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EFB344 Risk Management

and Derivatives
Lecture 05:
Forwards and Futures 1

Unit Content
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures 1
Week 7: Forwards and Futures 2
Week 8: Mid-Semester Exam and Reflective Practices
Week 9: Forward Rate Agreements (FRAs) and Swaps
Week 10: Options: introduction and pricing with the binomial
model
Week 11: Options: pricing with the Black-Scholes model
Week 12: Options: trading strategies and risk management
Week 13: Derivative Disasters
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Week 14: Revision

Lecture Outline
Overview
Futures
Forwards

Futures
ASX SPI200 Futures
NSW Wheat Futures
Hedging
Risk Management

Readings:
Hull et al. (2013) Fundamentals of Futures and Options,
Ch. 1: 1.1 1.4, Ch. 2 and Ch. 3
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Overview: Futures
A futures contract is an exchange traded contract that is an
agreement made today to exchange a specified asset at a
specified price at a specified date in the future.
Major exchanges include:

Chicago Mercantile Exchange (CME it merged with CBOT)


Euronext
Tokyo Financial Exchange
Australian Securities Exchange (ASX)
Singapore Exchange

Broad classes of assets for which futures are written include:


Agricultural, Currency, Energy, Equity, Interest Rates, Metals,
Real Estate, Weather and then there are Futures on Options.
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Overview: Futures
Chicago Board of
Trade (CBOT) est.
1848

Sydney Greasy CME introduces:


Wool Futures Interest Rate and
Exchange (SFE) est.
Equity Futures

1874

Chicago Produce
Exchange est.
(becomes CME)

1960

1972 1981-2

ASX ceases
Wool Futures
Trading

2006-7

2014

CME introduces: CME and CBOT merge


Currency Futures SFE and ASX merge

te sure of the date of this information (source below it would be recent), but 95
all futures volume is in financial futures: Specifically:
42% 3-year bonds
26% 90-day bank bills
18% 10-year bonds
9% SPI200
urce: http://www.asx.com.au/documents/about/fact_sheet.pdf
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Overview: Forwards
A forward is an over-the-counter contract made today to be
performed at some set time in the future at a set price for
goods of a particular quality delivered to a set location.
Over-the-counter (OTC) markets

A telephone and computer linked network of dealers who


generally work for financial institutions or large corporates.
Market makers quote both bid (price willing to buy) and offer
(price willing to sell) prices. They aim to make the spread,
which is the difference in the bid and offer prices.
Because there is no exchange clearing the contracts,
counterparties are exposed to each others credit risk.

Major Forward Contracts

Currency and Interest Rates (not surprising given the


standardised nature of these assets)

Overview: Forwards
Notional amount refers
to
the face value of the
contracts, e.g. $100m
Gross market value
represents the value
of the contracts. On
inception, the
Contracts generally
have a value of $0, V0
= 0.

Decline in global value


may
indicate
maturing account
of
global notional OTC exposure (includes swaps), interest
rates contracts
f
contracts
that
had
value and currency contracts account for 12% (its 65% and 33% in Aust., respe
substantial value.
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http://

Futures
Can be bought (long position) or sold (short position)
Have a maturity date (also known as delivery month)
At any one time, a range of delivery dates can be traded

Most positions are closed out rather than delivered


More efficient to close out
Not all contracts are deliverable, e.g. SPI200 contract

Contracts are highly specified given that they often


deal with non-standard assets
Asset, Quality, Quantity and Delivery or Cash Settlement

Price Limits
Maximum daily price movement: limit down or limit up

Position Limits
Maximum number of contracts a speculator may hold
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Futures
Price Convergence:
0
F0,T < S0 or
F0,T = S0 or
F0,T > S0

T
FT,T =
ST

F0,T is the current price of the futures contract with delivery at T


FT,T is the price at maturity (T) of the futures contract with delivery at T
S0 is the current spot price
ST is the spot price at T

If F0,T > S0, is this not an arbitrage?


No! Because you have to purchase and hold the asset from 0 to T. As
such you would lose interest on your savings (opportunity cost). This is
referred to as cost-of-carry and is why we generally expect F 0,T > S0.
As we approach T, the difference between and Ft,T and St should
decrease.

Futures
Daily Settlement:
At the end of every trading day, futures positions are marked-tomarket. That is, any gains or losses are added or withdrawn from
the investors margin account.
The margin account is an initial deposit that the investor lodges
with their broker. The broker also has a margin account but with
the clearing house. The clearing house marks-to-market the
brokers and the brokers then mark-to-market their clients.
If the balance of the margin account falls below a maintenance
margin, which may be the initial deposit amount, the investor
receives a margin call from the broker requesting the margin
account be restored to its original balance. Failure to pay the extra
funds (variation margin) will result in the broker closing out the
investors position.
Ultimately, daily settlement is how the exchange manages their
credit risk exposure to the various brokers and their clients. By
doing so, losses that cannot be paid are limited to a few days at
most.
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Futures
Daily Settlement: Table 2.1: Hull et al. (2013), p.30
Long SPI200 Index Future where 1 Point = $25.
0

T-1

FT,T
FT,T
=468 =464
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3
(750) (1150)

F1,T
F2,T
F3,T
F0,T
= 4636 = 4632 = 4630 = 4649
(100)

(50)

475

3250

3250

3250

3250

5475 4725

Daily G/L

(100)

(50)

475

(750) (1150)

Margin Call

100

50

Daily G/L:
Margin Account:
Open. Bal.

