payoff discount factor initial outlay

k here is the discount rate appropriate to the degree of risk in the investment In an efficient market the npv from doing this will be zero 0 = E ( ST ) e k .T F0 .e rT F0 = E ( ST ) e( r k ).T so the relationship between futures price and the expected future spot price is F0 = E ( ST ) e( r k ).T
The capital asset pricing model (security market line) k = r + E ( RM ) r

where E ( RM ) is the expected return on the market portfolio (i.e. the sharemarket). This is always higher than the risk free rate r is the risk free rate of interest

M = the correlation () multiplied by the ratio of the standard i

deviation of the return on the stock market and the standard deviation of the return on the asset This equation says that the rate of return on an asset depends on the correlation between returns on that asset and the returns on the market portfolio (which in practice means the stock market) via the beta factor. If the correlation is zero then k = r F0 = E ( ST ) If the correlation is > zero then k > r F0 < E ( ST ) If the correlation is < zero then k < r F0 > E ( ST )

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Futures Contracts and Hedging

There are various differences between futures and forward contracts, as well as many features in common. Futures contracts are exchange traded whereas forward contracts are over the counter contracts. There is a part of the exchange called the exchange clearing house, which performs the functions of matching buyers and sellers and making and receiving payments to / from market participants. It acts as the counterparty to every futures market transaction. A holder of a long futures and a holder of short futures each have a contract with the clearing house and not with each other. The exchange clearing house administers a system of deposits and margins for futures contracts. This means that for futures contracts there may be various cashflows paid / received prior to the maturity date. Forward contracts dont have this problem. The system of margins and deposits provides protection to users of the market against the risk of default by the counterparty. So the level of counterparty credit risk is lower with futures contracts than with forward contracts. The futures contracts are standardized in their features. This enhances the liquidity of the market for them. Forward contracts are not standardized. Futures contracts can be reversed easily by entering into an opposite transaction in the same contract. This is a process known as closing out a futures contract. Forward contracts are much more difficult to reverse once entered into.

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Sydney Futures Exchange (SFE) Bank Bill Futures Contract

The details of the contract which are standardized include: The quality and quantity of the underlying asset, The maturity dates The settlement method, The method of quotation of the futures price, The minimum price movement
Contract Unit: (underlying asset) Contract Months: (available terms to maturity) Minimum Price Movement:

A$1,000,000 face value 90-Day Bank Accepted Bills of exchange March/June/September/December up to twenty quarter months or five years ahead

One hundred minus annual percentage yield quoted to two decimal places. 12.00 noon on the business day immediately prior to Last Trading Day: settlement day.2 The second Friday of the delivery month. Settlement Day: 5.10pm 7.00am and 8.30am 4.30pm2 (during US Trading Hours: daylight saving time)3 5.10pm 7.30am and 8.30am 4.30pm2 (during US non daylight saving time)3 Ten bank accepted bills or ten bank negotiable Settlement certificates of deposit (NCDs) each of face value Method: A$100,000, or two bank accepted bills or or bank negotiable certificates of deposit each of face value A$500,000 or one bank accepted bill or EBA or bank negotiable certificate of deposit of face value A$1,000,000 maturing 85-95 days from settlement day.

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The method for quoting the futures price on the ASX for interest rate futures.

The quoted futures price is not the same as the cash delivery price (the actual dollar amount you have to pay on the delivery date). Instead it is quoted as Q = 100 y where y is the annual yield to maturity expressed as a percentage. For example if the annual yield to maturity is y = 6% then the futures quote is Q = 100 y = 100 6 = 94 . To compute the actual cash delivery price we need to compute the yield y from the quote Q and then use the yield as the input to the bank bill valuation formula, which is 1000000 1000000 value = = = 985421.1663 90 y 90 6 1 + 1 + 365 100 365 100

So when the contract matures, you would pay $985,421.17 in cash and receive a 90 day bank accepted bill with a face value of $1,000,000 and a term of 90 days. The futures quote was 94 but the cash delivery price is not 94.
The settlement method:

