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Fuqua School of Business Duke University

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**Hedging Stock Market Risk: S&P500 Futures Contract
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A futures contract on the S&P500 Index entitles the buyer to receive the cash value of the S&P 500 Index at the maturity date of the contract. The buyer of the futures contract does not receive the dividends paid on the S&P500 Index during the contract life. The price paid at the maturity date of the contract is determined at the time the contract is entered into. This is called the futures price. There are always four delivery months in effect at any one time. » March » June » September » December The closing cash value of the S&P500 Index is based on the opening prices on the third Friday of each delivery month.

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) l l l l l l Contract: S&P500 Index Futures Exchange: Chicago Mercantile Exchange Quantity: $250 times the S&P 500 Index Delivery Months: March. June.S..10 Index Pts. ($25 per contract). Sept. index futures prices for Feb’17. Min. Delivery Specs: Cash Settlement Based on the value of the S&P 500 Index at Maturity. 3 W.J. 1998 4 2 . Price Move: 0.Hedging Stock Market Risk: S&P500 Futures Contract (cont. Dec.

1997 we observed: » The closing price for the S&P500 Index was 786. F. – What is the futures price for the futures contracts maturing in March. using the fact that PV(F)=PV(ST): F = S0e ( r − d ) T 5 Example l On Thursday January 22. your payoff at the maturity date. December 1997? 6 3 . T.11% » Assume the annual dividend yield on the S&P500 Index is 1. Payoff = ST − F The amount you put up today to buy the futures contract is zero. ST.1% per year.Valuation of the S&P500 Futures Contract l When you buy a futures contract on the S&P500 Index.23. is the difference between the cash value of the index. » The yield on a T-bill maturing in 26 weeks was 5. and the futures price. June. September. This means that the present value of the futures contract must also be zero: PV (ST − F ) = 0 ⇒ PV (ST ) = PV ( F ) l l The present value of ST and F is: PV ( S T ) = S 0 − PV ( Div ) = S 0 e − dT PV ( F ) = Fe − rT l Then.

Position Borrow Buy e(-dT) units of index Sell 1 futures contract Net position 0 782.26 Actual Price 791.17 799. » At maturity.0511− 0.88 8 l l 4 . How could you profit from this price discrepancy? We want to avoid all risk in the process.15 815.8 7 Index Arbitrage l Suppose you observe a price of 820 for the June 1997 futures contract.12 807.00 T -799.23e ( 0.12 » Similarly: Maturity March June September December Days 57 148 239 330 Price 791.12 ST 820-ST 20.00 0.6 799.0 806. Buy low and sell high: » Borrow enough money to buy the index today and immediately sell a June futures contract at a price of 820.73 -782.Example l l Days to maturity » June contract: 148 days Estimated futures prices: » For the June contact: FJune = S0 e( r − d )T = 786. settle up on the futures contract and repay your loan.73 0.011)(148/ 365) = 799.8 814.

» Current worth: $99.00 » December S&P500 futures price is 645. » At settlement.845(645. » Lock in a total value for the portfolio of: $99.59 780.59 0 0.15 9 l Hedging with S&P500 Futures l l l Suppose a portfolio manager holds a portfolio that mimics the S&P500 Index. the total number of contracts that need to be sold is: 100 .00) = $161. up 20% through mid-November ‘ 95 » S&P500 Index currently at 644.16 161. Since one futures contract is worth $250(645.00 T 807. cover your short position and settle your futures position. buy a September futures contract at a price of 790.00) million = $100. – How can the fund manager hedge against further market movements? Lock in a price of 645. How could you profit from this price discrepancy? Buy Low and Sell High: » Sell the index short and use the proceeds to invest in a T-bill.00/644.00 million = 620. At the same time.250.15 -ST ST-790 17. Position Lend Sell e(-dT) units of index Buy 1 futures contract Net position 0 -780.00 million.00 for the S&P500 Index by selling S&P500 futures contracts.845 million.250 10 5 .00.Index Arbitrage l Suppose the futures price for the September contract was 790.

