Derivatives

Notes on Futures/Forwards
Robert Wood
Distinguished Professor of Finance

1
 Structure of Futures Market

Clearinghouse Customer

Futures Commission
EXCHANGE MEMBERS
Merchant (FCM)
Clearing Nonclear
Members Members
2
 Structure of Futures Market
 Futures Commission Merchant
 Exchange Members
 Floor Broker (Commission broker)
 Floor Trader (Local)
Day traders
Scalpers
Position traders
 Clearinghouse
3
BUYER FCM FCM SELLER

Floor Broker Floor Broker

TRADING PIT

Floor Broker Floor Broker

Clearinghouse
FCM FCM
4
 Liquidating a Futures position
 Physical Delivery
 Offsetting
 Exchange of Futures for Physicals
 Flexibility
 Cash Delivery

5
 Margin Requirement
 Initial Margin
 Maintenance Margin
 variation margin
 Open account with $5000 on Feb 20
 Feb 25: Buy 2 May contracts, Margin needed 2x3000=$6000
 Feb 26: Add $1000 to margin to meet $6000 requirement
 Feb 26: Marking to market gain 1400; Account value 7400
 Feb 27: Marking to market loss 2500; Account value 4900; Above
maintenance margin of 4200
 Feb 28: Marking to market loss 1000; Account value 3200; margin
call of 2800
6
 Futures Trading
 Open Outcry
 Board Trading
 insufficient liquidity for open outcry
 Electronic Trading
 Opening and Closing Call
 Settlement Price
 Price Limits
 Position limits
7
Changing Commodity Trading Volume

8
 Key Players
 Hedgers
 Wheat farmer
 Cereal manufacturer
 Speculators -- selling insurance
 Arbitrageurs -- correct mispricing
 Speculators and arbs cannot survive without
hedgers
9
Open Interest

10
 Notation
 T: time until delivery date (in years)
 S: price of the asset underlying the forward
contract today
 K: delivery price in the forward contract
 f: value of a long position in the forward contract
today
 F: forward price today
 r: risk-free rate of interest per annum today, with
continuous compounding, for an investment
maturing at the delivery date (i.e., in T years)
11
 Forwards vs. Futures
 Forward contracts:
 Customized size and amount
 Negotiated rate -- more costly
 More difficult to cancel/reverse
 Do not exist for all markets
 Futures contracts
 Daily mark to market
 Standardized sizes and expirations
 Do not exist for all markets
 Prices may vary slightly
 90 percent of forward contracts are delivered. Only
five percent of futures contracts are delivered.
12
 Pricing Forwards: No Income on Underlying
 90-day Forward contract on stock
 Stock price is $20, 90-day bond yields 4%
 What is the forward price?
 Strategy 1
 Buy forward contract with forward price F
 Strategy 2
 Buy stock for $20
 Payoff the same for both strategies
 Thus price today should be the same
 F = S(1+r)T = (20)(1+0.04)(0.25) = $20.20
13
 Arbitrage: An Example
 Assume that the forward price is $21
 Forward overpriced and/or stock underpriced
 Strategy
 Buy stock, sell forward, borrow $20 @ 4%
 Cash flow at execution = 0
 Cash flow at delivery
 Sell stock through forward for $21
 Pay back borrowing and interest
 Profit = 21 - (20)(1+0.04)(0.25) = $0.80
14
Pricing Forwards: Known Cash Income
on Underlying
 1 year forward on a bond
 Bond
 matures in 5 years,
 pays $50 in interest every six months,
 price today is $1200
 Interest rates
 6-month: 8%,
 1-year: 10%
15
 Pricing Forwards: Known Cash Income
on Underlying
 Strategy 1
 Buy bond
 Strategy 2
 buy forward
 buy 6-month bond that pays $50
 buy 1 year bond that pays $50
 Strategies have same payoff
 Cost of strategies should be same
 S=F(1+r)-T+I1(1+r1)-T1 + I2(1+r2)-T2
 F = (1200 – 50(1+0.08)-0.5 – 50(1+0.1)-1)(1+0.1) = 1217.08
16
 Arbitrage: An Example
 Assume forward price is $1230
 Forward is overpriced / bond is underpriced
 Strategy
 Buy bond at a cost of $1200
 Sell forward
 Borrow $1200
Pay back $50 in 6 months (PV = $48)
Pay back remaining in 1 year (PV = $1152)
 On delivery
 Sell bond through forward for $1230
 Pay back borrowing (FV = 1273 - 50 = 1223) 17
 Pricing Forwards with Storage Costs
 Assume that the PV of storage costs is U
 If underlying has income with PV of I
 F = (S - I)(1+r)T
 Since costs are negative income, replace -I with U
to get
 F = (S + U)(1+r)T

18
Pricing Forwards: Storage Costs
 6-month forward on Gold
 Spot price of gold = $300/oz.
 Storage costs for gold = $1/six months/oz. paid up front
 6-month interest rate = 5%
 What is the forward price?
 F = (S + U)(1+r)T
 S = 300, U = 1
 F = (300 + 1)(1+0.05)(0.5) = 308.43