For this contract it is settled by physical delivery (in other words the holder of a long position actually receives a 90 day bill) instead of cash settlement. Some contracts are settled by physical delivery but some are instead settled in cash. Suppose that you entered a bank bill futures contract today (15 August 2005), to buy at a futures quote of 94, for delivery in December 2005. Then the delivery date would be the second Friday of December 2005 (the 9th of December 2005).
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On that date you would be obligated to buy a bank bill with a face value of $1000000 and a maturity date 90 days after 9/12/2005, which happens to be 9/3/2006). The price of this bill would be $985421.17. It is possible that on the date when the futures matures, the bank bill yield has dropped to 5% p.a., so that the bank bill price has risen to 1000000 price = = $986,619.81 90 5 1 + 365 100 Under this scenario, you can buy the bill for $985421.17 and then immediately sell it for $986,619.81. This makes you a profit of $986,619.81-$985421.17 =1198.65 If the contract were cash settled instead of settled by physical delivery, then on the delivery date the futures exchange would pay you as the holder of the long position in the futures contract, an amount of cash equal to the profit you could get by immediately selling the asset. Instead of paying $985421.17 and receiving a 90 day bank bill with $1m face value, you would instead receive $1,198.65 in cash.
For our purposes we shall treat futures and forward contracts as almost identical. Example of Using Bill Futures for hedging:

Hedging is like insurance: the motivation is to reduce financial risk. Let us suppose you are a corporation and you know that you will have to borrow $100m for 90 days in December 2005, to finance the purchase of imported luxury cars for your car dealing business. It is currently 15 August 2005. You dont know what the interest rates on 90 day bills will be in December. You want to eliminate the risk of an increase in interest rates. Today, 90 day bank bill yields are 6.0%. and the December bill fufures contract is trading at a quoted futures price of 94. To protect the firm from an increase in interest rates, you need to enter a short futures contract to sell bank bills in December. Remember that borrowing money is financially equivalent to selling a debt security: a lender buys and a borrower sells a debt security.
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You can enter a contract today to borrow money for 90 days starting from 9/12/2005, at a yield of 6% buy shorting futures contracts. The delivery price of the $1m face value 90 day bill will be $985,421.17. This is the amount you as the holder of 1 futures contract would receive on the maturity date of the futures contract which is 9/12/2005. Then when the bank bill matures, 90 days later on 9/3/2006 you would have to pay back $1,000,000. The amount of money you wanted to borrow in December was $100m, not $985,421.17. To be able to guarantee you could borrow this amount in December you would need to short sell n bill futures contracts where 100,000,000.00 n= = 101.4795 101.5 985,421.17 But you cant buy a fraction of a contract, only a whole number of contracts. This is one of the problems with futures contracts: the standardization of the contract means that the contract may not perfectly match the needs of the users. This is not such a big problem in this example, but suppose you wanted to borrow $0.5m in December instead of $100m. Then the bill futures contracts standardized amount would be more of a problem.
The payoff from hedging:

Let us ignore the complication that we cant trade 101.4795 contracts and pretend that we can trade the number of contracts that we want. In December when the futures matures, it is possible that 90 day bank bill interest rates have risen to 7%. This would mean that for $1m face value, the sale proceeds would be $983,032.59 instead of $985,421.17. Buy selling bank bill futures, we have been able to save the firm an amount of $242,391.60 =101.4795 ( $985,421.17 - $983,032.59 ) Compared with the amount of money we could have raised by selling 101.4795m of 90 day bills in the physical market payoff = ( number of futures contracts ) ( X - ST )

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 X = delivery price of futures contract ST = price of the underlying asset (a 90 day bank bill) at the maturity date of the futures
Deposits and margins

The futures exchange requires that anyone who wants to trade a futures contract (either long or short) must open a special type of bank account with the exchange clearing house. This is called the margin account. The first deposit is required on the day when the futures contract is initiated. It is called the initial deposit or the initial margin. It is an amount of money equal to the maximum likely price fluctuation in the contract over a 1 day period. The exchange decides the amount of the initial deposit. It is usually approximately 5% of the value of the underlying asset. At the end of each day, every futures contract is revalued according to the closing futures price. This process is called marking to market. It is possible that your futures position may have increased in value or it may have decreased in value. If it has decreased in value, the exchange will require you to pay an additional amount into the margin account. This amount is called the variation margin also known as a maintenance margin. It is usually equal to the amount by which your contract has fallen in value over the last 1 day.
Example: long bank bill futures position

