Fall 2013 ADVANCED FINANCIAL INSTRUMENTS AND MARKETS

LectureNo. No 10 FinancialStrategiesUsing Futures

Hammad HassanMirza AssistantProfessor(Finance) DepartmentofBusinessAdministration UniversityofSargodha

Introduction

ForwardsAgreement FutureAgreement CounterParty yRisk MarginAccount FutureCurve

ABriefHistory
In the 1840s, 1840s Chicago had become a commercial center and Midwest farmers came to Chicago to sell their wheat to dealers who, in turn, shipped it all over h country. H d of fT d b the Hence Chi Chicago B Board Trade became the first commodity exchange where raw g and sold, via commodities were traded; bought standardized contracts called Futures

 Beforetheactualharvest, harvest Farmerswantedtotradeinfuturestoreducetherisk ofbearishpricesatharvest Dealerstradedinfuturestoreducetheriskofbullish pricesatharvestaswellasconsistentqualityasall commoditiestradedattheexchangearegradedand standardized.

WhatIsAFuturesContract?
Futures contract is a standardized contract, traded on a futures exchange, g , to buy y or sell a certain underlying y g instrument ( (e.g. g g gold) ) at a specific date in the future, at a preset price. The future date is called the delivery date. The preset price is called the futures price. As time passes the value of the contract changes relative to the pre set price based on the traders expectations of the future spot price of the underlying commodity. Over a period of time the price of the futures contract converges to the spot price of the respective commodity. On the day of the contact maturity/delivery date the price of the futures contract will be equivalent to the spot price of the underlying asset.

SpecificationsofFutureContract
The following specifications are usually listed on a Futures contract: y g commodity y, for example p Gold The name of the underlying The type of settlement, either cash settlement or physical settlement Th tit and d units it of f th d l i g asset t The quantity the underlying The currency in which the futures contract is quoted grade or q quality y of the deliverable The g The delivery month The last trading date

Futuresvs. vs Stock
Unlike stocks, stocks which represents equity in a company and can be held for a long time, if not indefinitely, futures contracts have finite lives and a determined expiry date A futures investor can sell a future without having first bought it if he is expecting prices of the commodity to go down in the future future. This option of selling before buying does not exist with stocks. Futures are highly leverage investments. The trader puts up a small fraction of the underlying contract (usually between 5% 25%) as margin, yet can ride over the full value of the contract as it moves up and down. The money he puts up is not a down payment on the underlying contact, but a performance bond

WhoTradesFutures&Why?
Futures traders are typically put in one of the two groups: Hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes. They typically include producers and consumers of a commodity Speculators, who seek to make a profit by predicting market moves and buying a commodity on paper for they have no l use. practical Arbitrageurs, who seek to make risk free profit on a commodity by exploiting differentials between the spot price and the futures market of a particular commodity due to mispricing. Such opportunities are rare and fleeting. The presence e e e of arbitrageurs bit ge e ensures e that th t futures f t e prices i e move o e in i tandem with the cash/spot rates.

HowDoesArbitrageMake TheFuturesMarketEfficient
Arbitrageursinthefuturesmarketarealwayswatchingtherelationship betweenthespotandthefuturesinordertoexploitsuchmispricing. If,forexample,anarbitrageurrealizedthatthegoldfuturesinacertain monthwasoverpricedinrelationtothegoldspotrateand/orriskfree interestrate,hewouldimmediatelysellthesecontractsknowingthathe couldeasilylockinariskfreeprofit. PriceofFuturegoldcontract(maturingin1month)..Rs.12,500 SpotpriceofgoldRs.12,000 Riskfreeinterestrateof12%p perannum...Rs. 120 Bysellingfuturescontractandbuyinggoldonspotpricethearbitrageur makesa riskfreeprofitofrupees380(1250012000120)

TakingAPosition
A trader can take any of the two positions based on his expectation about the h price i trend d of f the h underlying d l i commodity di in i the h future. f Long positions
At commodity futures exchange, if a trader purchases a buy contract then his stakes k are positively i i l related l d to the h price i of f the h underlying d l i commodity di i.e. i the h higher the commodity price the more profit he will make. This purchase of a buy futures contract is called taking a long position

Short position
Reversely, if a trader purchases a sell contract, then his stakes are negatively related to the price of the underlying commodity i.e. the lower the commodity price the more p p profit he will make. This p purchase of a sell futures contract is called taking a short position

To maximize his profit, if he expects prices to fall, he should take a short position and if the expectation p p is of the commodity p prices to g go up p in the future then he should consider a long position

TakingDelivery
Brokerage firms watch their open accounts and know who has long (buy contract) and short (sell contract) positions in contracts nearing maturity. i Prior to delivery day they inform customers who have open long positions that they must either close out the position by selling g the contract in the futures market or prepare to take delivery and pay the full value (spot commodity rate on the day of maturity) of the underlying y g contract. On the few occasions that a buyer accepts delivery against his futures contract, he is given a receipt entitling him to fetch the commodity from a central distribution point, point like in the case of gold gold , the gold bars can be picked up by the buyer against a receipt from NCEL designated vaults.

ClearingHouse
Each futures exchange has a clearing association which operates in conjunction with the exchange in a manner similar to a bank clearing house. NCEL has an in house clearing d department t t All brokers are members of the Clearing House. Every clearing margins g house member must put p up p fixed original g g and maintain them with the clearing house in the advent of adverse price fluctuations. In such instances, the clearing house may request for additional margin payment. payment The exchange has the final say in all instances where a dispute arises
The information in this publication is taken from official web site of Pakistan Mercantile Exchange (PMEX). It is, however, intended for purposes of information and education only and is not guaranteed by Pakistan Mercantile Exchange (formerly Nation Commodity Exchange (NCEL) as to accuracy, completeness, nor any trading result and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures.

