- Week+3+-+MGT4068
- HK holiday list
- Business Finance Final (1)
- Futures
- COT_Indicator_Manual.pdf
- mid ans
- Forwards and Futures
- Samlpe Questions FMP FRM I
- 1 Ms&T-ncl U-mar8043_part1 Ncl(1)
- Managing Transaction Exposure
- Futures and Options for CMA Exam
- How to Play Russia
- Gold Market
- hw2
- E minis
- Hedging
- Des Project1st Chapter
- Commodity Market
- International Trade and Exchange Rate Volatility
- Wikki- Derivatives types
- F&O
- financial derivatives
- ARGI SPECIAL REPORT.pdf
- Emini SP500 Daily Sep 01 2014
- Foreign Exchange Market
- DISSERTATION on commodities market.docx
- Interest Rate Markets - Siddhartha Jha
- Carbon Update 12 March 2013.pdf
- Commodity Market
- Report -1 page (2)
- Alfaz del Pi Guiden
- analysis on laptop.pdf
- Panduan PPGB 2015[Update].pdf
- Implementación de Estándares
- TEMA 1
- ISTINA_O_BOSNI_I_HERCEGOVINI_DOKUMENTI_1991_1995.pdf
- IIST Brochure
- Fiqih Kls 4 PAS I 2017
- Papa Francesco Angelus 2013-09-01 AR
- tentangyu.xlsx
- How to Make Dark Panther White
- Kronologi Meli
- 350493546-p3-Minyak-2-Selasa.docx
- ppt biotek
- LITURGI Leksionari I Minggu, 18 Juni 2017 Pept. Tohudan Jam 18.00
- Seguimiento Insercion Empresa
- Manual de Usuario Generico HDCVI S3
- Soap
- Resonancia Magnética Funcional (RMf) Principios y aplicaciones en.pdf
- 2. Sk Pelayanan Tb
- Archivo Cualquier
- Concordancia Do Verbo Com o Sujeito 7
- E-book 6 - Ghidul fericirii (EXT-OPTIN).pdf
- 8-17_math.pdf
- Deandra Odel
- Gestión :: Gestión De Eventos: Cómo Organizar Un Seminario O Un Evento
- Materi Kul. Bio Aver (PLATYHELMINTHES).pdf
- Biología Humana
- Mirai
- protocolo UDP.pdf
- Lec04_Determination of Forward and Futures Prices
- Ch06_
- Lec05_Determination of Forward and Futures Prices II
- Lec03 Interest Rates
- Lec02_Futures Market and Hedging Strategies.pdf
- Lec02_Futures Market and Hedging Strategies.pdf

**Mechanics of Futures Markets
**

& Hedging Strategies Using Futures

EF4420. Derivative Analysis and Advanced Investment Strategies

Dr. Yongjin Kim

20 January, 2017

1 / 38

Lecture Outline

**• Mechanics of Futures Markets
**

• Specification of Futures Contract

• Payoff of Forward and Futures

• Delivery of Futures

**• Hedging Using Futures
**

• Perfect and Imperfect Hedge

• Cross Hedge

• Hedge Using Stock Index Futures

2 / 38

Specification of Futures Contract

**• Recall that an exchange acts as an intermediary connecting buyers
**

and sellers of futures contracts.

**• 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).

3 / 38

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.

• For many futures contract, the delivery period is whole month.

4 / 38

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).

**• Payoff of forward contract:
**

(

long position: ST − F

short position: F − ST

where ST is the spot price of the asset at the maturity.

**• A forward contract is settled only once on the expiration date, so cash
**

flow takes place only on the date.

5 / 38

Payoff of Forward and Futures

• Suppose we enter a futures contract on day 0 and the contract will

expire on date T .

• Unlike forward, the futures will be settled every day.

**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 )

6 / 38

Payoff of Forward and Futures - Daily Settlement of

Futures

• Suppose we long futures with futures price F0 .

**• 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

(F1 − F0 ) + (F2 − F1 ) + (F3 − F2 ) + . . . + (FT − FT −1 )

=FT − F0

• This is the same as payoff of forward contract.

7 / 38

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.

**• During the contract period, investors are also required to maintain
**

the balance in the margin account at a certain level.

• Maintenance margin: the minimum amount that must be

maintained during the contract.

• If the balance in the account falls below the maintenance margin,

investors receive a margin call from exchange. Then, they need to top

up the margin account up to the initial margin.

