Class #5: Futures, page 1

Class Currency Futures Ch 8

Introduction.........................................................................................1
Comparison between Futures and Forward contracts:........................2
Example of ail! Cas" Flows...............................................................2
#in$ between currenc! futures and forward mar$ets..........................2
%argins and %aintenance #e&el..........................................................'
Example of margin and maintenance le&el...............................'
(edging wit" futures: )pplication.......................................................'
*asis...........................................................................................'
e+nition..........................................................................'
*asis ,is$..........................................................................5
Example of "edging wit" futures and basis ris$...............5
Example of "edging wit" futures - cost of borrowing......5
INTRODUCTION
Currenc! futures are anot"er t!pe of +nancial instrument, one t"at is
di.erent from fwd contracts and options. Currenc! futures are , "owe&er,
&er! similar to commodit! futures.
Currenc! futures are usuall! traded in a formal mar$et place, li$e t"e
International %onetar! %ar$et /I%%0 of t"e C"icago %ercantile Exc"ange or
t"e #ondon International Financial Futures Exc"ange /#IFFE0.
1nli$e fwd contracts w"ic" are written for amounts and dates to suit t"e
con&enience of eac" customer, future contracts are relati&el! "omogeneous,
t"at is, t"e contracts are onl! for a limited number of dates /four dates, t"e
2rd 3ednesda! of %arc", 4une, 5eptember and ecember0 and for +xed
amounts. (ere are some examples:
Contract Face )mount
6 /I%%, #IFFE0 72,588
% / 0 125,888
Can9 /1%%0 188,888
)not"er ma:or di.erence is t"at w"ile a fwd contract re;uires cas" <ows
onl! on t"e maturit! date, future contracts /ma!0 re;uire dail! cas" <ows to
maintain !our margin at t"e re;uired le&el.
="us, it s"ould be ob&ious t"at futures are less fexible t"an fwd contracts.
="us, t"e! are, in most cases, less useful for "edging fx ris$ and more useful
for speculating.
Class #5: Futures, page 2
COMPARISON BETWEEN FUTURES AND FORWARD CONTRACTS:
Futures Forward
> ail! cas" <ow /see example0 5ingle CF at maturit!
/="erefore time pattern of CFs and roi become important0
> Futures are traded onl! in standardi?ed amts@ Fwds an!
> Futures "a&e +xed maturit! /onl! '0 dates@ Fwds donAt
> Futures are traded in central m$ts@ Fwds in B=C mar$ets
> Futures "a&e dail! price limits@ Fwds do not
EXAMPLE OF DAILY CASH FLOWS
5uppose t"at !ou go long a 625,888 futures contract at C
8
D 91.'5E6 and
t"e settlement prices for t"e next two da!s are : C
1
D 91.''78E6 and C
2
D
91.'518E6.
="en t"e cas" <ows are t"e following:
a! 1 : F/C
1
G C
8
0 H625,888 D /91.''78E6 G 91.'5E60D G 9188
a! 2 : F/C
2
G C
1
0 H625,888 D /91.'51E6 G 91.1.''7E60D F9125
3ould !ou prefer t"is pattern of cas" <ows or would !ou prefer to recei&e F
9125 on t"e +rst da! and G9188 on t"e second da!I Crefer to recei&e 9125
on da! 1 and pa! out 9188 on da! 2 G because of t"e time &alue of mone!.
#t us stud! t"is in greater detail.
LINK BETWEEN CURRENCY FUTURES AND FORWARD MARKETS
It s"ould be clear to all of !ou t"at since t"e fwd and futures contracts are
similar in so man! wa!s t"ere s"ould be a relation between t"eir prices. If
t"e price of t"e forward &aried a lot from t"e price of t"e futures t"ere would
be an arbitrage opportunit!.
Can !ou guess w"at t"e relations"ip betwen t"e forward and t"e futures
price is if t"e interest rate is positi&el! related to t"e futures priceI
)nswer: J K F, t"at is t"e futures is more costl! t"an t"e forward. ="e reson
for t"is is, t"at since t"e futures price is positi&el! correlated wit" t"e
interest rate, gains on t"e /long0 futures position are made w"en t"e interest
rate is "ig", and losses are made w"en t"e interest rate is low, and "ence
are c"eaper to +nance. Jot itI
=o understand t"is let us loo$ at a simple example, wit" onl! t"ree dates: t D
8, t D 1, and tD 2, t"e maturit! date.
Class #5: Futures, page 2
5uppose !ou bu! t"e 6 fwd toda!, for t"e maturit! of date of t D 2. ="en,
t"e gainEloss on t"e fwd contract will be t"e di.erence between t"e fwd
price paid and t"e spot rate at t D 2.