00 at the maturity date of the futures contract. The value of the stock portfolio is: 99.00 at the maturity date of the futures contract.33 in December) 12 6 .00/644.55 million The loss on the 620 futures contracts is: 620(250)(645.845 million.845(635. The value of the stock portfolio is: 99. repay $2.00) = 98.32m (if you borrow this now. up 20% through mid-November ‘ 95 » S&P500 Index currently at 644.845(655. maturing in December » Black -Scholes value for put option is 14.00) = -1.00-655.00) = 101. » Current worth: $99.96=$7479 » Need to buy 310 options for portfolio of $100m: 310*$7479=$2.00 Lock in 645 for the S&P500 index by buying the put options at a strike price of 645. l l l Suppose the S&P500 Index increases to 655.00-635) = 1.00/644. 11 Hedging with S&P500 Options l l Reconsider the case of a fund manager who wishes to insure his portfolio » holds a portfolio that mimics the S&P500 Index.45 million The profit on the 620 futures contracts is: 620(250)(645.96 » Premium for one option contract is $500*14.55 million The total value of the portfolio at maturity is $100 million.Hedging with S&P500 Futures Scenario I: Stock market falls l Scenario II: Stock market rises l l l l Suppose the S&P500 Index falls to 635.55 million The total value of the portfolio at maturity is $100 million.

00/644.1m-2.77m l l 13 Hedging Interest Rate Risk With Futures Contracts l There are two main interest rate futures contracts: Õ Eurodollar futures (CME) Õ US Treasury-bond futures (CBOT) l The Eurodollar futures is the most popular and active contract.55m The total value of the portfolio at maturity is $98.55m-$2.33m=$100.00) = 98.00 at the maturity date of the option.00/644.Hedging with S&P500 Options Scenario I: Stock market falls l l Scenario II: Stock market rises l l l Suppose the S&P500 Index falls to 635.845(635.33m=$97. Open interest is in excess of $4 trillion at any point in time.00 at the maturity date of the put option. 14 7 . The value of the stock portfolio is: 99. The value of the stock portfolio is: $99.45m+$1.45 million The profit on the 310 put options is: 310(500)(645-635) = $1.1m The put remains unexercised in this case The total value of the portfolio at maturity is $103.845m(665.00) = $103.67m l Suppose the S&P500 Index increases to 665.33m =$100m-$2.

15 LIBOR l US banks commonly charge LIBOR plus a certain number of basis points on their floating rate loans. LIBOR is an annualized rate based on a 360-day year.e. l Eurodollar time deposits are non-negotiable.08 ($ 1. l This rate is known as LIBOR (London Interbank Offer Rate) and has become the benchmark short-term interest rate for many US borrowers and lenders. those not subject to US banking regulations). fixed rate US dollar deposits in offshore banks (i.000 .000 4 16 8 ..LIBOR l The Eurodollar futures contract is based on the interest rate payable on a Eurodollar time deposit. Example: The 90-day LIBOR 8% interest on $1 million is calculated as follows: l l 0.000 ) = $20.

June. It is based upon a 90-day $1 million Eurodollar time deposit. the futures price is 100-LIBOR. It is settled in cash. Prior to expiration.000.Eurodollar Futures Contract l l l The Eurodollar futures contract is the most widely traded short-term interest rate futures. Delivery Specs: Cash Settlement Based on 3-Month LIBOR Min Price Move: $25 Per Contract (1 Basis Pt.. and Dec.) (1 / 100)(1%)($1.000) = $25 4 18 9 . é é At expiration. the quoted futures price implies a LIBOR rate of: Implied LIBOR = 100-Quoted Futures Price 17 Eurodollar Futures Contract l l l l l l Contract: Eurodollar Time Deposit Exchange: Chicago Merchantile Exchange Quantity: $1 Million Delivery Months: March. Sept.