Futures P/L:

0
3575
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Futures
Given daily settlement:
Investors may lodge financial securities as initial deposit to
ensure that they earn a market rate of return on their capital.
Margin requirements are the same for long and short traders as
the clearinghouse faces credit risk on both positions, but may
change on trader type (e.g. hedger vs. speculator).
Given daily settlement, an investors futures contact price is reset
each day. This differs from the forward contract where settlement
only occurs at maturity.
Margin accounts manage credit risk. While brokers may become
bankrupt, no clearing house has ever defaulted. This includes 19
October 1988 when the S&P500 fell 20% in one day.
Note that brokers who are not members of the clearinghouse, and
therefore do not have a clearing margin with the clearinghouse,
must trade through a broker who is a member of the clearing
house and maintain a margin account with this broker.
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Futures
Regulation
Prior to 2010, the ASX regulated the Australian Futures
Market; it was a self regulator.
Subsequently, Australian Securities and Investments
Commission (ASIC) has become the regulator.
Note that you cannot corner the market.

Accounting and Tax


The accounting treatment of the changes in futures prices
differs for traders who are hedging and for those that
are speculating. That is, the speculator recognises
gains and losses as they occur; while the hedger
recognises the gain or loss in the same period the
underlying gain or loss is realised.
Tax regulations also vary from hedgers to speculators and
also depend on the nature of the business.

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ASX SPI200 Futures


Underlying:
S&P/ASX200
Price:
$25 per point, e.g. 5,100 x $25 = $127,500
Maturing Months: Mar., Jun., Sept. and Dec. up to 1.5
years
ahead.
Trading Times: 5:10pm 7:00am and 9:50am
4:30pm
(during US daylight savings time)
Last Trade:
12:00pm on third Thursday of
settlement
month.
Settlement:
Cash Settlement
Settlement Day: Two business days after expiry.
For more detail, refer:
http://www.asx.com.au/documents/products/asx-spi-200-fututres.pdf
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ASX SPI200 Futures

es in volume relate to the maturity of the nearest dated contracts as investors r


tions; move from maturing contact to next nearest dated contract.

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Source: ASX, http://www.asx.com.au/documents/products/asx-spi-200-fututres.pd

ASX SPI200 Futures

Bid:
highest price willing to buy at
Ask:
lowest price willing to sell at
Last Trade:
last price that transaction occurred
Traded Vol.: total number of contacts traded in day

Source: ASX http://www.asx.com.au/prices/asx-futures.htm

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NSW Wheat Futures

Underlying:
NSW Wheat (Newcastle and Port
Kembla)
Grade:
Grain Trade Australia (GTA) Wheat
Standard CSG 103 (APW1) 10.5% Protein
Contract Size: 20 tonnes
Maturing Months: Jan. Mar., May. Jul. and Sept. Trading
Times:
11:00am 4:30pm and 5:00pm
7:00pm
Last Trade:
12:00pm on third Thursday of
settlement
month.
Settlement:
Physical delivery
Delivery Period: Second business day of maturity month
For more detail, refer:
and finishes at 3:00pm on last trade
http://www.asx.com.au/products/agricultural-derivatives/nsw-wheat-futures.htm
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day.

NSW Wheat Futures

h smaller volumes than ASX SPI 200 Futures. Not surprising given that 95% of fu
trading relates to financial futures.
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Hedging
Defined:
A trade designed to reduce risk, Hull et al. (2013).
Taking an additional exposure to reduce the risk
associated with an underlying exposure.

Types:
Short Hedge:
a short position to hedge an asset already owned or one that
will be sold in the future (e.g. wheat farmer, equity portfolio
manager).

Long Hedge:
a long position to hedge an asset that will be purchased in
the future. (e.g. food manufacturer, debt portfolio
manager).

Golden Rule:
Do in futures now what you plan to do in physical later

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Hedging
Arguments against hedging:
Risk management is irrelevant
Shareholders can do their own hedging
Hedging can exasperate some risk exposures. For example, if
a hedged crop fails and the prices increase, the loss in futures
is not offset by a gain in the physical.

