FM423

Asset Markets
Lecture 13: Forwards and Futures –
Introduction
 0. Overview Page 1

Overview

(1) Introduction to Derivatives

(2) Introduction to Forwards and Futures

(3) Uses of Forwards and Futures

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

 1. Introduction to Derivatives Page 2

1. Introduction to Derivatives

• A derivative security is a financial security (asset, claim) whose value is derived from other (more
primitive) variables such as

– stock prices

– exchange rates

– interest rates

– commodity prices

• This course will examine two basic classes of derivative securities:

– Forwards and futures

– Options

• The principles behind the valuation techniques are general

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Why do derivatives matter?

• Derivatives make risk transfer (and speculation, and investment) cheaper

(1) Lower transactions costs

(2) Minimize taxes

(3) Avoid regulatory constraints

(4) Simplify credit problems

(5) Lump many transactions together

• In other words, derivatives help work around market imperfections

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Examples

(1) Foreign tax-exempt institution wants to invest in U.K. stocks

• Problem: reclaiming withholding tax on dividends involves legal costs, delays, and may not even be
allowed

• Solution: find local tax-exempt institution who will swap pre-tax cash-flows from equities for fixed
payment

(2) CEO has massive exposure to his company through restricted stock options

• Problem: legally barred from selling his own stock

• Solution: sell stock index future and buy other component stocks

(3) Portfolio manager wants to follow policy of lower risk in falling markets

• Problem: constant rebalancing is expensive in time and commissions

• Solution: buy long-term put option on portfolio

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Derivatives Universe

• Derivatives can be classified based on

– Underlying risk type: interest rate, foreign exchange, credit, equity, commodity...

– Payoff type: forwards and futures, options, swaps...

– Market place: over-the-counter (OTC) vs. organized exchanges

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492 of the world’s 500 largest companies manage their risks using derivatives

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Valuation of New Products

• Usually, markets exist and then we develop tools to analyze them

• For the derivative market, a bit of a chicken-and-egg problem:

– Products and valuation tools are inseparably linked

• Markets (of this size) for derivative products would not exist in the absence of reliable models for
pricing and hedging them

• Understanding valuation models is of fundamental importance

– Securities often intricate and specialized in their application

– In contrast, valuation tools are very general

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2. Introduction to Forwards and Futures

• A forward contract is an obligation to buy/sell the underlying asset at a

– specified price (forward price)

– specified time (maturity or expiration date).

The buyer and seller of a forward contract are involved in a forward transaction

– Price is agreed today

– Transaction occurs at maturity

• A futures contract is the same as a forward contract, except that:

– It is typically standardized and traded on an exchange

– Gains and losses are settled daily

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Examples

Obligation to:

• buy 1000 barrels of crude oil at $57/barrel on September 15, 2008.

• sell 15000 lbs of orange juice at 83 cents/lb on November 15, 2008

• buy the S&P500 at $1200 on December 20, 2008
– one unit of the contract traded on the CME is worth $250 times the S&P500 index

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Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Notation

F = Forward price

T = Maturity (expiration date)

S = Current price of the underlying asset

ST = Price of the underlying asset at maturity

rT = T -year spot rate (annualized rate, compounded annually)

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Value at Maturity

Suppose that you take a long position in a forward contract.

• You agree to buy the underlying at the price F at maturity

• The value of the contract at maturity is ST − F
• The payoff diagram plots the value at maturity as a function of ST
Long position in forward contract

Payoff

ST − F

0 ST
F

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Value at Maturity (cont’d)

Suppose that you take a short position in a forward contract

• You agree to sell the underlying at the price F at maturity

• The value of the contract at maturity is F − ST
• Payoff diagram:
Short position in forward contract

Payoff

0 ST
F

F − ST

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Settlement

• Settlement of forward contracts occurs at maturity

• By convention, at inception of the contract, the delivery or forward price is chosen so that the contract
has zero value

• The delivery price remains fixed through the life of the contract

• Thus the value of the contract can be positive or negative

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Settlement of Futures Contracts

• Settlement of futures contracts occurs daily

• Buyers and sellers deal through the exchange, not directly

• Thus default risk is borne by the exchange, not by individual parties

• Default risk is controlled by margin accounts and daily marking-to-market

• Futures contracts are “marked to market”

• Gains and losses settled at the end of each trading day

• Let Ft be the futures price at time t

• Payoff at date t is Ft − Ft−1 (payoff at maturity is ST − FT −1 )

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Settlement of Futures Contracts (Cont’d)

Operation of margins: example

• Long position in two gold futures contracts

• Contract size: 100 ounces

• Initial futures price: $400 per ounce

• Initial margin: $2000 per contract

• Maintenance margin: $1500 per contract

• For the purpose of illustration, suppose the interest rate is zero

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Futures Daily gain Cumulative Margin a/c Margin

