Title: Investment Analysis and Portfolio Management Frank K' Reilly
1Investment Analysis and Portfolio
ManagementFrank K. Reilly Keith C. Brown
CHAPTER 22
BADM 744 Portfolio Management and Security
AnalysisAli Nejadmalayeri
2Hedging With Forwards and Futures
- Create a position that will offset the price risk
of another holding - holding a short forward position against the long
position in the commodity is a short hedge - a long hedge supplements a short commodity
holding with a long forward position
3Hedging With Forwards and Futures
- Relationship between spot and forward price
movements - basis is spot price minus the forward price for a
contract maturing at date T - BtT St - Ft,T
- forward price converges to the spot price as the
contract expires - hedging exposure is correlation between future
changes in the spot and forward contract prices
and can be perfectly correlated with customized
contracts
4Hedging With Forwards and Futures
- Calculating the Optimal Hedge Ratio
- net profit from the position
-
beta of portfolio with respect to the
underlying futures index
5Financial Forwards and FuturesApplications and
Strategies
- Interest rate futures and forward
- Long-term interest rates
- T-note T-bond mechanics
- Duration hedging
- Funding commitment hedging
- T-note/T-bond spread (NOB)
- Short-term interest rate
- Euro-dollar T-bill mechanics
- Altering duration
- Synthetic fix rate funding
- T-bill/Eurodollar spread (TED)
- Stock futures
6Long-term Bond Futures
- Treasury bond and note contract mechanics
- CBT 100,000 face value
- T-bond gt15 year maturity
- T-note 10 year - bond with 6.5 to 10 year
maturity - T-note 5 year - bond with 4.25 - 5.25 years
- Delivery any day during month of delivery
- Last trading day 7 days prior to the end of the
month - Quoted in 32nds
- Yield quoted is for reference
- Treasury bonds pay semiannual interest
- Conversion factors for differences in deliverable
bonds
7Long-term Bond Futures
- A duration based approach to hedging
8Long-term Bond Futures
- A T-Bond/T-Note (NOB) Futures Spread
- expecting a change in the shape of the yield
curve - unsure which way rates will change
- long one point on curve and short another point
9Short-Term Interest Rate Futures
- Eurodollar and Treasury bill contract mechanics
- Chicago Mercantile Exchange (CME or Merc)
- International Monetary Market (IMM)
- LIFFE
- LIBOR
- Quote is 100 YIELD
10Short-Term Interest Rate Futures
- Altering bond duration with futures contracts
- You hold 6-month T-bill but fear rates drop in 3
months - Sell your holding and by something with shorter
maturity - Use 3-month T-bill futures
- Short the futures while holding the T-bills
11Short-Term Interest Rate Futures
- Creating a synthetic fixed-rate funding with a
Eurodollar strip - Assume the following LIBOR curve
- 90-day 5.00
- 180-day 5.10
- 270-day 5.20
- 360-day 5.30
12Short-Term Interest Rate Futures
- Creating a TED spread
- When the spread expected to rise
- Long T-bill futures
- Short Eurodollar futures
- When the spread expected to decline
- Short the T-bill futures
- Long the Eurodollar futures
13Stock Index Futures
- Stock index arbitrage (i.e., Program Trading)
- When,
- then do
- 1) short futures 2) borrow to long stocks
- When,
- then do
- 1) short stocks and lend 2) long futures
14Stock Index Futures
- Hedging an individual stock with an index
isolates the unsystematic portion of that
securitys risk
15FYI
- Following section contains material that you
find useful as an overview Some helpful
sites www.futuresmag.com - www.futuresbasics.com
- www.futuresweb.com
- www.tfc-charts.w2d
16An Overview of Forward and Futures Trading
- Forward contracts are negotiated directly between
two parties in the OTC markets. - Individually designed to meet specific needs
- Subject to default risk
- Futures contracts are bought through brokers on
an exchange - No direct interaction between the two parties
- Exchange clearinghouse oversees delivery and
settles daily gains and losses - Customers post initial margin account
17Forward and Futures ContractsBasic Valuation
Concepts
- Forward and futures contracts are not securities
but, rather, trade agreements that enable both
buyers and sellers of an underlying commodity or
security to lock in the eventual price of their
transaction
18Valuing Forwards and Futures
- Valuing futures
- contracts are marked to market daily
- the possibility that forward and futures
prices for the same commodity at the same point
in time might be different
19The Relationship Between Spot and Forward Prices
- If you buy a commodity now for cash and store it
until you deliver it, the price you want under a
forward contract would have to cover - the cost of buying it now
- the cost of storing it until the contract matures
- the cost of financing the initial purchase
- These are the cost of carry necessary to move the
asset to the future delivery date
20The Relationship Between Spot and Forward Prices
- Contango - high storage costs and no dividends
- Premium for owning the commodity
- convenience yield
- results from small supply at date 0 relative to
what is expected at date T (after the crop
harvest) - Backwardated market - future is less than spot