For the bank bill futures contract above, let us assume that 1. the initial deposit is 5% of the value of the underlying asset and 2. that we are long the futures (not short as above). The initial futures quote was 94.00 and the implied yield to maturity was 6%, so the delivery price is $985,421.17
The initial deposit would be = 985421.17 0.05= $49,271.06

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Let us suppose that on day 2, the futures quote for this contract changes from 94.00 to 93.80. This means the yield to maturity has changed to 6.20% and the futures price has changed to $984,942.52. The value of our long futures contract has fallen by an amount $985,421.17 - $984,942.52 = $478.64 We are required to pay in a variation margin of $478.64, taking the amount in the margin account to $49,749.70 Now suppose that on day 3, the futures quote changes to 93.70. This means a yield of 6.30% and the delivery price changes to $984,703.37. The value of our long futures position has fallen again, this time by an amount of $239.15. The variation margin we would have to pay is $239.15
Example: closing out the contract

On day 4, the futures quote falls again to 93.50. You went long the December bill futures contract because you thought that bill yields were going to fall but instead they have been rising, the prices of bills for delivery in December has been falling. You decide you want to cut your losses and get out of the contract. To do this you have to enter into a contract over the same underlying asset (the 90 day bill) with the same maturity (December 2005) but opposite in direction (i.e. short instead of long). To cancel out your long December bill futures at 94.00 you have to go short another December bill futures at a quote of 93.50. Under the long futures contract you are obligated to buy a 90 day bank bill on 9 december 2005 for a price of $985,421.17. Under the short futures contract you are obligated to sell a 90 day bank bill 1000000 = $984,225.43 on 9 december 2005 for a price of 90 6.5 1 + 365 100

39

Let ST be the actual price of a 90 day bill on 9 december 2005. Then the payoff from this combination of long and short futures contracts is
payoff = ( ST - $985,421.17 ) + ( $984,225.43-ST )   
  

long futures payoff short futures payoff

note that this is independent of ST payoff = $984,225.43-$985,421.17= -$1,195.74 This is a loss of $1195.74 and it is independent of the actual price of a bill on the maturity date. Your future obligations on the 2 contracts cancel out to this net amount. Your margin account would have an amount of $49,988.85 so the loss would be taken out of your margin account. The remaining balance of the margin account would be returned to you. This process of matching off 2 opposite transactions in the same asset for the same maturity date is called closing out the contract. By having this system of deposits and margins, the exchange clearing house protects itself (and hence protects futures market traders) from default by a party to futures contract. If a traders position is making losses, there is the possibility that they will default. If they cant pay the margin call (the variation margin) then the exchange will close out their futures contract as above and take the cost of doing so out of their margin account.

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Forward Rate Agreement (FRA)

This is an over the counter contract that a certain fixed interest rate will apply to a certain fixed principal amount during a specific future period of time. Suppose that the principal amount is L the FRA contract specifies that the holder (a financial institution say) will receive interest at rate RK on the amount L, for the period from time T1 to time T2 RF = the forward LIBOR interest rate for the period from time T1 to time T2 R = the actual LIBOR interest rate observed at time T1 for a deposit maturing at time T2 , and which has a term of T2 T1 The cashflows to the holder of the FRA are: L at time T1 (cash outflow from lending / investing) and +L 1 + RK (T2 T1 ) (cash inflow from maturity proceeds) at time T2
Valuing the FRA At zero cost it is possible at time 0 to enter into an arrangement to borrow L at time T1 and repay it at time T2 with interest at the forward interest rate RF (the forward rate, as observed at time 0 for a loan over the period from time T1 to time T2 ) by combining this forward borrowing with the above FRA we can generate a situation with the following cashflows: Time T1 cashflow = + L L = 0
Time T2 cashflow = + L 1 + RK (T2 T1 ) L 1 + RF (T2 T1 ) = L ( RK RF )(T2 T1 )

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The value of the FRA is the present value of this cashflow at time T2 The value of the FRA is thus
FRAvalue = L ( RK RF )(T2 T1 ) .exp ( R2 .T2 ) where P (0, T2 ) = exp ( R2 .T2 ) is the price at time 0 of a zcb maturing at time T2 (same as the discount factor at the risk free interest rate)

More about hedging with futures: A hedge is a transaction (or set of transactions) which is intended to offset the risk of loss due to changes in interest rates, exchange rates, financial market prices or commodity prices. If it works, it works by generating a situation where changes in the value of the hedge instrument are in the opposite direction to changes in the variable being hedged.

