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Forward and Futures Contracts

Chapter 23. Forward and Futures Contracts. Innovative Financial Instruments. Dr. A. DeMaskey. An Overview of Forward and Futures Trading. Forward contracts are negotiated directly between two parties in the OTC markets. Individually designed to meet specific needs Subject to default risk

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Forward and Futures Contracts

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  1. Chapter 23 Forward and Futures Contracts Innovative Financial Instruments Dr. A. DeMaskey

  2. An Overview of Forward and Futures Trading • Forward contracts are negotiated directly between two parties in the OTC markets. • Individually designed to meet specific needs • Subject to default risk • Futures contracts are bought through brokers on an exchange. • No direct interaction between the two parties • Exchange clearinghouse oversees delivery and settles daily gains and losses • Customers post initial margin account

  3. Futures vs. Forward Contracts

  4. Hedging With Forwards and Futures • Create a position that will offset the price risk of another holding. • Short hedge • supplements a long commodity holding with a short forward position • Long hedge • supplements a short commodity holding with a long forward position

  5. Relationship Between Spot and Forward Prices • The basis is the spread between the spot and futures price for the same asset at the same point in time T: • Bt,T = St - Ft,T • Initial basis • Maturity basis • At maturity, the forward price converges to the spot price (FT,T = ST)

  6. Basis Risk • Profit from short hedge: • Bt,T - B0,T = (St - Ft,T) - (S0 - F0,T) • Terminal value of hedge equals cover basis minus initial basis. • Real exposure is correlation between future changes in the spot and forward contract prices • Basis risk is small if price movements are highly correlated • Basis risk = 0 for forwards • Basis risk > 0 for futures

  7. Optimal Hedge Ratio Net profit of short hedge position: Variance of this value: Minimizing and solving for N:

  8. Valuing Forwards and Futures The value of unwinding a forward position early: The value of a futures, which are marked-to-market is: * = the possibility that forward and futures prices for the same commodity at the same point in time might be different.

  9. The Cost of Carry Model • If you buy a commodity now for cash and store it until you deliver it, the price you want under a forward contract would have to cover: • the cost of buying it now • the cost of storing it until the contract matures • the cost of financing the initial purchase • These are the cost of carry necessary to move the asset to the future delivery date.

  10. The Relationship Between Spot and Forward Prices • Contango • high storage costs and no dividends • Premium for owning the commodity • convenience yield • results from small supply at time 0 relative to what is expected at time T (after the crop harvest) • Backwarded market • future is less than spot

  11. Relationship Between Futures Price and Expected Future Spot Price • Pure Expectations Hypothesis • F0,T = E(ST) • Normal Backwardation • F0,T < E(ST) • Normal Contango • F0,T > E(ST)

  12. Applications and Strategies • Interest Rate Forward and Futures • Short-term • Long-term • Equity Index Futures • Currency Forward and Futures

  13. Long-Term Interest Rate Futures • Treasury bond and note contract mechanics • CBT $100,000 face value • T-bond >15 year maturity • T-note 10 year - bond with 6.5 to 10 year maturity • T-note 5 year - bond with 4.25 - 5.25 years • Delivery any day during month of delivery • Last trading day 7 days prior to the end of the month • Quoted in 32nds • Yield quoted is for reference • Treasury bonds pay semiannual interest • Conversion factors for differences in deliverable bonds

  14. A Duration Based Approach to Hedging

  15. Treasury Futures Application • A T-Bond/T-Note (NOB) Futures Spread • expecting a change in the shape of the yield curve • unsure which way rates will change • long one point on curve and short another point

  16. Short-Term Interest Rate Futures • Eurodollar and Treasury bill contract mechanics • Chicago Mercantile Exchange (CME or “Merc”), International Monetary Market (IMM), LIFFE • LIBOR • Altering bond duration with futures contracts • Creating a synthetic fixed-rate funding with a Eurodollar strip • Creating a TED spread

  17. Stock Index Futures • Intended to provide a hedge against movements in an underlying financial asset • Hedging an individual stock with an index isolates the unsystematic portion of that security’s risk • Stock index arbitrage • prominent in program trading

  18. Currency Forwards and Futures • Currency quotations • Direct (American) quote in U.S. dollars • Indirect (European) quote in non U.S. currency • Reciprocals of each other • Interest rate parity and covered interest arbitrage

  19. www.fiafli.org www.e-analytics.com/fudir.htm www.futuresmag.com www.mfea.com/planidx.html The InternetInvestments Online

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