8 / 38

Operation of Margin Accounts - Example

**• On day 0, we long a futures contract on gold at the futures price of
**

$1,250 per ounce. The contract size is 100 ounce per contract.

**• Initial margin is $3,000 and maintenance margin is $2,000 per
**

contract.

**Day Futures price Daily gain Margin account Margin calls
**

balance

0 1,250 3,000

1 1,241 (1,241-1,250)×100 = -900 2,100

2 1,238 (1,238-1,241)×100 = -300 1,800 1,200

3 1,244 (1,244-1,238)×100 = 600 3,600

4 1,242 (1,242-1,244)×100 = -200 3,400

.. .. ..

. . .

9 / 38

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.

• Let St be the spot price of the underlying asset on date t.

• Then, (

For t < T , Ft 6= St (usually)

For t = T , Ft = St

10 / 38

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)

**• Physical delivery may incur additional costs.
**

• warehouse costs

• transportation costs

• to feed and look after livestock

**• In reality, the majority of future contracts are closed before the
**

delivery.

• To close the position, investors can enter the opposite position of the

original one.

Ex. Suppose we took a long position of futures on gold for September delivery at

futures price of $1,250 on Jan 1. To close the position on May 30, we short

the futures for September delivery at futures price of $1,320. 11 / 38

Market Quotes

• Example of futures price quotes

• 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

12 / 38

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.

• How does this change the trading volume?

• How does this change the open interest?

13 / 38

Hedging Using Futures

14 / 38

Hedging Using Futures

**• Hedgers participate in futures market to reduce a particular risk they
**

face (e.g, fluctuations in oil price, foreign exchange rate).

**• To hedge a risk, hedgers take a futures position that neutralizes the
**

risk as far as possible.

**1 Short hedge: a hedge that involves a short position in futures
**

• reduce the risk when a hedger expects to sell an asset in the future

**2 Long hedge: a hedge that involves a long position in futures
**

• reduce the risk when a hedger expect to buy an asset in the future

15 / 38

Short Hedge - Example

**• On May 15, an oil producer negotiates a contract to sell 1 million
**

barrels of crude oil. The price in the sales contract is the spot price

on August 15.

**• 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.

16 / 38

Short Hedge - Example

**What if the the spot price of oil on August 15 turns out to be ...
**

1 $75 per barrel

Total revenue = |75 ×

{z1M} + |(79 − 75) × 1M = 79M

{z }

sales contract futures contract

2 $85 per barrel

Total revenue = |85 ×

{z1M} + |(79 − 85) × 1M = 79M

{z }

sales contract futures contract

17 / 38

Long Hedge - Example

**• On Jan 15, a copper fabricator knows it will require 100,000 pounds
**

of copper on May 15 to meet a certain contract.

**• 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.

18 / 38

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

2 $3.05 per pound

**Total payment = 3.05 × 100, 000 − (3.05 − 3.20) × 100, 000 = 320, 000
**

| {z } | {z }

sales contract futures contract

19 / 38

Perfect Hedge

**• In the previous examples, hedging using futures eliminates the risk
**

completely, thus leaving no risk.

**• This is called a perfect hedge. A perfect hedge is possible when all
**

of the following conditions are satisfied:

1 The asset whose price is to be hedged is the same as the asset

underlying futures contract.

2 The hedger is certain of the exact date to buy/sell the asset.

**3 The delivery date of futures contract is the same as the date to
**

buy/sell the underlying asset.

20 / 38

Perfect Hedge

**• Suppose that on date 0, a company knows it will sell an underlying
**

asset on date T.

**• To hedge the risk, the company short futures contract for delivery on
**

date T at futures price F0 .

• Then, the total revenue is

ST + (F0 − FT ) = ST + (F0 − ST ) = F0

21 / 38

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.

**• However, the company finds no futures available for delivery on date 1.
**

The closest delivery date is T .

• Shorting the future on date 0 and closing on date 1, the revenue is

S1 + (F0 − F1 ) = F0 + (S1 − F1 )

| {z }

6=0

22 / 38

Imperfect Hedge

**2 Mismatch in underlying asset
**

• Suppose that on date 0, a company knows it will sell an underlying

asset A on date T .

**• However, no futures is available for the underlying asset A. Asset B is
**

the most similar asset for which future contract is available.

