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CHAPTER 22 Investments Futures Markets Slides by Richard D. Johnson Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Cover image

Futures and Forwards: 

Forward - an agreement calling for a future delivery of an asset at an agreed-upon price Futures - similar to forward but feature formalized and standardized characteristics Key difference in futures Secondary trading - liquidity Marked to market Standardized contract units Clearinghouse warrants performance Futures and Forwards

Key Terms for Futures Contracts: 

Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot Key Terms for Futures Contracts

Figure 22.1 Futures Listings: 

Figure 22.1 Futures Listings

Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts : 

Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts

Figure 22.3 CBOT Trading Volume in Futures Contracts : 

Figure 22.3 CBOT Trading Volume in Futures Contracts

Table 22.1 Sample of Future Contracts: 

Table 22.1 Sample of Future Contracts

Trading Mechanics: 

Clearinghouse - acts as a party to all buyers and sellers. Obligated to deliver or supply delivery Closing out positions Reversing the trade Take or make delivery Most trades are reversed and do not involve actual delivery Open Interest Trading Mechanics

Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse : 

Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse

Margin and Trading Arrangements: 

Initial Margin - funds deposited to provide capital to absorb losses Marking to Market - each day the profits or losses from the new futures price are reflected in the account. Maintenance or variation margin - an established value below which a trader’s margin may not fall. Margin and Trading Arrangements

Margin and Trading Arrangements: 

Margin call - when the maintenance margin is reached, broker will ask for additional margin funds Convergence of Price - as maturity approaches the spot and futures price converge Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets Margin and Trading Arrangements

Trading Strategies: 

Speculation - short - believe price will fall long - believe price will rise Hedging - long hedge - protecting against a rise in price short hedge - protecting against a fall in price Trading Strategies

Basis and Basis Risk: 

Basis - the difference between the futures price and the spot price over time the basis will likely change and will eventually converge Basis Risk - the variability in the basis that will affect profits and/or hedging performance Basis and Basis Risk

Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15): 

Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15)

Futures Pricing: 

Spot-futures parity theorem - two ways to acquire an asset for some date in the future Purchase it now and store it Take a long position in futures These two strategies must have the same market determined costs Futures Pricing

Spot-Futures Parity Theorem: 

Spot-Futures Parity Theorem With a perfect hedge the futures payoff is certain -- there is no risk A perfect hedge should return the riskless rate of return This relationship can be used to develop futures pricing relationship

Hedge Example: Section 22.4: 

Hedge Example: Section 22.4 Investor owns an S&P 500 fund that has a current value equal to the index of $1,300 Assume dividends of $20 will be paid on the index at the end of the year Assume futures contract that calls for delivery in one year is available for $1,345 Assume the investor hedges by selling or shorting one contract

Hedge Example Outcomes: 

Hedge Example Outcomes Value of ST 1,305 1,345 1,405 Payoff on Short (1,345 - ST) 40 0 -60 Dividend Income 20 20 20 Total 1,365 1,365 1,365

Rate of Return for the Hedge: 

Rate of Return for the Hedge

General Spot-Futures Parity: 

General Spot-Futures Parity Rearranging terms

Figure 22.6 S&P 500 Monthly Dividend Yield: 

Figure 22.6 S&P 500 Monthly Dividend Yield

Arbitrage Possibilities : 

Arbitrage Possibilities If spot-futures parity is not observed, then arbitrage is possible If the futures price is too high, short the futures and acquire the stock by borrowing the money at the riskfree rate If the futures price is too low, go long futures, short the stock and invest the proceeds at the riskfree rate

Spread Pricing: Parity for Spreads: 

Spread Pricing: Parity for Spreads

Figure 22.7 Gold Futures Prices: 

Figure 22.7 Gold Futures Prices

Theories of Futures Prices: 

Theories of Futures Prices Expectations Normal Backwardation Contango

Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged: 

Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged