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Chapter 17 Futures Markets and Risk Management 587

FIGURE 17.8
Interest rate swap. Company A has issued a fixed-rate 7% coupon bond. It enters a swap to pay
LIBOR and receive 6.95%. Company B has issued a floating-rate bond paying the LIBOR rate.
It enters a swap to receive LIBOR and pay 7.05%.

6.95% 7.05%

7% coupon
Company A Swap dealer Company B
LIBOR

LIBOR LIBOR

Company B pays a fixed rate of 7.05% to the swap dealer in return for LIBOR.
Company A receives 6.95% from the dealer in return for LIBOR. The swap dealer
realizes a cash flow each period equal to .1% of notional principal.

• Forward contracts are arrangements that call for the future delivery of an asset at a currently SUMMARY
agreed-upon price. The long trader is obligated to purchase the good, and the short trader is
obligated to deliver it. If the price at the maturity of the contract exceeds the forward price,
the long side benefits by virtue of acquiring the good at the contract price.
• A futures contract is similar to a forward contract, differing most importantly in the
aspects of standardization and marking to market, which is the process by which gains and
losses on futures contract positions are settled daily. In contrast, forward contracts call for
no cash transfers until contract maturity.
• Futures contracts are traded on organized exchanges that standardize the size of the
contract, the grade of the deliverable asset, the delivery date, and the delivery location.
Traders negotiate only the contract price. This standardization creates increased liquidity
in the marketplace and means buyers and sellers can easily find many traders for a desired
purchase or sale.
• The clearinghouse acts as an intermediary between each pair of traders, acting as the
short position for each long and as the long position for each short, so traders need not
be concerned about the performance of the trader on the opposite side of the contract.
Traders are required to post margins in order to guarantee their own performance on the
contracts.
• The gain or loss to the long side for a futures contract held between time 0 and t is
Ft 2 F0. Because FT 5 PT at maturity, the long’s profit if the contract is held until
maturity is PT 2 F0, where PT is the spot price at time T and F0 is the original futures
price. The gain or loss to the short position is F0 2 PT .
• Futures contracts may be used for hedging or speculating. Speculators use the contracts
to take a stand on the ultimate price of an asset. Short hedgers take short positions in
contracts to offset any gains or losses on the value of an asset already held in inventory.
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Long hedgers take long positions in futures contracts to offset gains or losses in the
purchase price of a good.
• The spot-futures parity relationship states that the equilibrium futures price on an asset
providing no service or payments (such as dividends) is F0 5 P0(1 1 rf )T. If the futures
price deviates from this value, then market participants can earn arbitrage profits.
• If the asset provides services or payments with yield d, the parity relationship becomes
F0 5 P0 (1 1 rf 2 d )T. This model is also called the cost-of-carry model, because it states
that the futures price must exceed the spot price by the net cost of carrying the asset until
maturity date T.

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588 Part FIVE Derivative Markets

• Futures contracts calling for cash settlement are traded on various stock-market indexes.
The contracts may be mixed with Treasury bills to construct artificial equity positions,
which makes them potentially valuable tools for market timers. Market-index contracts
also are used by arbitrageurs who attempt to profit from violations of the parity
relationship.
• Interest rate futures allow for hedging against interest rate fluctuations in several different
markets. The most actively traded contract is for Treasury bonds.
• The interest rate swap market is a major component of the fixed-income market. In these
arrangements, parties trade the cash flows of different securities without actually exchang-
ing any securities directly. This is a useful tool to manage the interest rate exposure of a
portfolio.

KEY TERMS basis, 574
basis risk, 574
cash settlement, 571
clearinghouse, 567
convergence property, 570
cost-of-carry
relationship, 577
cross-hedging, 584
foreign exchange swap, 584
forward contract, 562 price value of a basis
futures price, 562 point, 584
index arbitrage, 581 program trading, 581
interest rate swaps, 585 short position, 563
long position, 563 single stock
maintenance futures, 565
margin, 569 spot-futures parity
marking to market, 569 theorem, 577
notional principal, 585 spread, 574

KEY FORMULAS Spot-futures parity: F0 5 (1 1 rf 2 d )T

PROBLEM SETS Select problems are available in McGraw-Hill’s

Connect Finance. Please see the Supplements
section of the book’s frontmatter for more information.

Basic
1. On January 1, you sold one March maturity S&P 500 Index futures contract at a futures
price of 1,200. If the futures price is 1,250 on February 1, what is your profit? The contract
multiplier is $250. (LO 17-1)
2. The current level of the S&P 500 is 1,200. The dividend yield on the S&P 500 is 2%.
The risk-free interest rate is 1%. What should a futures contract with a one-year maturity
be selling for? (LO 17-3)
3. A one-year gold futures contract is selling for $1,641. Spot gold prices are $1,700 and the
one-year risk-free rate is 2%. What arbitrage opportunity is available to investors? What
strategy should they use, and what will be the profits on the strategy? (LO 17-4)
4. You purchase a Treasury-bond futures contract with an initial margin requirement of 15%
and a futures price of $115,098. The contract is traded on a $100,000 underlying par
value bond. If the futures price falls to $108,000, what will be the percentage loss on your
position? (LO 17-1)
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5. a. Turn to Figure 17.1 and locate the contract on the Standard & Poor’s 500 Index. If the
margin requirement is 10% of the futures price times the multiplier of $250, how much
must you deposit with your broker to trade the September contract?
b. If the September futures price were to increase to 1,200, what percentage return would
you earn on your net investment if you entered the long side of the contract at the price
shown in the figure?
c. If the September futures price falls by 1%, what is the percentage gain or loss on your
net investment? (LO 17-1)

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6. Why might individuals purchase futures contracts rather than the underlying
asset? (LO 17-2)
7. What is the difference in cash flow between short-selling an asset and entering a short
futures position? (LO 17-1)

Intermediate
8. Suppose the value of the S&P 500 Stock Index is currently $1,200. If the one-year
T-bill rate is 3% and the expected dividend yield on the S&P 500 is 2%, what should the
one-year maturity futures price be? What if the T-bill rate is less than the dividend yield,
for example, 1%? (LO 17-3)
9. It is now January. The current interest rate is 4%. The June futures price for gold is
$1,646.30, while the December futures price is $1,651. Is there an arbitrage opportunity
here? If so, how would you exploit it? (LO 17-4)
10. Consider a stock that will pay a dividend of D dollars in one year, which is when a
futures contract matures. Consider the following strategy: Buy the stock, short a futures
contract on the stock, and borrow S0 dollars, where S0 is the current price of the
stock. (LO 17-3)
a. What are the cash flows now and in one year? (Hint: Remember the dividend the
stock will pay.)
b. Show that the equilibrium futures price must be F0 5 S0(1 1 r) 2 D to avoid
arbitrage.
c. Call the dividend yield d 5 D/S0, and conclude that F0 5 S0(1 1 r 2 d ).
11. a. A single stock futures contract on a nondividend-paying stock with current price
$150 has a maturity of one year. If the T-bill rate is 3%, what should the futures
price be?
b. What should the futures price be if the maturity of the contract is three
years?
c. What if the interest rate is 5% and the maturity of the contract is three
years? (LO 17-3)
12. The Excel Applications box in the chapter (available at www.mhhe.com/bkm; link to
Chapter 17 material) shows how to use the spot-futures parity relationship to find Please visit us at
a “term structure of futures prices,” that is, futures prices for various maturity www.mhhe.com/bkm
dates. (LO 17-3)
a. Suppose that today is January 1, 2012. Assume the interest rate is 1% per year and a
stock index currently at 1,200 pays a dividend yield of 2%. Find the futures price for
contract maturity dates of February 14, 2012, May 21, 2012, and November 18, 2012.
b. What happens to the term structure of futures prices if the dividend yield is lower
than the risk-free rate? For example, what if the interest rate is 3%?
13. One Chicago has just introduced a new single stock futures contract on the stock of
Brandex, a company that currently pays no dividends. Each contract calls for delivery of
1,000 shares of stock in one year. The T-bill rate is 6% per year. (LO 17-3)
a. If Brandex stock now sells at $120 per share, what should the futures price be?
b. If the Brandex stock price drops by 3%, what will be the change in the futures price
and the change in the investor’s margin account?
c. If the margin on the contract is $12,000, what is the percentage return on the investor’s
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position?
14. The multiplier for a futures contract on the stock-market index is $250. The maturity of
the contract is one year, the current level of the index is 800, and the risk-free interest
rate is .5% per month. The dividend yield on the index is .2% per month. Suppose that
after one month, the stock index is at 810. (LO 17-1)
a. Find the cash flow from the mark-to-market proceeds on the contract. Assume that
the parity condition always holds exactly.
b. Find the one-month holding-period return if the initial margin on the contract is
$10,000.

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590 Part FIVE Derivative Markets

15. Suppose the S&P 500 Index portfolio pays a dividend yield of 2% annually. The index
currently is 1,200. The T-bill rate is 3%, and the S&P futures price for delivery in one
year is $1,233. Construct an arbitrage strategy to exploit the mispricing and show that
your profits one year hence will equal the mispricing in the futures market. (LO 17-4)
16. a. How should the parity condition (Equation 17.2) for stocks be modified for futures
contracts on Treasury bonds? What should play the role of the dividend yield in that
equation?
b. In an environment with an upward-sloping yield curve, should T-bond futures prices on
more distant contracts be higher or lower than those on near-term contracts?
c. Confirm your intuition by examining Figure 17.1. (LO 17-3)
17. Desert Trading Company has issued $100 million worth of long-term bonds at a fixed
rate of 7%. The firm then enters into an interest rate swap where it pays LIBOR and
receives a fixed 6% on notional principal of $100 million. What is the firm’s overall cost
of funds? (LO 17-5)
18. What type of interest rate swap would be appropriate for a speculator who believes
interest rates soon will fall? (LO 17-5)
19. The margin requirement on the S&P 500 futures contract is 10%, and the stock index is
currently 1,200. Each contract has a multiplier of $250. How much margin must be put
up for each contract sold? If the futures price falls by 1% to 1,188, what will happen to
the margin account of an investor who holds one contract? What will be the investor’s
percentage return based on the amount put up as margin? (LO 17-1)
20. The multiplier for a futures contract on a certain stock market index is $250. The matu-
rity of the contract is one year, the current level of the index is 1,000, and the risk-free
interest rate is .2% per month. The dividend yield on the index is .1% per month.
Suppose that after one month, the stock index is at 1,020. (LO 17-1)
a. Find the cash flow from the mark-to-market proceeds on the contract. Assume that
the parity condition always holds exactly.
b. Find the holding-period return if the initial margin on the contract is $10,000.
21. You are a corporate treasurer who will purchase $1 million of bonds for the sinking fund
in three months. You believe rates soon will fall and would like to repurchase the compa-
ny’s sinking fund bonds, which currently are selling below par, in advance of require-
ments. Unfortunately, you must obtain approval from the board of directors for such a
purchase, and this can take up to two months. What action can you take in the futures
market to hedge any adverse movements in bond yields and prices until you actually can
buy the bonds? Will you be long or short? Why? (LO 17-2)
22. A manager is holding a $1 million bond portfolio with a modified duration of eight
years. She would like to hedge the risk of the portfolio by short-selling Treasury bonds.
The modified duration of T-bonds is 10 years. How many dollars’ worth of T-bonds
should she sell to minimize the risk of her position? (LO 17-2)
23. A corporation plans to issue $10 million of 10-year bonds in three months. At current
yields the bonds would have modified duration of eight years. The T-note futures con-
tract is selling at F0 5 100 and has modified duration of six years. How can the firm use
this futures contract to hedge the risk surrounding the yield at which it will be able to
sell its bonds? Both the bond and the contract are at par value. (LO 17-2)
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Challenge
24. The S&P 500 Index is currently at 1,200. You manage a $6 million indexed equity
portfolio. The S&P 500 futures contract has a multiplier of $250. (LO 17-2)
a. If you are temporarily bearish on the stock market, how many contracts should you
sell to fully eliminate your exposure over the next six months?
b. If T-bills pay 2% per six months and the semiannual dividend yield is 1%, what is the
parity value of the futures price? Show that if the contract is fairly priced, the total
risk-free proceeds on the hedged strategy in part (a) provide a return equal to the
T-bill rate.

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Chapter 17 Futures Markets and Risk Management 591

c. How would your hedging strategy change if, instead of holding an indexed portfolio,
you hold a portfolio of only one stock with a beta of .6? How many contracts would
you now choose to sell? Would your hedged position be riskless? What would be the
beta of the hedged position?
25. A corporation has issued a $10 million issue of floating-rate bonds on which it pays an
interest rate 1% over the LIBOR rate. The bonds are selling at par value. The firm is
worried that rates are about to rise, and it would like to lock in a fixed interest rate on
its borrowings. The firm sees that dealers in the swap market are offering swaps of
LIBOR for 7%. What swap arrangement will convert the firm’s borrowings to a
synthetic fixed-rate loan? What interest rate will it pay on that synthetic fixed-rate
loan? (LO 17-5)
26. The one-year futures price on a particular stock-index portfolio is 1,218, the stock index
currently is 1,200, the one-year risk-free interest rate is 3%, and the year-end dividend
that will be paid on a $1,200 investment in the index portfolio is $15. (LO 17-4)
a. By how much is the contract mispriced?
b. Formulate a zero-net-investment arbitrage portfolio, and show that you can lock in
riskless profits equal to the futures mispricing.
c. Now assume (as is true for small investors) that if you short-sell the stocks in the
market index, the proceeds of the short sale are kept with the broker and you do not
receive any interest income on the funds. Is there still an arbitrage opportunity
(assuming you don’t already own the shares in the index)? Explain.
d. Given the short-sale rules, what is the no-arbitrage band for the stock-futures price
relationship? That is, given a stock index of 1,200, how high and how low can the
futures price be without giving rise to arbitrage opportunities?

CFA Problems
1. The open interest on a futures contract at any given time is the total number of
outstanding: (LO 17-1)
a. Contracts.
b. Unhedged positions.
c. Clearinghouse positions.
d. Long and short positions.
2. In futures trading, the minimum level to which an equity position may fall before requiring
additional margin is most accurately termed the: (LO 17-1)
a. Initial margin.
b. Variation margin.
c. Cash flow margin.
d. Maintenance margin.
3. A silver futures contract requires the seller to deliver 5,000 Troy ounces of silver. Jerry
Harris sells one July silver futures contract at a price of $28 per ounce, posting a $6,000
initial margin. If the required maintenance margin is $2,500, what is the first price per
ounce at which Harris would receive a maintenance margin call? (LO 17-1)
4. In each of the following cases, discuss how you, as a portfolio manager, could use financial
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futures to protect a portfolio. (LO 17-2)

a. You own a large position in a relatively illiquid bond that you want to sell.
b. You have a large gain on one of your long Treasuries and want to sell it, but you would
like to defer the gain until the next accounting period, which begins in four weeks.
c. You will receive a large contribution next month that you hope to invest in long-term
corporate bonds on a yield basis as favorable as is now available.
5. Futures contracts and options contracts can be used to modify risk. Identify the funda-
mental distinction between a futures contract and an option contract, and briefly explain
the difference in the manner that futures and options modify portfolio risk. (LO 17-2)

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6. Joan Tam, CFA, believes she has identified an arbitrage opportunity for a commodity as
indicated by the information given in the following exhibit: (LO 17-4)

Commodity Price and Interest Rate Information

Spot price for commodity $120

Futures price for commodity expiring in one year $125
Interest rate for one year 8%

a. Describe the transactions necessary to take advantage of this specific arbitrage

opportunity.
b. Calculate the arbitrage profit.
7. Several Investment Committee members have asked about interest rate swap agreements
and how they are used in the management of domestic fixed-income portfolios. (LO 17-5)
a. Define an interest rate swap, and briefly describe the obligation of each party
involved.
b. Cite and explain two examples of how interest rate swaps could be used by a fixed-
income portfolio manager to control risk or improve return.
8. Janice Delsing, a U.S.-based portfolio manager, manages an $800 million portfolio
($600 million in stocks and $200 million in bonds). In reaction to anticipated short-term
market events, Delsing wishes to adjust the allocation to 50% stocks and 50% bonds
through the use of futures. Her position will be held only until “the time is right to restore
the original asset allocation.” Delsing determines a financial futures-based asset allocation
strategy is appropriate. The stock futures index multiplier is $250, and the denomination
of the bond futures contract is $100,000. Other information relevant to a futures-based
strategy is given in the following exhibit: (LO 17-2)

Information for Futures-Based Strategy

Bond portfolio modified duration 5 years

Bond portfolio yield to maturity 7%
Price value of basis point (PVBP) of bond futures $97.85
Stock-index futures price 1378
Stock portfolio beta 1.0

a. Describe the financial futures-based strategy needed, and explain how the strategy
allows Delsing to implement her allocation adjustment. No calculations are necessary.
b. Compute the number of each of the following needed to implement Delsing’s asset
allocation strategy:
i. Bond futures contracts.
ii. Stock-index futures contracts.
9. Maria VanHusen, CFA, suggests that forward contracts on fixed-income securities can be
used to protect the value of the Star Hospital Pension Plan’s bond portfolio against the
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possibility of rising interest rates. VanHusen prepares the following example to illustrate
how such protection would work:
• A 10-year bond with a face value of $1,000 is issued today at par value. The bond pays
an annual coupon.
• An investor intends to buy this bond today and sell it in six months.
• The six-month risk-free interest rate today is 5% (annualized).
• A six-month forward contract on this bond is available, with a forward price of $1,024.70.
• In six months, the price of the bond, including accrued interest, is forecast to fall to
$978.40 as a result of a rise in interest rates. (LO 17-2)

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