Chapter Outline,25.1 Forward Contracts 25.2 Futures Contracts 25.3 Hedging 25.4 Interest Rate Futures Contracts 25.5 Duration Hedging 25.6 Swap Contracts 25.7 Actual Use of Derivatives 25.8 Summary & Conclusions,25.1 Forward Contracts,A forward contract specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. Its not an option: both parties are expected to hold up their end of the deal. If you have ever ordered a textbook that was not in stock, you have entered into a forward contract.,25.2 Futures Contracts: Preliminaries,A futures contract is like a forward contract: It specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward: Futures are standardized contracts trading on organized exchanges with daily resettlement (“marking to market”) through a clearinghouse.,Futures Contracts: Preliminaries,Standardizing Features: Contract Size Delivery Month Daily resettlement Minimizes the chance of default Initial Margin About 4% of contract value, cash or T-bills held in a street name at your brokerage.,Daily Resettlement: An Example,Suppose you want to speculate on a rise in the $/ exchange rate (specifically you think that the dollar will appreciate).,Currently $1 = 140.,The 3-month forward price is $1=150.,Daily Resettlement: An Example,Currently $1 = 140 and it appears that the dollar is strengthening. If you enter into a 3-month futures contract to sell at the rate of $1 = 150 you will make money if the yen depreciates. The contract size is 12,500,000 Your initial margin is 4% of the contract value:,Daily Resettlement: An Example,If tomorrow, the futures rate closes at $1 = 149, then your positions value drops. Your original agreement was to sell 12,500,000 and receive $83,333.33:,You have lost $559.28 overnight.,But 12,500,000 is now worth $83,892.62:,Daily Resettlement: An Example,The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05 This is short of the $3,355.70 required for a new position.,Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.,Selected Futures Contracts,Futures Markets,The Chicago Mercantile Exchange (CME) is by far the largest. Others include: The Philadelphia Board of Trade (PBOT) The MidAmerica Commodities Exchange The Tokyo International Financial Futures Exchange The London International Financial Futures Exchange,The Chicago Mercantile Exchange,Expiry cycle: March, June, September, December. Delivery date 3rd Wednesday of delivery month. Last trading day is the second business day preceding the delivery day. CME hours 7:20 a.m. to 2:00 p.m. CST.,CME After Hours,Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts. Theres other markets, but none are close to CME and SIMEX trading volume.,Wall Street Journal Futures Price Quotes,Expiry month,Opening price,Highest price that day,Lowest price that day,Closing price,Daily Change,Highest and lowest prices over the lifetime of the contract.,Number of open contracts,Basic Currency Futures Relationships,Open Interest refers to the number of contracts outstanding for a particular delivery month. Open interest is a good proxy for demand for a contract. Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.,25.3 Hedging,Two counterparties with offsetting risks can eliminate risk. For example, if a wheat farmer and a flour mill enter into a forward contract, they can eliminate the risk each other faces regarding the future price of wheat. Hedgers can also transfer price risk to speculators and speculators absorb price risk from hedgers. Speculating: Long vs. Short,Hedging and Speculating Example,You speculate that copper will go up in price, so you go long 10 copper contracts for delivery in 3 months. A contract is 25,000 pounds in cents per pound and is at $0.70 per pound or $17,500 per contract. If futures prices rise by 5 cents, you will gain: Gain = 25,000 .05 10 = $12,500 If prices decrease by 5 cents, your loss is: Loss = 25,000 -.05 10 = -$12,500,Hedging: How many contacts?,You are a farmer and you will harvest 50,000 bushels of corn in 3 months. You want to hedge against a price decrease. Corn is quoted in cents per bushel at 5,000 bushels per contract. It is currently at $2.30 cents for a contract 3 months out and the spot price is $2.05. To hedge you will sell 10 corn futures contracts:,Now you can quit worrying about the price of corn and get back to worrying about the weather.,25.4 Interest