Session II
WaysDerivativesareUsed
To hedge risks To speculate l ( k a view on the (take h future f d direction of f the h market) To lock in an arbitrage g profit p To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another

ExampleofaFuturesTrade
Aninvestortakesalongpositionin2 DecembergoldfuturescontractsonJune5
contractsizeis100oz. futurespriceisUS$600 marginrequirementisUS$2,000/contract (US$4,000intotal) maintenance i t margin i is i US$ US$1,500/contract / t t (US$3,000intotal)

APossibleOutcome
Futures Price (US$) 600.00 5-Jun 597.00 . . . . . . 13-Jun 593.30 . . . . . . 19-Jun 587.00 . . . . . . 26 J 26-Jun 592 30 592.30 (600) . . . (420) . . . (1,140) . . . 260
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Day

Daily Gain (Loss) (US$)

Cumulative Gain (Loss) (US$)

Margin Account Margin Balance Call (US$) (US$) 4,000

(600) . . . (1,340) . . . (2,600) . . . (1 540) (1,540)

3,400 . . .

0 . . .

2,660 + 1,340 = 4,000 . . . . . 3 000 < 3,000 2,740 + 1,260 = 4,000 . . . . . . 5 060 5,060 0

OtherKeyPointsAboutFutures
Theyaresettleddaily Closingoutafuturespositioninvolvesenteringinto anoffsettingtrade l doutb f maturity i M Mostcontractsareclosed before

ForwardContractsvs Futures Contracts

FORWARDS Private contract between 2 parties Non-standard contract Usually Usua y 1 specified spec ed delivery de ve y date Settled at end of contract Delivery or final cash settlement usually occurs
Some credit risk

FUTURES Exchange traded Standard contract Range a ge of o delivery de ve y dates Settled daily Contract usually closed out prior to maturity
Virtually y no credit risk
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HedgingStrategiesUsingFutures
Alongfutureshedgeisappropriatewhenyouknow youwillpurchaseanassetinthefutureandwantto lockintheprice Ashortfutureshedgeisappropriatewhenyouknow youwillsellanassetinthefutureandwanttolockin theprice

BasisRisk
Basisisthedifferencebetweenthespotand futuresprice Basisriskarisesbecauseoftheuncertaintyabout thebasiswhenthehedgeisclosedout

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LongHedge
Wedefine F1 : InitialFuturesPrice F2 : FinalFuturesPrice S2 : FinalAssetPrice Ifyouhedgethefuturepurchaseofanassetby entering gintoalong gfuturescontractthen CostofAsset=S2 (F2 F1) = F1 +Basis
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ShortHedge
Againwedefine F1 : InitialFuturesPrice F2 : FinalFuturesPrice S2 : FinalAssetPrice Ifyouhedgethefuturesaleofanassetby enteringintoashortfuturescontractthen PriceRealized=S2+ (F1 F2) = F1 + Basis
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ChoiceofContract
Chooseadeliverymonththatisascloseas possibleto,butlaterthan,theendofthelife ofthehedge g Whenthereisnofuturescontractonthe assetbeing ghedged, g ,choosethecontract whosefuturespriceismosthighlycorrelated withtheassetprice.Thisisknownascross hedging.
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OptimalHedgeRatio
Proportionoftheexposurethatshouldoptimally behedgedis S F where iationofS,thechangein S isthestandardde deviation thespotpriceduringthehedgingperiod, F isthestandarddeviationofF,thechange g in thefuturespriceduringthehedgingperiod isthecoefficientofcorrelationbetweenS and F.
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TailingtheHedge
Twowayofdeterminingthenumberof contractstouseforhedgingare
Comparetheexposuretobehedgedwiththevalue oftheassetsunderlyingonefuturescontract Comparetheexposuretobehedgedwiththevalue ofonefuturescontract(=futurespricetimesizeof futurescontract

Thesecondapproachincorporatesan adjustmentforthedailysettlementoffutures
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HedgingUsingIndexFutures
Tohedgetheriskinaportfoliothenumberof contractsthatshouldbeshortedis P F whereP isthevalueoftheportfolio, isitsbeta,and F isthevalueofonefuturescontract

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Example

S&P500futurespriceis1,000 1 000 ValueofPortfoliois$5million Betaofportfoliois1 5 1.5 What Wh tposition iti in i futures f t contracts t t onthe th S&P 500isnecessarytohedgetheportfolio?
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ChangingBeta
Whatp positionisnecessary ytoreducethebetaof theportfolioto0.75? Whatpositionisnecessarytoincreasethebetaof theportfolioto2.0?

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WhyHedgeEquityReturns
May want to be out of the market for a while. Hedging avoids the costs of selling and repurchasing the portfolio S o e stocks to k i o portfolio o tfolio h e an average e ge Suppose in your have beta of 1.0, but you feel they have been chosen well and will outperform p the market in both g good and bad times. Hedging ensures that the return you earn is the riskfree return plus the excess return of your portfolio over the market. market
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Rolling gTheHedge g Forward

Wecanuseaseriesoffuturescontractstoincrease thelifeofahedge Eachtimeweswitchfromonefuturescontractto anotherweincuratypeofbasisrisk

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ThankYou!