Financial Futures

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Financial Futures
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Forward Contract An agreement to buy or sell a
specified amount of a specified commodity at a
specified price on a future day. What cash flows
take place? When? Credit Risk? Private,
custom-tailored agreement Standardized contract
Futures contract Allows daily trading
liquidity Requires margin "Marked to
market" daily Exchange acts as
intermediary Credit risk?
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Valuing a Forward Contract No storage
costs gold Price set so that initial value of
contract is zero. How is this possible? Gold, one
year hence, current price 400, interest rate
10 Suppose forward (futures) price
450 Strategy "Buy the Basis" Now Borr
ow funds 400 Buy gold
-400 Sell gold futures contract
0 Net cash flow 0 One year
later Deliver gold at contract price
450 Pay off loan -440
Net cash flow
10 Risk?
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Suppose Forward (futures) price 420 Strategy
"Sell the Basis" Now Short gold in cash
market 400 Invest funds in 10 loan
-400 Buy gold futures contract
0 Net cash flow 0 One year
later Buy gold at contracted price -
420 Deliver on short position Receive payment
on loan 440 Net cash flow
20 Risk?
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Equilibrium (No Arbitrage) Price? 440 Cost of
carry formula F S (1r)
400(1.10) 440
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Stock Index Futures Suppose stocks pay 3
dividend, current level 500 interest rate
10 If forward price at 550 Now Borrow
funds 500 Buy stocks -500 Sell index
futures contract 0 Net cash flow
0 One period hence Receive dividends
15 Deliver stock at contract price
550 Pay off loan -550 Net
cash flow 15
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If forward price at 525 Now Short stocks in
cash market 500 Invest funds at
10 -500 Buy index futures contract
0 Net cash flow 0 One year
later Pay dividends on short position
-15 Buy stocks at contracted price
-525 Deliver on short Receive payment on loan
550 Net cash flow 10 Equilibrium Price?
Forward price Spot (1 cost of carry) 500
(1 .10 - .03) 535
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Stock Index Futures Risk Program
Trading Transaction costs Short sale Cash
settlement Borrowing/lending rates Marking to
market Question Is the prevailing futures
(forward) price an estimate of the expected index
level in the future?
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"Interest Rate" Futures Really bond
futures Suppose 1000 Treasury bond with 8
coupon, currently trading at 92, 6 short term
rate If futures contract selling at
910 Now Borrow funds 920 Buy bond
-920 Sell Treasury futures
0 Net cash flow
0 One
year later Receive coupon
80 Deliver bond at contract
price
910 Pay off loan -920 Pay
off loan interest
_55 Net cash flow

15 Which bond to buy? "Cheapest to
deliver" Which bonds can be used?
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Chicago Board of Trade Long-Term U.S. Treasury
Bonds delivery months The current month and any
subsequent months are determined by the Financial
Instruments Committee or the Board of Directors,
including March, June, September, and
December trading unit U.S. Treasury bonds
having a face value at maturity of 100,000 or
multiples thereof minimum fluctuation Minimum
price fluctuations shall be in multiples of one
thirty-second (1/32) point per 100 points (31.25
per contract) par shall be on the basis of 100
points daily price movement limits 64/32 above
or below the previous day's settlement
price position limits None positions of 100
contracts require reporting to the CFTC
positions of 50 contracts require reporting to
the exchange grades deliverable Long-term U.S.
Treasury bonds which, if callable, are not
callable for at least 15 years or, if not
callable, have a maturity of at least 15
years Delivery By book-entry in accordance
with Department of the Treasury Circular
300 trading hours 800 a.m. to 200 p.m.
Central Time
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MidAmerica Commodity Exchange Treasury
Bonds delivery months March, June, September,
and December trading unit U.S. Treasury bonds
with a face value at maturity of 50,000 minimum
fluctuation 1/32 of a percentage point (15.62
per contract) daily price movement limits
64/32 of a percentage point (1,000 per
contract) no limit in the spot month position
limits 100 million face value net long or
short grades deliverable U.S. Treasury bonds
maturing at least 15 years from the date of
delivery if not callable if callable, not
callable for at least 15 years from date of
delivery Delivery Federal Reserve book-entry
wire transfer system invoice is adjusted for
coupon rates and term to maturity or
call trading hours 800 a.m. to 215 p.m.
Central Time last day of trading, 800 a.m. to
1215 p.m.
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If futures contract selling at 880 Now Short
bond in cash market 920 Invest funds at 6
-920 Buy bond futures 0 Net Cash Flow
0 One year later Receive
loan principal 920 Receive loan
interest 55 Pay coupon on shorted bond
-80 Buy bond at contracted price
-880 Deliver on bond ___
_ Net Cash Flow
15 Equilibrium Price? Who will set the prices?
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What about F/X Futures? If F/X futures are set
by interest covered arbitrage, is the futures
price the price that is expected to prevail? If
the Fisher equation is satisfied, i.e. real
interest rates are equal across the
orders. What about risk? If futures prices
are risky, shouldn't an investor be compensated
for bearing that risk? i.e. shouldn't futures
sell below the expected price so the price
increase will give the buyer a premium for risk
incurred?