For a futures contract purc"ased for t"e same maturit!, t"e gainEloss will
also depend on w"at "appens at t D 1. ="ere are two possibilities:
Eit"er, at t D 1, t"e 9 futures price of t"e 6 is abo&e t"e original &alue and
t"e bu!er of t"e futures contract will poc$et a gain at t"is time, w"ic" "e
can in&est for t"e maturit! of t D 1 to t D 2, t"ereb! generating an extra
gain o&er and abo&e t"e di.erence between t"e original futures price and
t"e spot price at t D 2@
Br, t"e futures price is below its original price, and t"e loss "as to be made
good, b! borrowing at t"e interest rate pre&ailing at t D 1, and t"us t"ere is
a a loss at maturit! o&er and abo&e t"e di.erence between t"e original
futures price and t"e spot price at t D 2@
If t"e interim interest rate at tD1 were certain /or independent of t"e futures
price0 t"en t"e in&estmentE+nancing of t"e interim cas" <ow would be done
at t"e same interest rate /disregarding bidGas$ spreads0, and t"e prospect of
t"e t"e extra gain would actuariall! cancel out t"e prospect of t"e extra
loss. *ut if t"ere is a probabilistic tendenc! for t"e interim gains to be
in&ested at an interest rate "ig"er t"an t"e one at w"ic" t"e interim losses
are +nanced /positi&e correlation0, it is clear t"at bu!ing t"e futures o.ers
an ad&antage o&er bu!ing t"e forward contract. (ence, for t"e case of
positi&e correlation, t"e futures price will be abo&e t"e forward price.
Note, "owe&er, t"at t"e prices of t"e two need not be identical, for w"ile
forward contract re;uires onl! a single cas" <ow at maturit!, t"e futures
contract ma! re;uire dail! cas" <ows and "ence we must ta$e into account
ris$ considerations arising from uncertaint! about t"e roi pre&ailing during
t"e life of a futures contract.
If t"e roi was nonGstoc"astic t"en t"e futures price would be exactl! e;ual
t"e forward price. (owe&er, e&en w"en t"e roi is stoc"astic, t"e price
di.erence between t"e forward and t"e future is &er! small and t"erefore
we will not go into t"e gor! details of t"is /till C 'LM0.
MARGINS AND MAINTENANCE LEVEL
3"en one opens a futures contract, one is re;uired pa! a fee to t"e bro$er
and to post a margin. ="e margin is posted to ensure t"at deals are
"onored. 3"en t"e e;uit! position falls, t"en t"is margin must be
supplemented b! additional cas" to bring it up to t"e maintenance level.
Class #5: Futures, page '
Example of margin and maintenance level
5uppose t"e margin on a futures contract on t"e 6 is 92888 and t"e
maintenance le&el is 92588. ="en as long as t"e t"e decline in t"e futures
position is less t"an 9588 !ou need not ta$e an! action, but once t"e futures
position declines b! more t"an 9588 !ou need to post additional margin
e;ual to t"e full decline in &alue in t"e futures position.
HEDGING WITH FUTURES: APPLICATION
5uppose !ou "a&e exported goods to t"e 1N and expect to recei&e 6 in t"e
future. ="us, !ou "a&e a long position in t"e 6. =o "edge t"is, !ou wis" to
ta$e suc" a position in t"e futures t"at w"en !our original position loses
mone!, t"e position in t"e futures s"ould gain mone!.
="e w"ole point of t"e stor! t"at I am going to tell !ou, and t"e example
t"at we will do, is t"at to be "edged CE,FEC=#O t"e &alue of !our position in
futures s"ould c"ange exactl! oneGforGone /and in t"e opposite direction0 for
a c"ange in t"e &alue of t"e underl!ing original position. ="at is, t"e futures
price s"ould mo&e oneGforGone wit" t"e price of t"e underl!ing position. And
this may not happen all the time.
#et,
5 D c"ange in t"e spot position
J D c"ange in t"e futures position
="en since we are long in t"e spot position and s"ort t"e futures, t"e total
c"ange in t"e position, = is:
= D 5 G J /negati&e sign on F because we are s"ort Fut
Pow, as long as JD5 exactl!, = D 8 and t"e "edge is perfect. (owe&er, if
J is not e;ual to 5 t"en !ou are not "edged perfectl!, and !ou ma! end
up ma$ing or losing some mone!.
Basis
Defnition
="e basis is t"e di.erence between t"e spot price and t"e futures price.
*
t
D J
t
G 5
t
If t"e mo&ement in t"e spot price and t"e futures price is oneGforGone, t"en
t"e basis is constant.
Class #5: Futures, page 5
asis !is"
3"en !ou "edge wit" futures t"ere is alwa!s a ris$ t"at t"e mo&ement in
t"e spot and t"e futures price will not be oneGforGone. ="is is called t"e
basis ris".
