Futures contract specifies
Deliver of receive a specified amount
On a specific date
for a specified price
Purpose of trading financial futures
to speculate on prices
to hedge existing position
Steps involved in trading futures
OTC trading
Electronic trading
trading through a brokerage firm
type of orders
how orders are executed
Impact of the opportunity cost of financial futures
There are no dividends in owning the futures
Owning the underlying asset may result in a payment such as the SP $500 dividends from owning the stock
Owning the futures contract allows a small down payment and may generate interest income from investing th
Explaining price movements of bonds futures contracts
Prices driven by economic forces
Treasury Bond Price Movements
Futures move with bond prices
when indicators signal an increase in economic growth, interest rates increase. Bond prices decline and futures prices fall
Impact of leverage
since initial payments are very small relative to the total contract market value, return is magnified substantially
Closing out the future position
because futures are most often used as a hedging or speculating strategy actual delivery or receiving never takes place
closing done to offset to the original position
owning both a contract to receive as well as to deliver the obligations net out
Interest Rate (Bond) Futures - short bond
If you think interest rates will rise in the future
Interest Rate (Bond) Futures - long bond
If you think interest rates will decline in the future
Stock Index Futures Long
If you think stock prices are going to rise in the future
Stock Index Futures Short
If you think stock prices are going to decline in the future
Interest Rate (bond) futures to create a short hedge
Short bond futures protect your bond portfolio from losses due to rising interest rates. As interest rates rise your Bond portfolio declines, but your losses in the Bond portfolio are offset by the gain in your bond futures position
Interest Rate (bond) futures to create a long hedge
If you believe the interest rates on bonds are going to go down before you make your investment
Stock index futures (short hedge)
With stock futures you offset the expected declines in your stock from a declining stock market
Arbitrage with stock futures
Securities firms act as arbitrageurs by capitalizing on discrepancies between prices of stock index futures and the underlying stock.
Single stock futures
A contract to buy or sell a single stock (usually 100 shares)
Settlement dates are quarterly
Offers potentially high returns (high risk)
Closing out involves taking opposite position anytime before settlement date
Risk of trading futures contracts - Market Risk
Fluctuations in the value of the instrument as a result of market conditions
Risk of trading futures contracts - Basis Risk
the risk that the position being hedged by the futures contract is not affected the same way as the instrument underlying the futures contract
Risk of trading futures contracts - Liquidity Risk
Refers to the potential price distortions due to the lack of liquidity (availability of willing buyers or sellers when you wish to liquidate the contract)
Risk of trading futures contracts - Credit Risk
the risk that a loss will occur because a counter party defaults on the contract
Risk of trading futures contracts - Prepayment risk
the risk from the possibility that the asset to be hedged may be prepaid earlier than the designated maturity
Risk of trading futures contracts - Operational Risk
risk of losses due to inadequate management or controls
Commercial Bank Use of Futures
Take position in futures contracts to hedge against interest rate risk
Savings institutions use of futures
Take positions in futures contracts to hedge against interest rate risk (savings
Securities firm use of futures
execute futures transactions for individuals and firms
take position in futures contracts to hedge their own portfolios against stock market or interest rate movements
Mutual funds use of futures
take positions in futures contracts to speculate on future stock market or interest rate movement
take positions in futures contracts to hedge their portfolios against stock market interest rate movements
Pension Funds use of futures
Take positions in futures contracts to hedge their portfolios against stock market or interest rate movements
Insurance Companies use of futures
Take positions in futures contracts to hedge their portfolios against stock market or interest rate movement
Spratt Company purchased Treasury bill futures contracts when the quoted price was 93-50. When this position was closed out, the quoted price was 94-75. Determine the profit or loss per contract, ignoring transaction costs.
12,500
Marks Insurance Company sold S&P 500 stock index futures that specified an index of 1690. When the position was closed out, the index specified by the futures contract was 1,720. Determine the profit or loss, ignoring transaction costs.
-7500
Jasmine buys an S&P 500 futures contract with a September settlement date when the index is 1,400. By the settlement date, the S&P 500 index rises to 1,750. The value of an S&P 500 futures contract is $250 times the index. The return on Jasmine's position
25%
Interest Rate Swaps
an arrangement whereby one party exchanges one set of interest rate payments for a different set of interest rate payments
Provisions of an interest rate swap include:
Notional principaIs the reference value to which the interest rates are applied to determine the interest payments to the respective participating parties
Fixed interest rate
Formula and type of index used to determine the floating rate
Frequency of payme
Where are swaps traded
These are facilitated by over the counter trading, rather than trading on an organized exchange
Are swaps less standardized?