• Let S denote the spot price of A and S ∗ denote the spot price of B.

• Shorting the future on date 0 and closing on date T, the revenue is

ST + (F0 − FT ) = F0 + (ST − ST∗ )

| {z }

6=0

23 / 38

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.

• Then, the revenue is

S1 + (F0 − F1 ) = F0 + (S1 − F1 )

| {z }

basis

**1 In perfect hedge, basis = 0
**

2 In imperfect hedge, basis is uncertain and usually nonzero.

S1 − F1 = (S1 − S1∗ ) + (S ∗ − F1 )

| {z } | 1 {z }

mismatch in asset mismatch in delivery

24 / 38

Cross Hedging

**• Cross hedging is to hedge a risk of price of an asset using futures
**

contract on a different underlying asset.

**Ex. An airline that is concerned about the future price of jet fuel uses
**

futures contract on heating oil.

**• Hedge ratio = size of position in futures contract
**

size of exposure

1 In perfect hedge, hedge ratio = 1

2 In cross hedge, hedge ratio is not equal to one usually.

**• In cross hedging, the hedge ratio is chosen to minimize the variance
**

of the value of the hedged position.

25 / 38

Cross Hedging - Minimum Variance Hedge Ratio

**• Assume that we have one unit of an asset and shorts futures on h
**

units of underlying asset.

**• Let ∆S denote the price change in the asset and ∆F denote the
**

change in futures price in the hedge period.

• Then, the change in the portfolio value is

∆S − h∆F

• The variance of the value change is

Var (∆S) − 2h × Cov (∆S, ∆F ) + h2 × Var (∆F )

26 / 38

Cross Hedging - Minimum Variance Hedge Ratio

• We want to find h such that minimizes the variance.

**• To do so, we calculate the derivative of the variance with respect to h
**

and set it equal to 0:

Cov (∆S, ∆F )

h∗ =

Var (∆F )

**• The hedge ratio can be rewritten as
**

σS

h∗ = ρ

σF

where ρ is the correlation coefficient between ∆S and ∆F , σF is the standard deviation of

∆F , and σS is the standard deviation of ∆S .

27 / 38

Cross Hedging - Minimum Variance Hedge Ratio

**• Given the optimal hedge ratio, we want to know the optimal number
**

of futures contract.

**• Let QA denote units of assets to be hedged, and QF denote units of
**

underlying assets of one futures contract.

• Then, the number of contracts N ∗ should satisfy

N ∗ QF

h∗ =

QA

• Thus,

h∗ QA

N∗ =

QF

28 / 38

Cross Hedging - Example

**• An airline expect to purchase two million gallons of jet fuel in one
**

month and decides to use heating oil futures for hedging. The

standard deviation of futures price is σF = 0.0313, the standard

deviation of jut fuel price is σS = 0.0263, and the correlation

coefficient is ρ = 0.928.

Q1. What is the minimum variance hedge ratio?

**Q2. Each of the futures contract is for 42,000 gallons of heating oil. How
**

many contracts does the airline need?

29 / 38

Stock Index Futures

**• A stock index tracks changes in the value of a hypothetical portfolio
**

of stocks (e.g. Dow Jones Industrial Averages, S&P 500)

• In the exchange, we have futures contract on these indices available.

**• Suppose we invest in a portfolio of stocks (not same as the index
**

portfolio). Futures on this specific portfolio is not available.

**• How can we hedge the risk of the portfolio value?
**

⇒ we use futures on a stock index.

30 / 38

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.

• Then, the change in the portfolio value is

rS − hrF

• To minimize the variance of the value change, we choose

Cov (rS , rF ) Cov (rS , rM )

h∗ = ≈ =β

Var (rF ) Var (rM )

where rM is the return on the market portfolio.

31 / 38

Stock Index Futures

• We want to know the optimal number of contracts on the index.

**• Let VA be the current value of the portfolio, VF be the current value
**

of one futures contract.

• Then, the number of contracts N ∗ should satisfy

N ∗ VF

β=

VA

• Thus,

VA

N∗ = β

VF

32 / 38

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.

• The optimal number of contract to be shorted:

5, 050, 000

N = (1.5) = 30

250 × 1, 010

33 / 38

Stock Index Futures - Example

**• What if S&P 500 index and futures prices are as follows three months
**

later?