Argument for hedging:


The business is not in the business of speculating on market
prices.
Risk management because we do not have perfect capital
markets (transaction costs, taxes, information asymmetries).
Reduces the probability of bankruptcy and increases debt
carrying capacities.
The company can carry out the hedging cheaper than the
investor.
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Hedging
Example:
Its August 2014, a NSW wheat farmer anticipates a crop
of 1,000 metric tonnes in January 2015. The spot price of
wheat is $275 per tonne, S 0 = $275, while the January
2015 futures contract has a bid/ask quote of $286/$294.
Complete the following:
1. Provide a rationale for the why the farmer would
hedge and the type of risk theyre hedging.
2. Outline whether they buy or sell futures and the
number of contracts they trade.
3. Determine the dollar/tonne return if the farmer
harvests 1,100 tonnes in January, sells their crop in
the spot market at $250 per tonne , S T = $250, and
closes out the futures position when the bid/ask on
the January 2015 futures is $248/$256.
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Hedging
1. As a producer of wheat, the farmer is concerned about a fall
in the market price of wheat between August and January. As
they have a range of costs associated with production, they
may want to ensure that the price earned on the crop is
sufficient to cover costs, which reduces the probability of
defaulting on creditors. The risk associated with the
movement in market prices is known as market risk. This
hedge does not reduce the risk associated with crop failure.
2. As the farmer will be selling wheat in the future, they should
sell January 2015 wheat futures now. If prices decline, the
farmer will close out the position by buying the futures at a
lower price. Hence, theyll make a profit from futures to
offset the loss in the physical (spot) market. Number of
contracts = 1,000/20 = 50.
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Hedging
3. Scenario
August 2014
Sell January 2015 Wheat Futures
50 x 20 x 286 (F0,T)
= 286,000
January 2015
Buy January 2015 Wheat Futures
50 x 20 x 256
= (256,000)
Futures Profit (FT,T)
= 30,000
Sell wheat in spot (ST)
1,100 x 250 (FT,T)
= 275,000
Overall Crop Return
= 305,000
Return per tonne
= $277/tonne
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Hedging
Why was the return per tonne $277 when the farmer
initially sold futures at $286?
1. S0 FTT
This can be due to the physical product not exactly
matching the characteristics of the contract. It may
also be associated with the maturity of the contract
not matching the physical sale. There are also
transactions costs as noted by the bid ask spread.
2. E0(CROPT) CROPT
Farmers do not have perfect foresight in terms of
total production especially when it depends on
climatic events, e.g. rain.

The first of these reasons is referred to as Basis Risk.


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Hedging
Hedging equity portfolios:
As a portfolio manager, you may be concerned
about a fall in the prices of the assets within
your portfolio.
To remove this risk, you can
Sell the assets, but this will involve transactions
costs and have tax implications. Furthermore,
you want to re-enter the market at a later date.
Sell Equity Index Futures such as the ASX
SPI200. But you need to consider how many
contracts you need to sell, the hedge ratio.

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Hedging
If
VA is the value of the portfolio and VF is the
notional value of a futures contract (F0,T x $25),
you can apply a nave hedge ratio

But this may be less than optimal, as it has not


considered how sensitive the underlying portfolio
is to changes in market conditions. That is, it has
not adjusted for the portfolios .

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Hedging
Minimum Variance Hedge Ratio:

Specify variance of portfolio

Differentiate portfolio variance with respect to and set equal


to 0 to find minimum variance portfolio:

Therefore:
(note the text uses N* rather than h)

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Hedging
Example:
Starting Information:

Vp,0 = 2,100,000
p = 1.50
S0 = 4,070
T = 3/12
F0,T = 4,200
VF,0 = 4,200 x 25 = 105,000
Rf = 5.60% p.a. (the risk-free rate)
= 3.86% p.a. (this is the dividend yield on the market)

Scenario: ST = 4,000 and FT,T = 4,109


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Hedging
Hedge
Ratio

Futures Trading
Now (0)
Sell Futures 30 x 4,200 x 25
Then (T)
Buy Futures 30 x 4,109 x 25
Futures P/L
=

= 3,150,000
= (3,081,750)
68,250

Or VF,T = h x (F0,T FT,T) x 25 = 30 x (4,200 4,109) x 25


= 68,250
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Hedging
Return on Portfolio

Value of Portfolio with Futures Hedge

Note that

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Risk Management
Beta
Targeting

Portfolio is a weighted average of the asset s. Given


that Index futures have a , we can add futures to the
underlying portfolio to achieve a target . That is,
Solving for noting that

If
, which is the minimum variance hedge ratio

If and

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Risk Management
Alpha Capture

Gets its name from the CAPM

, where
If the expected excess return on you asset is greater than the
beta adjusted expected excess return on the market , you have
outperformed the market on a risk adjusted basis. Alpha is a
measure of skill.

E[Ri]*
E[Ri]
Rf

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Risk Management
Alpha Capture

The idea is to target a beta of 0, such that

If you have skill as a portfolio manager, you can earn above the
risk-free rate because you are generating positive alpha.
How do you get

set

Also known as an Absolute Return fund:


http://
www.blackrockinvestments.com.au/individual/literature/fund-in-focus/bl
ackrock-australian-equity-absolute-return-fund-fund-profile-indiv-en-a
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u.pdf