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20 January, 2017
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Lecture Outline
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Specification of Futures Contract
Thus, the exchange should specify in detail the exact nature of the
contracts. These include..
1 Underlying asset
For commodities, there can be a variation in quality of the asset (e.g,
grade A orange juice).
For financial assets, usually no variation in the grade of the asset.
2 Contract size
Amount of asset that will be delivered under one contract (e.g. One
future contract on British pound is to buy/sell 62,500).
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Specification of Futures Contract
3 Delivery arrangement
Place where delivery will be made (e.g. warehouse in Florida)
4 Delivery month
Futures contract is referred to by its delivery month (e.g., corn futures
on CME has delivery months of March, May, July, September, and
December).
The exchange must specify the exact period during the month when
the delivery can be made.
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Payoff of Forward and Futures
Forward and futures are very similar to each other, but a forward
contract is simpler to analyze.
Let F denote the forward price (the promised price to buy/sell at the
maturity T of the contract).
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Payoff of Forward and Futures
Suppose we enter a futures contract on day 0 and the contract will
expire on date T .
Ex. Suppose we long futures on gold at the futures price of $1,250 per
ounce on day 0.
If later futures prices are as follows, then ...
Day Futures price Daily gain
0 1,250
1 1,241 (1,241-1,250) = -9
2 1,238 (1,238-1,241) = -3
3 1,244 (1,244-1,238) = 6
.. .. ..
. . .
T FT (FT FT 1 )
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Payoff of Forward and Futures - Daily Settlement of
Futures
On the next day, suppose that new futures price becomes F1 . Then,
we settle the old contract and receive F1 F0 . Right after the
settlement, we start with new futures contract with F1 .
Assume that the risk-free rate is 0. Then, the cumulative gain from 0
to contract end T is
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Operation of Margin Accounts
The exchange requires investors to set up a margin account when
they enter a position in futures.
Initial margin: the amount that must be deposited at the time the
contract is entered (e.g. $3,000 per contract)
Once the margin account is set up, the gain/loss from daily
settlement of futures will be added/subtracted to the account.
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Futures Price and Spot Price
Consider futures contracts for delivery on date T . Let Ft denote the
futures price on the contract starting on date t.
Then, (
For t < T , Ft 6= St (usually)
For t = T , Ft = St
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Delivery of Futures
There are two types of delivery of futures:
1 Physical delivery: physically deliver underlying assets (e.g. commodity)
2 Cash settlements: final payoff of futures is paid in cash (e.g. stock
index)
Prices
Open: the price at which contracts were trading at the beginning of
the trading day
High: the highest price during the day
Low: the lowest price during the day
Settlement: the price used for calculating daily gain/loss (usually
closing price of the day)
(Trading) Volume: the number of contracts traded in a day
Open interest: the number of contracts outstanding
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Market Quotes
Q. One day, one trader who already holds 10 futures contracts sells those
10 futures contracts to a new trader entering the market.
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Hedging Using Futures
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Hedging Using Futures
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Short Hedge - Example
Oil futures price for August delivery is $79 per barrel, and each
contract is for delivery of 1,000 barrels.
Q. To hedge the risk, what position on futures should the producer take?
short 1,000 futures contract.
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Short Hedge - Example
What if the the spot price of oil on August 15 turns out to be ...
1 $75 per barrel
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Long Hedge - Example
Copper futures price for May delivery is $3.20 per pound, and each
contract is for delivery of 25,000 pounds.
Q. To hedge the risk, what position on futures should the fabricator take?
long 4 futures contract.
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Long Hedge - Example
What if the the spot price of copper on May 15 turns out to be ...
1 $3.25 per pound
Total payment = 3.25 100, 000 (3.25 3.20) 100, 000 = 320, 000
| {z } | {z }
sales contract futures contract
Total payment = 3.05 100, 000 (3.05 3.20) 100, 000 = 320, 000
| {z } | {z }
sales contract futures contract
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Perfect Hedge
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Perfect Hedge
To hedge the risk, the company short futures contract for delivery on
date T at futures price F0 .
ST + (F0 FT ) = ST + (F0 ST ) = F0
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Imperfect Hedge
Futures contracts may not be available for a certain delivery month or
a certain underlying asset.
Then we try to use futures with the closest delivery month and on the
most similar underlying asset. However, this does not eliminate risk
completely.
1 Mismatch in delivery date
Suppose that on date 0, a company knows it will sell an underlying
asset on date 1.
S1 + (F0 F1 ) = F0 + (S1 F1 )
| {z }
6=0
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Imperfect Hedge
Let S denote the spot price of A and S denote the spot price of B.
ST + (F0 FT ) = F0 + (ST ST )
| {z }
6=0
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Imperfect Hedge - General Case
Suppose that on date 0, a company knows it will sell an underlying
asset A on date 1.
Also, suppose that we try to hedge using futures on asset B for date
T delivery.
S1 + (F0 F1 ) = F0 + (S1 F1 )
| {z }
basis
S1 F1 = (S1 S1 ) + (S F1 )
| {z } | 1 {z }
mismatch in asset mismatch in delivery
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Cross Hedging
Ex. An airline that is concerned about the future price of jet fuel uses
futures contract on heating oil.
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Cross Hedging - Minimum Variance Hedge Ratio
Let S denote the price change in the asset and F denote the
change in futures price in the hedge period.
S hF
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Cross Hedging - Minimum Variance Hedge Ratio
Cov (S, F )
h =
Var (F )
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Cross Hedging - Minimum Variance Hedge Ratio
Given the optimal hedge ratio, we want to know the optimal number
of futures contract.
N QF
h =
QA
Thus,
h QA
N =
QF
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Cross Hedging - Example
Q2. Each of the futures contract is for 42,000 gallons of heating oil. How
many contracts does the airline need?
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Stock Index Futures
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Stock Index Futures
Suppose we invest $1 in the portfolio and short futures on$ h amount
of index.
Let rS denote the return on the portfolio and rF denote the the return
on futures over the hedging period.
rS hrF
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Stock Index Futures
N VF
=
VA
Thus,
VA
N =
VF
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Stock Index Futures - Example
Suppose we want to hedge the value of a stock portfolio over the next
three months. We use a futures contract with four months to
maturity. The situation is ...
S&P 500 index = 1,000
S&P 500 futures price = 1,010
Value of portfolio = $5,050,000
Risk-free interest rate = 4% per annum
Beta of portfolio = 1.5
One futures contract is for delivery $250 times the index.
5, 050, 000
N = (1.5) = 30
250 1, 010
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Stock Index Futures - Example
What if S&P 500 index and futures prices are as follows three months
later?
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Stock Index Futures - Example
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Stock Index Futures - Example
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Stock Index Futures - Example
What if S&P 500 index and futures prices are as follows three months
later?
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Things To Do
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