FIN 410 CH 14

Short Hedge

-A company has a large inventory that will be sold at a future date. The company will suffer losses if the value of inventory falls. -Suppose the company wants to protect the value of their inventory: *selling futures contracts today offsets potential declines in the value of the inventory. *the act of selling future contracts to protect from following prices is called SHORT HEDGING.

Default

-One party faces default risk, because the other party might have an incentive to default on the contract. -to cancel the contract, both parties must agree -one side might have to make a dollar payment to get the other side to agree to cancel the contract.

long hedge

-a company need to buy a commodity at a future date. The company will suffer "losses" if the price of the commodity increases before then. (That is, they paid more than they could have) -suppose a company want to "fix" the price that they will pay for the commodity -buying the futures contracts today offsets the potential increases in the price of the commodity -the act of buying futures contracts to protect from rising is called long hedging.

Future trading accounts

-a future exchange, like a stock exchange, allows only exchange members to trade on the exchange -exchange members may have firms or individuals trading for their own accounts. or they may be brokerage firms handling trades for their customers.

Why futures?

-a futures contract represents a zero-sum game between the buyer and the seller. -gains realized by the buyer are offset by losses realized by the seller (and vice versa) -the futures exchanges keep track of the gains and losses every day.

Hedging with futures

-a hedger trades future contracts to transfer price risk. -hedgers transfer price risk by adding a futures contract position that is opposite of an existing position in the commodity or financial instrument. -when the hedge is in place: *the futures contract "throws off" cash when cash is needed *the future contract "absorbs" cash when cash is available.

A short hedge will protect your bond portfolio against the risk of a general rise in interest rate during the life of the futures contracts:

-bond prices call when interest rates rise -selling bond futures throws off cash when bond prices falls

Speculating with futures, long:

-buying a futures contract (today) is often referred to as "going long", or establishing a long position. -recall: each futures contract has an expiration date. -everyday before expiration, a new futures price is established. -if this new price is higher (lower) than the previous days price, the holder of a long futures contract position profits (losses) from this future price increase (decrease).

To protect a portfolio against changing interest rates we may:

-cross hedge using future contracts on US treasury notes

Futures contracts are used for hedging and speculation:

-hedging and speculating are complementary activities. -hedgers shift price risk to speculators or other hedgers. -speculators absorb price risk and provide liquidity to the market.

Speculating with futures, short:

-selling a futures contract (today) is often "going short" or establishing a short position.

Because of the difficulty of actual delivery, stock index futures are usually cash settled:

-that is, when the future contract expires, there is no delivery of shares of stock -instead, the position are "market-to-market" for last time, and the contract no longer exists.

If the buyer and seller DO NOT know each other:

-the "negotiation" occurs in the fast paced frenzy of a futures pit. -the terms of the contract are standardized. -performance bond or margin (3-12%)-> Leverage -the "futures price" is the price at which the trade will occur is determined "in the pit" or increasingly, "in the electronic market". -there are daily "market to market" cash flows -The futures exchange where the contract is traded guarantees each trade- no default possible. -to cancel the contract, an offsetting trade is made, wither "in the pit" or "in the electronic market".

cash prices and basis

-the cash price (or spot price) of a commodity or financial instrument is price for immediate delivery (immediate delivery can be 2 or 3 days later) -the cash market (or spot market) is the market where commodities or financial instruments are traded for immediate delivery -cash prices and future prices are seldom equal -the difference between the cash price and the futures price for i commodity is known as basis. basis=cash price-futures price

Arbitrage and Spot-futures parity

-the relationship between spot prices and future prices that must hold to prevent arbitrage opportunities is known as spot futures parity condition

In general, futures contracts must stipulate at least the following five terms:

1. The identify of the underlying commodity or financial instrument. 2. The futures contract size 3. The futures maturity date, also called the expiration date. 4. The delivery or settlement procedure. 5. The futures price.

Spot futures parity with dividends

FT= S(1+r-d)^T - D note...this is essentially the calculation that is done in the report "fair value" of the futures contract *If there is a dividend yield (d=D/S). the formula is: FT= S(1+r-d)^T

the equation for spot futures parity relationship is

FT=S(1+r)^T in this equation... -F represents the futures price -S= spot price -r= risk free rate -T= the number of periods before the futures contract expires *for a stock or index that will pay dividends during the life of the contract, we will need to adjust the equation for dividends.

important aspect of futures trading accounts

MARGIN IS REQUIRED -initial margin (which is a "good faith deposit" also called performance bond) is required when a futures position is first established. -Initial margin levels depend on: the price volatility of the underlying asset, can differ by type of trader -when the balance in the trading account gets "too low" it violates the maintenance margin levels, and a margin call is issued. THE CONTRACT VALUES ARE MARKET TO MARKET ON A DAILY BASIS. A FUTURES POSITION CAN BE CLOSED OUT AT ANY TIME. THIS IS DONE BY ENTERING A REVERSE TRADE.

stock index futures

There are a number of futures on stock market indexes. Important ones include: -the S&P 500 -Dow Jones Industial Average

Forward Price

The price at which the trade will occur, also determined when the agreement is made *generally, no cash changes hands until the trade is made.

Future Contract

an agreement made TODAY between a buyer and a seller who are OBLIGATED to complete a transaction with one another at a set date in the future. -the buyer and seller know each other, and they negotiate terms of the contract. -The terms of a forward contract are customized. (What to trade, where to trade, how to trade, what quality of good to trade,-all customized under the terms of the forward contract)

cash futures arbitrage

earning risk free profits from an unusual difference between cash and future prices is called cash future arbitrage. -in a competitive market, cash futures arbitrage has very slim profit margins -for commodities with storage costs, the cash price is usually less than the futures price. i.e., basis<0. This is referred to as carrying-charge market -sometimes the cash price is greater than the futures price. i.e., basis>0 This is referred to as an inverted market. -basis is kept at an economically appropriate level by arbitrage.

Cross hedging

hedging a particular spot position with future contracts on a related but not identical , commodity, or financial instrument. -it is called a cross hedge if the value of the bond portfolio held does not move in tandem with the value of the US treasury notes.

Index Arbitrage

refers to trading stock index futures and underlying stock to exploit deviations from spot futures parity. -index arbitrage is often implemented as a program trading strategy -program trading can account for up to half of daily trading volume on the NYSE -not all program trading involves stock index arbitrage. -program trading can be defined as all aspects of computerized trading including algorithmic trading, high frequency trading, and quantitative trading.