Day price (loss) gain (loss) balance call

400.00 4000

June 5 397.00 (600) (600) 3,400

June 6 396.10 (180) (780) 3,220

June 9 398.20 420 (360) 3,640

June 10 397.10 (220) (580) 3,420

June 11 396.70 (80) (660) 3,340

June 12 395.40 (260) (920) 3,080

June 13 393.30 (420) (1,340) 2,660 1,340

June 16 393.60 60 (1,280) 4,060

June 17 391.80 (360) (1,640) 3,700

June 18 392.70 180 (1,460) 3,880

June 19 387.00 (1,140) (2,600) 2,740 1,260

June 20 387.00 0 (2,600) 4,000

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Standardization of Contract Terms

• Contract terms must be standardized, since buyer and seller do not interact directly

• Perhaps the most important task performed by the exchange

• Essential in promoting liquidity and improving quality of hedge

• Involves three components:

(1) Quantity (size of contract)

(2) Quality (standard deliverable good)

(3) Delivery options (other deliverable grades + price adjustment mechanism)

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Unilateral Reversal of Positions

Unlike forward contracts, holders of futures contracts can unilaterally reverse (or “close out”) their positions

• Reversal involves taking the opposite position to the original

• For example, suppose an investor has a long position in 10 COMEX gold contracts for delivery in
December

• To reverse this position, the investor has to take a short position in 10 gold contracts for delivery in
December

• But, reversal may not be costless (“market risk”)

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Reversal of Positions (Cont’d)

• For example, suppose the long position in the 10 COMEX gold contracts was taken at the futures price
of $280 per oz

• Suppose that the price at the time of close-out is $275 per oz

• Then, effectively the investor has agreed to buy at $280 per oz and sell at $275 per oz for a net loss of
10 × 100 × 5 = $5000 on the position
Why is reversal important?

• Standardization of delivery dates creates “delivery basis risk”: delivery dates on the contract may not
match the market commitment dates of the hedger

• Allowing for reversal allows elimination of part of delivery basis risk

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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3. Uses of Forwards and Futures

• Hedging
– An investor has a long position in the S&P500. To reduce the risk of the position, the investor can
sell S&P500 futures

– A farmer expects a wheat crop in six months. To lock in a price, the farmer can sell wheat futures

• Speculation
– Buy S&P500 futures, speculating that the S&P500 will go up

• Funding
– Repo contract

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Hedging with Forwards and Futures

Suppose that on October 15, 1997, you have a long position in the S&P500, worth $50 million. You are
becoming increasingly concerned about the market, and want to hedge your risk. What should you do?

• Sell all your stocks and buy T-bills

– Involves transaction costs and capital gains taxes

• Sell S&P500 futures

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Hedging: Payoff Diagrams

Buy Stock Sell Futures Portfolio

Payoff ST Payoff Payoff

0 ST 0 ST 0 ST
F

F − ST

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Constructing a Hedged Portfolio

• How many S&P500 futures contracts should you sell?

• Consider the December futures

• Relevant information:
– S&P500 futures contract size: 500 units of the index

– S&P500 index value on October 15 is 965.72

– S&P500 futures price on October 15 is 973.50

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Constructing a Hedged Portfolio (cont’d)

• On October 15 you own

50m 50m
= = 51775
S 965.72
shares of the S&P500

• Suppose that you sell y futures contracts. Value of your portfolio at maturity of futures contract is

51775ST + y(F − ST )500

= 51775ST + y(973.5 − ST )500

= y486750 + ST (51775 − y500) .

• Value of your portfolio should be independent of ST . Therefore, you should choose y such that

51775 − y500 = 0 ⇒ y = 103.55.

• Value of your portfolio at maturity is

y486750 = 50.4m

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Tracking the Portfolio’s Performance

• Suppose that on a given day t, subsequent to October 15

– S&P500 index value is St

– S&P500 futures price is Ft

Value of

– stock portfolio is 51775St

– futures position is 103.55(973.50 − Ft )500

(Assuming for simplicity that r = 0)
– hedged portfolio is

51775St + 103.55(973.50 − Ft )500

= 51775(St − Ft ) + 50.4m
At maturity, ST=FT, portfolio value = 50.4m

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Tracking the Portfolio’s Performance (cont’d)

Index Futures Stock Futures Hedged
Date Value Price Portfolio ($m) Position ($m) Portfolio ($m)