Eurodollar Futures: Example l Suppose in February you buy a March Eurodollar futures contract. If the 90-day LIBOR rate at the end of March turns out to be 4.4.14% p. The LIBOR rate at the time the contract expires is 4.000. The quoted futures price at the time you enter into the contract is 94. our payoff is: Payoff = l (95 .86 )(10.86 − 94 .86.14%. This means that the futures price at maturity is 100 .000 ) = $2..500 4 The increase in the futures price is multiplied by $10. l é é 19 Eurodollar Futures: Example l In dollar terms. l 20 10 .000.000 because the futures price is per $100 and the contract is for $1. what is the payoff on your futures contract? The price at the time the contract is purchased is 94.86.14 = 95.86.a. We divide the increase in the futures price by 4 because the contract is a 90day (90/360) contract.

é You want a futures position that gives a positive return if interest rates rise. if the interest rate is higher.Hedging Interest Rate Risk With Futures Contracts l Suppose a firm knows in February that it will be required to borrow $1 million in March for a period of 90 days.86. l l l 21 Hedging Interest Rate Risk with Futures (cont. you want a futures position that gives a positive return if the futures price falls. That is.) l Step 1: Specify the risk. é $1 mm amounts to one contract. Step 3: Determine the amount. 22 l l 11 . Assume that the March Eurodollar futures price is 94. Step 2: Determine an appropriate futures position. That is. The firm is concerned that interest rates may rise before March and would like to hedge this risk. Hence. you want a futures position that gives a positive return if (100-LIBOR) falls. your firm will have to pay more interest on the loan. Therefore you sell Eurodollar futures. The rate that the firm will pay for its borrowing is LIBOR + 50 basis points. é Your company will lose if interest rates rise.

The gain (loss) on the futures contract should exactly offset any increase (decrease) in the firm’ s interest expense.005)($1.600 4 The payoff on the Eurodollar futures contract is: − (93.14%.000) = − $16.) l Suppose LIBOR increases to 6.0614 + 0.86 = 5.500 4 24 12 .000) = $2. the firm should sell one March Eurodollar futures contract.Hedging Interest Rate Risk With Futures (cont. If the LIBOR rate increases. l l 23 Hedging Interest Rate Risk With Futures (Cont.86 − 94.86)(10.14% at the maturity date of the futures contract. The interest expense on the firm’ s $1 million loan commencing in March will be: l − l (0. the futures price will fall. to hedge the interest rate risk.) l The LIBOR rate implied by the current futures price is: 100-94. Therefore.000.

000 ) = − $ 2 .500 -14.000) = − $11.86 )(10 . The interest expense on the firm’ s $1 million loan commencing in March will be: − l (0.) l LIBOR Rate is 6. Cash Flow Interest on Loan Futures Payoff Net Payoff Amount -16.Hedging Interest Rate Risk with Futures (Cont.000.100 25 Hedging Interest Rate Risk With Futures (Cont.) l l Now assume that the LIBOR rate falls to 4.005)($1.600 2.86 − 94 .14% at the maturity date of the contract.14%.500 4 26 13 .0414 + 0.600 4 The payoff on the Eurodollar futures contract is: − ( 95 .

100 27 Hedging Interest Rate Risk With Futures (Cont. The firm’ s futures position has locked in the current implied LIBOR rate. Cash Flow Interest on Loan Futures Payoff Net Payoff Amount -11.14%. over 90 days on $1 million.64% p.14%. The 5.Hedging Interest Rate Risk with Futures (Cont.a. l l l 28 14 .64% borrowing rate is equal to the current implied LIBOR rate of 5. plus the additional 50 basis points that the firm pays on its short-term borrowing.) l The net outlay is equal to $14.600 -2.500 -14.100 regardless of what happens to LIBOR. This is equivalent to paying 5.) l LIBOR Rate is: 4.

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