Professional Documents
Culture Documents
Week 2: Forwards,
Futures, and Swaps
Fall 2015
Professor Albert Wang
Lecture
Current Events Update
CH22-23
Payoff/Profit Diagrams
Forwards/Futures
Forwards/Futures examples
Swaps
Page 2
Current Events
TAIEX Index: 8307.04
S&P500 Index: 1,966.97
Recent financial news
US Federal Reserve no Sept. change in
policy
Volkswagen cheated on US emissions
tests, fines could be huge. Other
countries may follow up.
Page 3
Price of underlying
Payoff (time T)
Price of underlying
Page 4
Page 5
Forwards
Forwards
Contract set today for delivery of a good
at a set date in the future at a set price.
Forwards are priced to have zero value
today
No money changes hands until maturity when
delivery is taken
Page 7
Futures
Futures
Identical in spirit to forwards
Standardized, Regulated forwards
Clearinghouse serves as middle-man
Guarantees delivery of cash and underlying to both
sides of transaction
Regulates and evaluates financial health of members
Provides standardization and a market
Holds diversified portfolio of default risk
Margin account to insure against default
Page 8
Trading Mechanics
Opening positions
Contact broker to trade futures
Contact counterparty directly (or through broker)
to trade forwards
Closing positions
Trade in identical forward/future in opposite
direction with ANY counterparty (not necessarily
original)
Most often positions are closed in this manner
Forward counterparty rarely wants to reverse the trade
Futures counterparty does not need to be known
Non-technical Summary
Summary of key characteristics futures
Forwards or Futures?
Basis Risk
Future and Spot (underlying) values diverge
Depends on interest rate so has the same risk
components.
Default Risk
From counterparty if using forwards
Margin call risk if using futures
Page 11
Possible Underlying
Instruments
Agricultural commodities
Metals and minerals (including energy contracts)
Foreign currencies
Financial securities futures
Interest rate (and bond) futures
Stock index futures
Individual stock futures
ANYTHING!
Futures are exchange-traded and standardized, so what
you see is what you get
Forwards for ANYTHING can be negotiated by any i-bank,
typically at very low cost
Page 12
Forward/Futures Pricing
There are two ways to acquire an
underlying asset for some future date
1: Purchase it now and store it
2: Take a long position in futures
Time (0,t)
No cost
Time t
Pay F, receive
underlying
Buy underlying
Time 0
Pay S
Time (0,t)
Pay holding costs,
receive dividends
Time t
No cost; already
have underlying
Page 17
Spot-Futures Parity
Essentially equates the cash outflow at the
maturity date from the 2 ways to get
underlying exposure
A) long futures: pay F
B) buy underlying: pay FV(S) FV(Div) +
FV(costs)
F S (1 rf ) D C
t
S (1 rf d c)t
Se
Page 18
FV(Costs), C
Cost rate, c
Riskfree rate, r
Page 19
Arbitrage Possibilities
If spot-futures parity is not observed,
then arbitrage is possible
If the futures price is too high, short
the futures and acquire the stock by
borrowing the money at the riskfree
rate
If the futures price is too low, go long
futures, short the stock and invest the
proceeds at the riskfree rate
Page 20
Page 21
continued
S = $1000, rccr=5%
PV(Dividends) = $30 (milk)
PV(Cost) = $10 (hay, water)
F Se FV (CF )
rt
.05
Page 22
continued
Example continued:
Instantly after going long a single cow
forward, the price of cows increases to
$1100.
What is the VALUE of the long position?
What is the implied cow exposure in
number of cows?
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Page 24
Profit
Fo
Price
Page 25
Futures Seller
Fo
Price
Page 26
Hedge Example
Investor owns an index fund that has a
current value of $900
Assume dividends of $20 will be paid on the
fund at the end of the year
Assume futures contract that calls for
delivery of one index unit in one year is
available for $925
Assume the investor hedges by selling or
shorting one contract
What is the riskfree rate?
Page 28
885
925
965
Payoff on Short
(925 - ST)
40
-40
Dividend Income 20
20
20
Total
945
945
945
Page 29
S0
(925 20) 900
5%
900
Page 30
Forwards/Futures
Page 31
.25
Page 34
Speculate on Margin
Your third cousin Jeeesper from Timbucktoo has a
dead-end job and no education. He has managed
to save $10000 and is on the way to the gas station
to buy lottery tickets. Knowing that lottery tickets
are priced to return about 50 cents on the dollar,
you suggest speculating in the crude oil market
where at least the odds are even. Each crude oil
futures contract represents 1000 barrels, and each
barrel currently trades at $68. Exposure to each
futures contract requires $1000 to be placed in a
margin account. How much exposure to oil can
Jeesper obtain? Assuming he sells the maximum
amount of futures and the price of oil decreases to
$45 per barrel, what is his profit? At what price
would he be wiped out (assuming no maintenance
margin)?
Page 38
Speculate continued
He can obtain exposure to 10 contracts:
10 contracts x $68/barrel x 1000 barrels/contract
= $680,000 of spot crude oil exposure
Page 39
Normal Backwardation
Time
Delivery date
F converges to S as T approaches
Page 40
F vs E(S)
Normal Backwardation
Economists Keynes and Hick said, its normal
for farmers to hedge commodity outputs by
shorting futures.
Entice non-hedgers to buy futures: lower F below
E(S)
Contango
Opposite to Normal Backwardation
There are more natural buyers of the commodity
than sellers; they need to buy futures
Entice non-hedgers to sell futures:increase F
above E(S)
Page 41
Swaps
A swap is a pair of forwards
Long one forward
Short another forward
What is the total cost to enter a swap???
Swaps
OTC so there is default risk.
Swap the total return on ANY 2 securities, for the same notional
amount for each securities
Only the difference b/w the total return of securities actually
changes hands, NOT the notional amount
No forward pricing necessary just exchange total return
The fair value of $1mm notional in S&P500 is the same as the fair
value of $1mm notional in IBM bonds. Its $1mm notional! Just
exchange the cash flows to each
Page 43
Swap Pricing
Swap pricing is based on the fact that
a swap is simply a series of 2 (or
more) forward contracts
Applicable when a fixed amount should be
paid each period (i.e. not necessary in a
swap of index total return swaps)
Start by pricing individual forwards, which
leads to floating values per period
Set fixed amount such that discounted
value equals discounted value of separate
forwards
Page 44
Assignment
Read CH6
Form Project Groups
Each HW group may do the following:
Search online or print news
ANY source
Real stories only
No timetable (any current or historical example)