October 15 965.72 973.50 50.000 0.000 50.000

October 16 955.25 959.80 49.458 0.709 50.167

October 17 944.18 948.65 48.885 1.287 50.172

October 20 955.60 962.25 49.476 0.582 50.059

October 21 972.28 979.45 50.334 -0.308 50.032

October 22 968.48 974.30 50.143 -0.041 50.102

October 23 950.68 955.50 49.221 0.932 50.153

October 24 941.61 944.00 48.752 1.527 50.279

October 28 921.85 924.50 47.729 2.537 50.266

October 29 919.16 924.25 47.590 2.550 50.139

October 31 914.62 924.00 47.354 2.563 49.917

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Raw vs. Hedged Portfolio Value

50.5

50

49.5

Raw
Hedged
49

48.5

48

47.5

47
13-Oct-97 15-Oct-97 17-Oct-97 19-Oct-97 21-Oct-97 23-Oct-97 25-Oct-97 27-Oct-97 29-Oct-97 31-Oct-97 2-Nov-97

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Hedging Summary

• It is possible to hedge a portfolio using futures contracts

• Movements in the value of the

– stock portfolio

– futures position

cancel each other (approximately)

• As a result, value of the hedged portfolio stays constant (approximately)

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Evaluating Hedging Strategies

• A hedging strategy does not always produce a gain

– (Financial Times, 17 November 2009). Higher fuel costs weighed on full-year profits at Easyjet after
the low-cost airline hedged a lot of its fuel needs at high prices. Although the price of oil has fallen
from a high of $147.27 in July 2008 to about $80 a barrel this month, Easyjet’s locked-in hedges
caused an “adverse variance to market rates” of about $330m for the full year. The loss from the
fuel hedge contrasts with Easyjet’s rival Ryanair, which two weeks ago reported a near quadrupling
of first half pre-tax profits to e419m, after benefiting from the lower fuel price.

• The purpose of a hedging strategy is to reduce risk

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Speculation with Forwards and Futures

• Like spot transactions, forward positions can be used to express a view on markets

• The main difference is that forward positions involve leverage

• For example, consider a stock trading at $100 that has a forward price for delivery in 1 year’s time of
$100:

Spot Price in 1 year’s time 90 110

Return on cash market investment -10% +10%

Return on long forward -100% +100%

(assuming 10% collateral = $10)

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Futures Overlay

• Suppose you invested in S&P 500 and wish to temporally invest in Treasury bonds

• Strategy:
– Sell S&P 500 futures

– Buy T-bond futures

• Portable Alpha: futures overlays can help create a position where you earn beta in one asset category
and alpha in another

– You believe there are no alpha opportunities in S&P500 stocks but you have identified a
market-neutral hedge fund that you believe will generate positive alpha

- Invest in market-neutral hedge-fund

- Buy S&P 500 futures

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Funding: Repo Contract

• A repurchase agreement (repo) entails selling a security with an agreement to buy it back at a fixed
price – effectively, a sale coupled with a long forward contract

– The counterparty holds the security as a collateral

– The borrower typically also has to post collateral in excess of the notional amount of the loan (the
“haircut” = 1 − F/C , C - collateral value, F - loan value)

– The borrower pays the cash lender interest in the form of the repo rate

– Repo is exempt from automatic stay in bankruptcy

• The reverse transaction is called a reverse repurchase agreement or reverse repo

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Repo: Example

• Suppose you enter into a 1-week repo in which you receive $98m loan and put T-bills (worth $100m) as
a collateral. You agree to repurchase it in one week for $98.098m

98
haircut =1− = 2%
100

98.098
repo 1-week rate = − 1 = 0.1%
98

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Convergence Trade

• Newly issued on-the-run 30-year Treasury bonds are typically sold at a lower yield than an almost
1
identical off-the-run 29 2 -year Treasury bonds

• Bet that the yields on of the 30-year and 29 21 -year bonds would converge

• Arbitrage trade:

– Buy off-the-run bond and repo it

– Borrow on-the-run bond by entering into a reverse repo and sell it

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LTCM Convergence Trade

• (Lowenstein, R., 2000, “When Genius Failed: The Rise and Fall of Long-Term Capital Management”).
“No sooner did Long-Term buy the off-the-run bonds than it loaned them to some other Wall Street
firm, which then wired cash to Long-Term as collateral. Then Long-Term turned around and used this
cash as collateral on the bonds it borrowed. The collateral it paid equaled the collateral it collected. In
other words, Long-Term pulled off the entire $2 billion trade without using a dime of its own cash.”

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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Shadow Banking System

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis

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4. Conclusions

Derivatives are assets whose value is derived from an underlying asset.

Key features of forwards / futures

• Obligation to buy/sell the underlying asset at a prespecified price

• Value of the contract is set to zero at inception

• Futures contracts are standardized forward contracts with gains / losses settled daily

• Facilitate hedging, speculation, and funding

Lecture 13: Forwards and Futures – Introduction Copyright c Zachariadis