Yes, thus a telecommunications network is more appropriate than an exchange network to work out the specific provisions of swaps
Use of swaps for hedging
Commercial banks in the US traditionally had more interest rate sensitive liabilities than assets, and therefore, were adversely affected by increasing interest rates
conversely, some commercial banks in Europe had access to long term fixed rate funding b
Do US and European institutions reduce their exposure to risk by engaging in an interest rate swap
Yes
When are swaps used for speculative purposes?
It is done to benefit from expectations that interest rates will rise even if its other operations are not exposed to interest rate movements
Who uses Swaps?
Commercial banks, pension funds, insurance companies, intermediaries to swaps
Swaps: Plain vanilla
referred to as a fixed-for-floating swap, in which fixed rate payments are periodically exchanged for floating rate payments
Swaps: Forward
Involves an exchange of interest payments that does not begin until a specified future point in time
Swaps: Callable
also known as a swap option or swaption, provides the party making fixed payments with the right to terminate prior to its maturity. Allows the fixed rate payer to avoid exchanging future interest payments if it desires.
Disadvantage of a callable swap
Party given the right to terminate the swap pays a premium that is reflected in a higher fixed interest rate than the party would pay without the call feature. May also incur a termination fee
Swaps: Putable
Provides the party making the floating rate payment with a right to terminate the swap.
Swaps: Extendable
contains a feature that allows the fixed for floating party to extend the swap period.
Swaps: zero-coupon for floating
The fixed rate payer makes a single payment at the maturity date of the swap agreement while the floating rate payer makes periodic payments throughout the swap period
Swaps: Rate capped
Involves the exchange of fixed rate payments for floating rate payments that are capped
Swaps: Equity
Involved the exchange of interest payments for payments linked to the degree change in a stock index
Risks of interest rate swaps: Basis Risk
the interest rate of the index used for an interest rate swap will not necessarily perfectly track the movements of the floating rate instruments of the parties involved in the swap
Risks of interest rate swaps: Credit Risk
The risk that a firm involved in an interest rate swap will not meet its payment obligations
Concerns about a swap credit crisis
The willingness of large banks and securities firms to provide guarantees has increased the popularity of interest rate swaps but has also increased concerns over the potential
Pricing interest rate swaps
Prevailing market interest rates
Availability of counter parties
Credit and sovereign risk
Factors affecting the performance of interest rate swaps
indicators monitored by participants in the swaps market
Interest rate caps
an agreement that offers payments to the purchaser of the cap when a specified interest rate exceeds a specified ceiling (cap) interest rate
Interest Rate Floors
an agreement , which, for a fee the purchaser of the agreement receive payments in periods when a specified interest rate index falls bellow a specified floor rate
Interest rate collar
involves the purchase of an interest rate cap and the simultaneous sale of an interest rate floor.
Globalization of swap markets: Currency swap
an agreement whereby currencies are exchanged at specified exchange rates and at specified intervals
Credit Default Swaps (CDS)
Privately negotiated contract that protects investors against the risk of default on particular debt securities. Similar to a financial insurance contract
Who purchases Credit Default Swaps
Financial Institutions purchase these contracts to protect their own investments in debt securities against default risk.
Characteristics of credit defaults Swaps: Maturity
typically between 1 and 10 years with the most common being 5 years
Characteristics of credit defaults Swaps: Notional Value
typically between 10 and 20 million
Characteristics of credit defaults Swaps: Trading
CDS contracts have traded over the counter and were not backed by an organized exchange
Characteristics of credit defaults Swaps: Secondary Market for CDS contracts
the counterparty can sell the CDS to another financial institution, subject to the approval of the other party on the contract
Dodd Frank Financial Reform Bill (2010)
endeavors to move derivatives trading (allowing exceptions) on to organized exchanges
Development of credit default swaps
created in the 1990 to protect investors that purchased bonds against default risk
over time CDS contracts were adapted to protect investor that purchased mortgage backed securities
Institutional Use of Foreign Exchange markets
as international trade and investing have expanded so has the need to exchange currencies. foreign exchange markets consist of a global telecommunications network among the large commercial banks that serve as financial intermediaries for such exchange
Direct exchange rate
specifies the value of the currency in US dollars for example the mexican peso may hay have a value of $.10, or the British pound $2.00, or the Euro $1.25
Indirect Exchange rate
specifies the value of the currency as the number oof that currency equal to the a US dollar.
Spot rate
Present exchange rate
Forward rate
the exchange rate at which a specified currency can be purchased or sold at a specified future point in time. Forward rate maybe above the spot rate (contains a premium) or below the spot rate (at a discount)
Cross exchange rates
calculating the exchange rate between two non dollar currencies
Bretton Woods era
From 1944 to 1971 the exchange rate at which one currency could be exchanged for another was maintained by governments within 1% of a specified rate. Under this international fixed rate exchange rate regime, currencies were pegged to the United States dol
Smithsonian Agreement
approved in December 1971 this agreement allowed for the devaluation of the dollar and widened the boundaries from 1% to 2.25% around each currency's set value.