(edging wit" futures will ne&er eliminate )## t"e ris$. ="ere will alwa!s be
some basis ris$. ="e important point to remember is t"at, normall!, t"e
basis ris$ is muc" smaller t"an t"e ris$ of an open position, t"at is if !ou did
not "edge at all.
#et us now loo$ at a numerical example to ma$e sense of t"is all.
Example of hedging with futures and basis risk
5uppose !our original position is long 625,888 and !ou wis" to "edge t"is b!
going 5(B,= one futures contract.
5
t
D 91.15'5E6@ J
t
D 91.1728E6
5
tF1
D 91.1258E6@ J
tF1
D 91.1'78E6
Q1. Calculate t"e basis toda! and t"e basis after a mont"I
Q2. Calculate t"e net gainEloss on t"e "edged positionI
Q2. Compare t"e net gainEloss of t"e "edged position to t"at of t"e
un"edged positionI
A#. *asis
t
D 5
t
G Fut
t
D G 8.88L5
*asis
tF1
D 5
tF1
G Fut
tF1
D G 8.8118
A$. 5pot position: F9E6/1.1258 G 1.15'50H625,888D G9'ML.58
Fut position: /G09E6/1.1'7 G 1.1720H625,888D F9'88.88
PE= #oss D G 9ML.58
Alternate %ay of calculating&
C"ange in basis D /G8.81180 G /G8.88L50H625,888 D G 9ML.58
A'. ="e loss on t"e un"edged position is G'ML.58
="e loss on t"e "edged position is GML.58
Bb&iousl!, "edging was a good idea.
Example of hedging with futures & cost of borrowing
Bn %arc" 21, a Canadian +rm borrows % 2 m for 2 mont"s at 7R p.a. in
Jerman!. 5ince t"e +rm needs t"e mone! in Canada, it "edges against
exc"ange ris$. Bn %arc" 21, t"e spot rate 9 .58E%, t"e S8Gda! forward rate
is 9 .51E% and t"e % 4une futures is 9 .51. )t t"e end of 4une, t"e spot
rate is 9 .'M . )ssume t"e +rm "edges onl! t"e principal and not t"e interest
pa!ments.
/a0 3"at is t"e e.ecti&e cost of borrowing /in percent p. a.0 if t"e +rm
"edges in t"e forward mar$etI
Class #5: Futures, page 7
/b0 3"at is t"e e.ecti&e cost of borrowing /in percent p. a.0 if t"e +rm
"edges in t"e futures mar$etI )ssume t"at t"e margin is 92888 per contract
/remember, eac" contract is for % 125,8880, t"at t"e +rm li;uidates t"e
futures contracts at a price of 9 .'M at t"e end of 4une, and t"at t"e +rm
borrows 9 at 1'R in order to pa! for t"e margins.
Ans. =o calculate t"e e.ecti&e rate of interest we need to +nd out "ow muc"
we are recei&ing toda!, and "ow muc" we are pa!ing at t"e end of 2
mont"s@ and we need to loo$ at t"ese amounts in Can9 terms.
="e amount t"at is recei&ed toda! is % 2m /98.58E%0 D 91m
First, let us calculate t"e interest on t"is loan:
% interest on t"e loan is % 2m /1.870
1E'
D % 8.82S2'Mm
5ince we do not "edge t"is, t"e 9 &alue of t"is /at 5
tF1
0 is
D % 8.82S2'M /% 8.'ME90 D 98.81'8MLm
/a0 Pow let us loo$ at t"e for%ard hedge calculations:
/10 *u! % 2m fwd, T 98.51E% to "edge t"e principal pa!ment D G 91.82m
/20 )dd t"e interest pa!ment amount D G 98.81'8MLm
/20 =otal amount to be paid bac$ is /10 F/20 D G 91.82'8MLm
="us, t"e e.ecti&e rate of interest is D 1.82'8ML
'
G 1 D (.#)')*+ pa
/b0="e calculations for t"e case w"ere we hedge %ith futures :
/10 ="e interest pa!ment amount D G 98.81'8MLm
/20 )dd t"e interest pa!ment on t"e margins D G 92888 /170 /1.1'
1E'
G 10
D G 98.8815SMm
/20 C"ange in &alue of underl!ing position D G %2m /9E% 8.'M G 8.580
D F 98.'m
/'0 C"ange in &alue of futures position D F %2m /9E% 8.'M G 8.510
D G 98.7m
/50 =otal amount to be paid bac$ is /10 F/20 F /20 F/'0 G 91m D G 91.8255ML
="us, t"e e.ecti&e rate of interest is D 1.8255ML
'
G 1 D (.#,(,+ pa
="us, it was c"eaper to "edge wit" forwards, ex post.