Perfect Hedge:
A perfect hedge is one that completely eliminates risk. It is rare to find a perfect hedge. An example of one is closing out the long bank bill futures contract by entering into a short futures contract, as described above. Buy and Hold (or set and forget) Sometimes a financial instrument exists that hedges the exposure and after you enter into the transaction you can hold your position until maturity without the need for any adjustments during the period. This is a buy and hold strategy.

Short Hedge:
You own some asset (e.g. gold) and you expect to sell it at some future time. You are worried about the possibility of the price falling between now and when you expect to sell it. You can hedge against this risk by shorting futures contracts on gold now. If the price of gold does fall, you make a gain on the futures that offsets the loss on the holding of physical gold.
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You are a gold miner and you expect to have 100000oz of gold ready to sell in 12 months time. The current gold price is $400 / oz. If the gold price were to fall to $300 in a years time you will make a loss of $100 / oz compared with todays prices. You could hedge against this risk by entering into a futures contract to sell gold at say $420 / oz in 12 months time. If the price of gold did fall to $300 then the futures contract would be in profit by $120 = $420-$300. This profit offsets the loss of $100 on the physical gold.

Long Hedge
This is appropriate if you know you will have to buy some commodity at some future time and you are concerned about the price of that commodity rising too much. For example plastics manufacturer needs to buy oil to stay in business. If it has fixed price contracts to supply customers it is exposed to loss if the price of oil goes up. It can reduce the extent of this loss by going long in oil futures contracts.

Motivations for hedging and arguments for and against it.

Most corporations are not in the business of forecasting or trading on the basis of changes in interest rates, exchange rates, financial market prices and commodity prices. They are in the business of producing goods and services. Their profits may be adversely impacted by changes in the above variables. It makes sense for them to hedge the risks associated with these variables as they arise. They can then focus on their core business activities, where they do have the requisite expertise. Hedging will help to avoid nasty surprises such as an increase in the cost of their inputs. In practice many risks are left unhedged. There are various reasons for this.

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Shareholders and risk: In some cases the shareholders may be able to hedge the risk themselves, independently of the company and they dont need the company to do it for them. For instance, a gold miner / manufacturer could hedge most of their gold price risk. Doing this would transform the returns from the business into an almost risk free operation. But the shareholders who bought the shares may have done so precisely because they wanted to speculate on gold prices. They might not want all risk to be hedged away. The company may be punished by a falling share price if the shareholders feel this way. There is a cost associated with hedging: There may be explicit costs associated with hedging: up front costs of purchasing financial instruments, brokerage, commission, margin calls on futures etc. There is also opportunity cost. If you hedge with futures then you are protected against upside risk (profit) as well as downside risk (loss). Industry practice: In some industries it is normal for prices to fluctuate up and down in response to changes in the costs of the raw materials and other inputs. This situation is a natural hedge for the firms profit because changes in the revenues and changes in the expenses offset each other. In this situation, a firm which hedges the costs of these raw materials will actually be worse off than one that does not.

Hedging may increase risk instead of reducing it. Basis Risk:

In practice, users of financial derivatives often dont know the precise date in the future when an asset may have to be bought or sold. Even if they do, it may not coincide with the maturity date for the available futures contracts.