Freely Floating System
In 1973, all boundaries were eliminated and ever since, the exchange rates of major currencies have been floating without Government imposed boundaries. Hence exchange rates are market determined.
Dirty Float
A system with no boundaries in which exchange rates are market determined but are still subject to government intervention
Pegged Exchange Rate Systems
Even when most exchange rates float, some currencies may be pegged to another currency or a unit of account and maintained within specified boundaries. e.g. Since 1983, Hong Kong has tied its currency(the Hong Kong dollar) to the US dollar(HK$7.8 =$1). Ch
What Affects Exchange Rates
Differential Inflation rates
Differential Interest Rates
Central Bank Intervention
Direct Intervention
This occurs when a country's central bank, such as the Federal Reserve Bank for the U.S., sells some of its reserves for a different currency. They will purchase the currency they wish to appreciate and sell the currency they wish to depreciate
Indirect Intervention
For example, the Federal Reserve can expand the U.S. money supply thus lowering interest rates (as long as this is not inflationary) which would discourage foreign investors from investing in the U.S. thus putting downward pressure on the U.S. $.
Foreign exchange Controls
Governments sometimes attempt to impose restrictions on the exchange of their currency in order to stabilize the exchange rate of their currency. One means is to place quotas on the amounts of local currency that can be exchanged for foreign currencies
Movements in Exchange Rates
Exchange rate movements can have profound effects on investor and company returns, and on a country's economy. Currency markets are the largest financial markets in the world and are the most volatile.
Forecasting Exchange rates
technical forecasting.
fundamental forecasting
market-based forecasting
mixed forecasting
market-based forecasting
A process of formulating exchange rate forecasts from market indicators, which is based on either the (1) the spot rate (the current exchange rate) or (2) the forward rate (the exchange rate at which a specified currency can be purchased or sold at an ind
Forecasting Exchange Rate Volatility
Volatility is our gauge of risk, and forecasting volatility allows analysts to assess exchange rate risks and enables decision-making strategies, regarding whether and when to hedge or not to hedge these risks
Methods for forecasting exchange rate risk include
Measuring the volatility of historical exchange rate movements; Use of a time series of volatility patterns from previous periods; Derive the forecasted exchange rate volatility from the implied volatility of the currency's options and the use of the opti
Speculation in Foreign Exchange Markets
Commercial Banks, other financial institutions and investors take positions in currencies to exploit exchange rate movements. They invest in currencies that they expect to appreciate and short those currencies they expect to depreciate. Shorting involves
Foreign Exchange Derivatives
These can be used to speculate in currency markets or to hedge currency risks.
Currency Forward Contracts
Customized (flexible) contracts negotiated through a commercial bank that permit the purchase or sale of an indicated amount of a given foreign currency at a specified exchange rate (the forward rate) on an indicated future date. A forward market via tele
Currency Futures Contracts
Standardized contracts that specify an amount of a particular currency to be exchanged on an indicated date and at a specified exchange rate. Companies can purchase a currency futures contract to hedge payables in a foreign currency by locking in the pric
Forward premium or discount
A premium in the forward currency rate exists when the forward rate exceeds the spot rate, and the forward rate exhibits a discount when the forward currency rate is below the spot rate. Forward contracts are sometimes expressed in terms of their percenta
Currency Swaps
An agreement that permits a given currency to be periodically exchanged for another at specified exchange rates
Currency Options (Calls and Puts)Contracts
These can be used to speculate in the currency markets or hedge currency risks. The advantage of options over Forward and Futures contracts is that they provide a right but not an obligation to purchase or sell a specific currency at an indicated price wi
Conditional Currency Options
Options which are structured with a conditional premium, such that the premium is predicated on the actual mo
Locational Arbitrage
The process of capitalizing on price discrepancies between the spot exchange rate at two different locations (banks) by purchasing the underpriced currency and simultaneously selling it where it is overpriced.
Triangular Arbitrage
When the quoted cross rate between two foreign currencies is not aligned with the two corresponding exchange rates, a discrepancy in exchange rate quotations exists. Investors can exploit this for gain by buying or selling the currency that is subject to
Covered Interest Arbitrage
The international money markets coexist with the international currency markets and create a special relationship between a forward rate premium and the interest rate differential of any two given countries. This relationship is referred to as Interest Ra
Interest Rate Parity theory suggests
In essence, interest rate parity asserts that any disparity in the interest rates of two countries is equalized or offset by the movement in their currency exchange rates. If the interest rate for the foreign country is lower than in the home country the
The Most Common Source of Funds for Commercial Banks
Bank market structure