Transcript Document 7341797

CHAPTER 11
FUTURES, FORWARDS, SWAPS,
AND OPTIONS MARKETS
The Purpose of Futures and
Forward Markets
• Purpose is to eliminate the price risk
inherent in transactions that call for
future delivery of money, a security, or a
commodity.
Forward Markets
• A forward contract is an agreement to
buy or sell an asset at a certain time in
the future for a certain price
– There is no daily settlement. At the
end of the life of the contract one party
buys the asset for the agreed price
from the other party (mandatory)
How a Forward Contract Works
• The contract is an over-the-counter
(OTC) agreement between 2 companies
• No money changes hands when first
negotiated & the contract is settled at
maturity
• The initial value of the contract is zero
– Similar to an NPV=0 calculation
Futures Markets
• Buying/selling of standardized contracts
specifying the amount, price, and future
delivery date of a currency, security, or
commodity.
• Buyers/sellers deal with the futures exchange,
not with each other.
• A specific trade (buy/sell) involves a hedger and
a speculator.
• Delivery seldom made -- buyer/seller offsets
previous position before maturity.
• Futures contracts expire on specific dates.
Spot versus Futures Market
• Trading for immediate or very-near-term
delivery is called the spot market.
• Trading for future delivery -- futures
market.
A Position in the Futures
Market
• Long -- an agreement to buy (purchase)
in the future.
• Short -- an agreement to sell (deliver) in
the future.
Margin Requirements
• Initial margin -- small percentage deposit
required to trade a futures contract.
• Daily settlements -- reflect gains/losses
daily and cash payments.
• Maintenance margin -- minimum deposit
requirements on futures contracts.
Forward Contracts vs. Futures Contracts
FORWARDS
FUTURES
Private contract between 2 parties
Exchange traded
Non-standard contract
Standard contract
Usually 1 specified delivery date
Range of delivery dates
Settled at maturity
Settled daily
Delivery or final cash
settlement usually occurs
Contract usually closed out
prior to maturity
Futures Exchanges
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Competition between exchanges is keen.
Contract innovation is common.
Exchanges advertise and promote heavily.
Exchange specifies terms of a contract.
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Dates.
Denomination.
Specific items that can be delivered.
Method of delivery.
Minimum daily price variance.
Rules for trading.
Interest Rate Futures Quotations
Futures Markets Participants
• Hedgers attempt to reduce or eliminate
price risk.
• Speculators accept the price risk in turn
for expected return.
• Traders speculate on very-short-term
changes in future contract prices.
Regulation of the Futures Market
• The Commodity Futures Trading
Commission (CFTC)
• The Securities Exchange Commission
(SEC) regulates options markets that
have equity securities as underlying
assets.
• Exchanges impose self-regulation with
rules of conduct for members.
Hedging Borrowing Costs with
T-Bond Futures
INITIAL POSITION
Corporation X sells 131 ($10 million in market
value) of T-bond futures at 76-10 for a yield of
10.94 percent. If it usually must pay 2 percent
over the T-bond rate to borrow $10 million one
year later--for total annual interest costs over
30 years of $1,294,000 per year.
ONE YEAR LATER
Corporation X buys back 131 futures contracts
at 72-22 (at a yield of 11.52 percent). Its
capital gain is $3,625 per contract, or
$474,875.
Because of its gain, it sells only $9,525,000
worth of corporate debt at an interest cost of
13.5 percent--for total annual interest costs of
$1,285,875 per year for 30 years (about what it
expected).
If it had not hedged, it would have incurred
total annual interest costs of $1,350,000 (13.5
percent of $10 million) per year for 30 years.
Risks in the Futures Markets
• Basis risk -- risk of an imperfect hedge because
the value of item being hedged may not always
keep the same price relationship to the futures
contracts.
• Cross-hedges -- using the futures market to
hedge a dissimilar commodity or security.
• Related-contract risk -- risk of failure due to a
unanticipated change in the business activity
being hedged, such as a loan default or
prepayment.
Risks in the Futures Markets
(concluded)
• Manipulation risk -- risk of price losses
due to a person or group trading (buying
or selling) to affect price.
• Margin risk -- the liquidity risk that
added maintenance margin calls will be
made by the exchange.
Swaps Compared to Forwards
and Futures
• Swaps are like forward contracts in that they
guarantee the exchange of two items in the
future, but a swap only transfers the net
amount.
• Swaps do not pre-specify the terms of trade as
do forward contracts. Prices are conditional on
changes in a indexed interest rate such as Tbills.
• Swaps are used to hedge interest rate risk as
are financial futures. Credit risk differences
between the parties provide the economic
incentive to swap future interest flows.
Swap Dealers Serve as Counter-parties
to both Sides of Swap Transactions
• Dealers negotiate a deal with one party,
then seek out other parties with opposite
interests and write a separate contract
with them.
• The two contracts hedge each other and
the dealer earns a fee for serving both
parties.
Swaps Have Limited Regulation
• Bank regulators require risk-based
capital support for swap-risk exposure.
• Other swap competitors, investment
banks and life insurance companies have
no regulatory capital costs.
Example of a Swap
Options
• Right to buy or sell an item at a
predetermined price (strike price) until
some future date.
Options versus Futures Contracts
• The option at the strike price exists over the
period of time, not at a given date.
• The buyer of an option pays the seller (writer) a
premium which the writer keeps regardless of
whether or not the option is ever exercised.
• The option does not have to be exercised by the
buyer; it can be sold if it has a market value,
before the expiration date.
• Gains and losses are unlimited with futures
contracts; with options the buyer can lose only
the premium and the commission paid.
Calls and Puts
• Call option -- buyer has the option to buy
an item at the strike price.
• Put option -- buyer has the option to sell
an item at the strike price.
Covered and Naked Options
• Covered option -- writer either owns the
security involved in the contract or has
limited his or her risk with other
contracts.
• Naked option -- writer does not have or
has not made provision to limit the extent
of risk.
Gains and Losses on Options and Futures
Contracts, If Options Are Exercised at Expiration
Listed Option Quotations