**S&P 500 index 900 1,100
**

in three months

Futures price 902 1,103

in three months

Gain on futures position

Expected return on portfolio

Expected portfolio value

Total value of position

in three months

34 / 38

Stock Index Futures - Example

**• If S&P 500 index is 900 and futures price is 902, then...
**

• Gain on futures = (1, 010 − 902) × 250 × 30 = 810, 000

• Return on the market portfolio is (900 − 1000)/1000 = −10%

• Using CAPM, the expected return on the portfolio is

E (r ) = rf + β(E (rm ) − rf ) = 1 + (1.5)(−10 − 1) = −15.5%

• Then, the expected portfolio value is

5, 050, 000 × (1 − 0.155) = 4, 267, 250.

• Total value of position is 810,000 + 4,267,250 = 5,077,250

35 / 38

Stock Index Futures - Example

**• If S&P 500 index is 1,100 and futures price is 1,103, then...
**

• Gain on futures = (1, 010 − 1, 103) × 250 × 30 = −697, 500

• Return on the market portfolio is (1, 100 − 1000)/1000 = 10%

• Using CAPM, the expected return on the portfolio is

E (r ) = rf + β(E (rm ) − rf ) = 1 + (1.5)(10 − 1) = 14.5%

• Then, the expected portfolio value is

5, 050, 000 × (1 + 0.145) = 5, 782, 250.

• Total value of position is -697,500 + 5,782,250 = 5,084,750

36 / 38

Stock Index Futures - Example

**• What if S&P 500 index and futures prices are as follows three months
**

later?

**S&P 500 index 900 1,100
**

in three months

Futures price 902 1,103

in three months

Gain on futures position 810,000 -697,500

Expected return on portfolio -15.5% 14.5%

Expected portfolio value 4,267,250 5,782,250

Total value of position 5,077,250 5,084,750

in three months

**• With hedging, the total value of position is almost independent of the
**

value of the index.

37 / 38

Things To Do

• Read the textbook chapters 2.1 - 2.7, 3.1 - 3.5

• Assignment 1 (due on Friday, 3 February at 11 pm)

38 / 38

- Week+3+-+MGT4068Uploaded byLaura Lynch
- HK holiday listUploaded bysahil2gud
- Business Finance Final (1)Uploaded byselina_kolls
- FuturesUploaded byShailendra Garg
- COT_Indicator_Manual.pdfUploaded byMarioEfrainParralesTorres
- mid ansUploaded byMuzzamil Qasmi
- Forwards and FuturesUploaded byasifanis
- Samlpe Questions FMP FRM IUploaded byShreyans Jain
- 1 Ms&T-ncl U-mar8043_part1 Ncl(1)Uploaded byRino Sriwijaya
- Managing Transaction ExposureUploaded byg00028007
- Futures and Options for CMA ExamUploaded bysridhartks
- How to Play RussiaUploaded byClaude
- Gold MarketUploaded byluvboy85
- hw2Uploaded bychrislmc
- E minisUploaded bylorejack
- HedgingUploaded bysapfico2k8
- Des Project1st ChapterUploaded bySandeep Madival
- Commodity MarketUploaded byRushabh Shah
- International Trade and Exchange Rate VolatilityUploaded byMaaz Ahmed
- Wikki- Derivatives typesUploaded bySanthosh
- F&OUploaded byjoshijaysoft
- financial derivativesUploaded byAmit Mishra
- ARGI SPECIAL REPORT.pdfUploaded byPamela Hudson
- Emini SP500 Daily Sep 01 2014Uploaded byDuma Dumai
- Foreign Exchange MarketUploaded byGaurav Dhall
- DISSERTATION on commodities market.docxUploaded bynishantforppt
- Interest Rate Markets - Siddhartha JhaUploaded byNipun Dua
- Carbon Update 12 March 2013.pdfUploaded byDavid Boles
- Commodity MarketUploaded byhaseeb_tankiwala
- Report -1 page (2)Uploaded byRamiz

- Lec04_Determination of Forward and Futures PricesUploaded by劉佳欣
- Ch06_Uploaded by劉佳欣
- Lec05_Determination of Forward and Futures Prices IIUploaded by劉佳欣
- Lec03 Interest RatesUploaded by劉佳欣
- Lec02_Futures Market and Hedging Strategies.pdfUploaded by劉佳欣
- Lec02_Futures Market and Hedging Strategies.pdfUploaded by劉佳欣