19
 Arbitrage: An Example
 Assume that the forward price is 317.20
 Forward is overpriced / gold is underpriced
 Sell forward
 Plan to sell/deliver gold in 6 months for $317.20/oz.
 Buy gold for $300/oz. and pay storage of $1 for 6 months
 Borrow $301 for 6 months at 5%
 Profit = 317.20 - (301)(1+0.05)(0.5) = 317.20 - 308.43 =
8.77

20
 Basis and Cost of Carry
 Basis = Spot Price - Forward Price
 Contango Market
 Forward Price > Spot Price
 Hedgers are net short; speculators long
 Cost of carry determines forward price
 F = S(1+c)T or c = (F/S)(1/T)-1
 Spot price of gold = 300, 6-month forward price is
308.62
 c = (308.62/300)(1/0.5)-1 = 5.83% 21
Basis Convergence

22
Patterns of Futures Prices

23
 Basis and Convenience Yield
 Assume that spot price of gold is $300 and the cost of carry is
5.67% per annum, storage costs are $1 per six months, interest
rate is 5%
 Expected 6- month forward price is $308.62
 You observe the forward price is $305
 Strategy
 Buy forward
 Sell 1 oz. of gold for $300 and save on storage costs of $1
 Invest $301 at 5%
 Profit would be $3.62

24
 Convenience Yield
 Strategy requires sale of gold
 Forward price may indicate that holders of
gold do not want to sell their holdings
 Convenience related to holding gold
 F = S(1+c-y)T, y is convenience yield
 305 = (300)(1+0.0567-y)(0.5) or y = 2.31%
 Attach a value of 2.31% to owning gold
25
 Using Models in Practice
 Futures on Stock Indices and Exchange Rates
 Underlying security has continuous income
Index: Income is dividend yield on index
FX: Income is the interest rate in “foreign” currency
 Futures on bonds with no coupons
 Underlying security has no income
 Futures on bonds with interest
 Underlying security has discrete income
 Futures on commodities
 Underlying security has storage costs
26
 Use of Futures: Arbitrage
 Use pricing model to determine theoretical price
 Compare the theoretical price with market price
 Strategy if futures is underpriced
Buy futures, Sell underlying, Invest proceeds of sale till
delivery
 Strategy if futures is overpriced
Sell futures, Buy underlying, Borrow money required for
purchase

27
 Futures Index Arbitrage: An Example
 Consider a futures contract on a stock market
index
 Current index value = 8300
 Delivery date = 6 months
 6-month interest rate = 8%
 Dividend yield on index is 5%
 Futures price is 8494
 Theoretical futures price is (8300)(1+0.08-0.05)
(0.50) or 8423.58
28
 Futures-Index Arbitrage
 Forward is overpriced
 Sell forward, Buy (1+q)-T units of index, Finance purchase of
index with borrowing at r% till delivery
Sell forward (forward price = 8494)
Buy 0.9759 (=(1+0.05)-(0.5)) units of the index for 8099.97
Borrow 8099.97 at 8% for 6 months
 Reinvest all dividends back in index
 On delivery date
Sell index through forward for 8494
Pay back borrowing, payback = 8099.97(1+0.08)(0.5) =
8417.74
Profit = 8494 - 8417.74 = 76.26 29
 Risk Management: Hedging
 Activity that controls the price risk of a position
 Combine the derivative with the underlying
 Position in derivative is opposite to that in
underlying
 Hedge ratio is the number of units of the
derivative to the underlying
 Hedge ratio minimizes the overall exposure to
price risk

30
 Problems with Simple Strategy
 The “commodity” you are interested in does not
have a futures contract
 Use a futures contract with an underlying that is
closely related to the “commodity”
 The date you need the “commodity” does not
match the delivery date
 Use a futures contract that has delivery as close to
(and greater than) the date you are interested in

31
 Managing the Risk of a Portfolio
Assume that you are managing a $2m portfolio of stocks

You want to hedge the portfolio using a futures contract

Futures contract on the S&P 500

Current futures price is 1024.20

Contract is for 250 units of the index

Beta of portfolio relative to the S&P 500 is 3.68

Number of contracts = (3.68)(2,000,000/(250*1024.2) =32 29

 Hedging
8
6
4 Unhedged
2 Hedged
0
-2Jan Feb Mar Apr May Jun

3
2
Unhedged
1 Hedged
0
Avg Std Dev
33
 Forward Rate Agreement
(illustrating forward rates)
 Used by large, international banks
 Buy a security from a bank
 Receive 15% for a year from the bank
 The interest will be received in the period
starting 6 months and ending 18 months
from now
 What is the 15% based on?
 1-year Forward rate in 6 months ( 0.5 r1.5)
34
 Forward Rate Agreements (cont.)
 Consider an FRA for a future period T to T*
 What should the FRA interest rate be?
 Spot rates for T and T* are r and r*
 (1+r*)T* = (1+r)T(1+k)(T*-T)
or k = [(1+r*)T*/(1+r)T][1/(T*-T)] - 1
 2 year rate is 12% and the 4 year rate is 14%
 k = [(1+0.14)4/(1+0.12)2][1/(4-2)] – 1 = 16.04% =
2r4