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The complications involved in hedging include

the asset price to be hedged is not exactly the same as the asset underlying the futures contract (e.g. a 2 year bond is not matched by the bank bill contract or the 3 year bond futures contract) the quantity of the asset to be hedged is not an exact integer multiple of the asset underlying the futures contract the exact date when the asset is to be bought or sold is not known with certainty or it does not match the maturity date of available futures the hedge may require that the futures contract be closed out before its expiration date
These complications give rise to what is known as basis risk

The basis is defined as

basis = spot price of asset - futures price of being hedged contract being used If the asset being hedged and the underlying asset for the futures are the same (in both quality and quantity) then the basis will be zero at the expiration date of the futures contract. Note that the spot price of the underlying asset and the futures price will be the same at the expiration date of the futures contract. For a proof of this see section 2.3 page 23-24 of Hulls book (5th edition). Before expiration the basis may be either positive or negative. When the spot price increases by more than the increase in the futures price the basis increases referred to as strengthening the basis. When the spot price increases by less than the increase in the futures price, the basis decreases referred to a weakening the basis. Notation:
S1 = spot price at time t1
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S2 = spot price at time t 2 F1 = futures price at time t1 for a futures that matures at time T F2 = futures price at time t 2 for a futures that matures at time T t1 <t 2 <T b1 = S1 F1 = basis at time t1 b2 = S2 F2 = basis at time t 2

Assume the hedge is implemented at time t1 and closed out at time t2.

numerical example:
S1 = 2.50 F1 = 2.20 S2 = 2.00 F2 = 1.90 t1 =0.25 t 2 =0.50 T=0.75 b1 = S1 F1 = 0.30 b2 = S2 F2 = 0.10

Suppose a hedger wants to sell the asset at time t2 and takes out a short futures contract at time t1. Suppose also that the asset exactly matches the underlying asset of the futures contract. The time t2 cashflow is S2 + F1 F2 = F1 + S2 F2 = F1 + b2 The numerical value here is 2.20+0.10=2.30 At time t1 the futures price F1 is known with certainty but the basis b2 at time t2 is not known with certainty. The hedging risk is the uncertainty in b2 and this is what we mean by basis risk. Basis risk when the asset being hedged is not the same as that underlying the futures contract.

S1* = spot price of the futures contract underlying asset at time t1 S2* = spot price of the futures contract underlying asset at time t 2
In this situation the basis risk is usually higher:

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Suppose a hedger wants to sell the asset at time t2 and takes out a short futures contract at time t1. The time t2 cashflow is S2 + F1 F2 = F1 + ( S2* F2 ) + ( S2 S2* ) in this case the basis is made up of 2 components
b2 = ( S2* F2 ) + ( S2 S2* )   
  

basis if assets were the same difference between 2assets

Choice of contract
A key decision is what futures contract to use for hedging. Need to consider what maturity date for the futures? which futures contract has the best underlying asset? If there is a futures contract with an asset that is the same as the asset being hedged then the choice is easier. If this is not the case then we need to consider which of the available futures contracts has futures prices that have the highest correlation with the price of the asset to be hedged. The normal choice for the maturity date is to pick the maturity date closes to but later than the date when the asset is to be bought / sold. Basis risk tends to increase with the time difference between the futures maturity date and expiration date of the hedge.

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Minimum Variance Hedge Ratio

The hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure. It is an important concept in derivative pricing and we will meet it again when we look at options. Notation

S =change in the spot price S during the term of the hedge F =change in the futures price F during the term of the hedge S = standard deviation of S F = standard deviation of F = correlation between S and F
the optimal hedge ratio is given by the formula
h* =

S F

Proof: suppose the hedger is long the asset and short h units of the futures contract: then the change in the value of the hedged position over the life of the hedge is S h F for each unit of the asset held the variance of the change in the value is var ( S h F ) = var ( S ) + var ( h F ) 2cov ( S , h F )

S 2 + h 2 F 2 2h S F = var ( h F S )

this variance is a function of h, the hedge ratio var = g ( h ) = S 2 + h 2 F 2 2h S F we can minimize this by choosing the right value of h. The right value of h is found by differentiating this function of h and equating the derivative to zero S F S d g ( h ) = 2h F 2 2 S F = 0 h = = dh F2 F
note that var ( h F ) = h 2 var ( F ) = h 2 F 2 and that cov ( S , h F ) = h.cov ( S , F ) = h. . S . F
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 if we have a situation where = 1 and

hedge and the hedge ratio is 1.00

S = 1 then we have a perfect F S = 0.50 then hedge ratio = F

if we have a situation where = 1 and

0.50. The futures price always changes by twice the change in the spot price, so half a futures contract is a perfect hedge.
The hedge effectiveness is defined as the proportion of the variance that is
eliminated by hedging. This is 2 = ( h *) F S
2 2