35
Forward Rate Agreements (cont.)
 Assume you entered into an FRA one year ago for
16% from year 2 to year 4
 Invest $100 in 2 years, receive 137.71 in 4
years (2 years later)
 Today, 1 year later, the 1-year and 3-year spot
rates are 14% and 15%
 What is the value of the FRA today?
 137.71(1+0.15)-3 – 100(1+0.14)-1 = 2.83

36
 Futures on Long-Term Debt
 Underlying pays known cash income
 T= time to delivery
 S = Spot cash price
 PVI = Present value of income until
delivery date of futures
 r = T-year zero-coupon yield
 Futures price F = (S-PVI)(1+r)T
37
 Problem with using formula
 Cash Spot Price vs. Quoted Spot Price
 Accrued Interest
 Choice of deliverable bond
 Any bond that satisfies requirements
 Conversion factor--standardizes deliverables
 Wild card option
 2pm futures (settlement price), 4pm underlying, 8pm intent
notice
 Cash Futures price vs. Quoted Futures Price
 Accrued interest and conversion factor

38
Applications of Financial Futures
 Changing maturity of T-bill investments
 Converting floating-fixed rates
 Immunization

39
 Forwards with Short-Term Rates
 Underlying is a short-term instrument
 90 day maturity;  No coupon
 Value of underlying at time 0 is S = 100(1+r*)-T*
 Forward price F at time T is S(1+r)T = [100(1+r)T] /
(1+r*)T*
 Forward rate from T to T* is
rf = [(1+r*)T* /(1+r)T] [1/(T*-T)] - 1
 Forward Price F at time T = 100(1+rf)-(T*-T)

T-bill Matures
at T*
240 days

0 150 240
40
Initiate futures contract Transfer t-bill at T for F
 Short-term Rate Forward Example
 150-day forward
 Obtain a 90-day zero-coupon bond at delivery
 150-day spot rate is 10%
 240-day spot rate is 12%
 Forward price?
 Forward rate = [(1+r*)T* /(1+r)T] [1/(T*-T)] - 1
= [1+0.12) (2/3) /(1+0.10) (5/12) ] [1/(0.25)] -1 = 15.41%
 Forward price = 100(1+0.1541)-(0.25) = 96.48

41
 Repo Arbitrage
 The 100-day forward price on a 90-day underlying is 98
 The 190-day spot rate is 10%
 F = 98 = 100(1+r)T /(1+r*) -T* = 100(1+r)0.2739 /(1+0.1)-0.5205
 Implied 100-day spot rate is 11.33%
 Compare implied with actual
 If implied > actual
 Lend at implied, borrow at actual (Type 1)
 If implied < actual
 Borrow at implied, lend at actual (Type 2)
42
 Repo Arbitrage
 100-day spot rate is 11% < 11.62%
 Borrow at the spot rate for 100 days
 Lend at the implied spot rate
 Sell the futures contract
 Invest borrowed money at spot rate for 190 days such that
payoff is $100
 Amount borrowed = 100(1+0.1)-(190/365) = 95.16
 Amount owed in 100 days = 95.16(1+0.11)(0.274) = 97.92
 Profit = 98-97.92 = $0.08

43
 Repo Arbitrage
 100-day spot rate is 12% < 11.62%
 Lend at the spot rate for 100 days
 Borrow at the implied spot rate
 Buy the futures contract
 Borrow money at spot rate for 190 days such that payoff
is $100
 Amount borrowed = 100(1+0.1)-(0.5205) = 95.16
 Amount obtained in 100 days=95.16(1+0.12)(0.274) =
98.16
 Profit = 98.16-98 = $0.16 44
 T-Bills and T-Bill Futures
 T-Bill quotes and cash price
 Cash price = 100 - (n/360)(Quoted price)
 T-Bill futures quotes and cash prices
 Futures quote = 100 - 4(100 - Cash price)
 60-day forward on 90-day T-bill
 150-day T-bill quoted at 9
 60-day interest rate is 6% per annum
 Cash price on 150-day T-bill = 100 - (150/360)(9) = 96.25
 Cash futures price = (96.25)(1+0.06)(60/360) = 97.19
 Quoted futures price = 100 - (4)(100-97.19) = 88.76
45
 Hedging Interest Rate Risk
 Duration
 Sensitivity of value to interest rate
 Equalize durations of futures and portfolio
 Equal sensitivity for futures and portfolio
 (NF)(F)(DF)=(S)(DS)
 Number of futures NF = (SDS)/(FDF)

46
 Stock Index Futures
 S&P500--the dominate stock index contract
 Cost of carry:

47
 Stock Index Futures
 Index arb -- program trading
 Portfolio insurance
 Dynamic hedging--replicate option w/cash and
stock
 Motivation – 1984 ERISA act
 Market crash
 Barings Bank -- risk management

48