Optimal Number of futures contracts:

Notation: N A = size of position being hedged in units QF = size of one futures contract in units N * = optimal number of futures contracts for hedging the number of futures contracts for hedging is N N * = h* A QF

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Numerical example: An airline needs to buy 2 million gallons of jet fuel in 2 months and decides to use heating oil futures for hedging. Based on historic data we have S = 0.0263 = standard deviation of change in jet fuel price S F = 0.0313 = standard deviation of change in heating oil futures price F = 0.0928 correlation between S and F 0.0263 h* = S = 0.928 = 0.78 0.0313 F the number of units of jet fuel being hedged is N A = 2,000,000 gallons the number of units of heating oil underlying the futures is QF = 42,000 gallons the optimal number of futures contracts is N 2000000 N * = h* A = 0.78 = 37.14 37 QF 42000

Stock Index Futures:

If the index underlying the futures contract is a good proxy for the market portfolio then the optimal hedge ratio to hedge a portfolio of shares is the same as the beta factor for that portfolio of shares. The optimal number of futures contracts to hedge an equity portfolio is P N * = where A P is the current value of the portfolio A is the current value of the stocks underlying one futures contract This is really the same as the formula N * = h* different notation.
NA above but written in QF

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Example:

the S&P 500 index value = $1,000 = F1 value of equity portfolio to be hedged = $5,000,000 = S1 risk free interest rate = 10% p.a. (continuously compounded) dividend yield on index = 4% beta of portfolio = 1.50 we want to hedge the portfolio value over the next 3 months by using a futures that matures in 4 months 1 futures contract is for delivery of $250 times the index
= 1020.20 The futures price should be F1 = 1000 e the number of futures contracts to be shorted to hedge the portfolio is P 5,000,000 N * = = 1.5 = 30 A 250,000 Scenario 1: in 3 months time the index is at 900. The futures price will then be F2 = 900 e
( 0.100.04 )
1 12

( 0.100.04 )

4 12

= 904.51

the gain on the short futures position is 30 ( F1 F2 ) 250 = 30 (1020.20 904.51) 250 = 867,676 the loss on the index is 10% (it fell from 1000 to 900) the index dividend yield is 4% p.a. (approx 1% per 3 months) the return on the index is therefore approx -9% over 3 months the risk free rate of interest is approx 2.5% over 3 months

We can estimate the return on the equity portfolio from the return on the index by using the capm equation k = r + ( E ( RM ) r ) = 0.025 + 1.5 ( 0.09 0.025 ) = 0.1475 the expected value of the equity portfolio at time 3 months is therefore S2 = 5,000,000 (1 + 0.1475 ) = $4, 262,500 The expected hedged equity portfolio value is therefore S2 + ( F1 F2 ) = $4, 262,500 + $867,676 = $5,130,176
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Reasons for hedging equity portfolio

If you expect the index to fall in value then it will probably take the value of your portfolio down with it. An alternative to hedging with futures is to sell the portfolio now and buy it back later. However the transaction costs would be huge. We can achieve the same thing using futures at a much lower transaction cost, and it takes less time to put the transaction into effect. Another reason is that you may believe that your portfolio will outperform the index. By shorting futures and being long the equity portfolio, the hedger is exposed only to the performance of the portfolio relative to the market index. Sometimes a portfolio manager may want to change the beta of the portfolio as part of active portfolio management. If they take the view that the market is going to go up, then they might want to increase the portfolio beta. One way to do this is to sell low beta stocks and buy high beta stocks. This involves a lot of trades and the associated transaction costs. Alternatively it can be achieved much more quickly and at lower transaction cost by using index futures. To change the portfolio beta from to * when > * we need to take a short position in

contracts when < * we need to take a long position in contracts

hedging exposure to an individual stock

P ( *) futures A P ( * ) futures A

On the SFE there are individual share futures contracts for some (but not all) stocks traded on the ASX. If so we can use this to hedge. If not you P need to hedge by shorting index futures where is the beta of that A stock, P is the value of the shares to be hedged and A is the value of the stocks underlying one index futures contract.
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