INVESTMENTS | BODIE, KANE, MARCUSCopyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinCHAPTER 22Futures MarketsINVESTMENTS | BODIE, KANE, MARCUSForward a deferred-delivery sale of an asset with the sales price agreed on now.Futures - similar to forward but feature formalized and standardized contracts.Key difference in futuresStandardized contracts create liquidityMarked to marketExchange mitigates credit riskFutures and Forwards2INVESTMENTS | BODIE, KANE, MARCUSA futures contract is the obligation to make or take delivery of the underlying asset at a predetermined price.Futures price the price for the underlying asset is determined today, but settlement is on a future date.The futures contract specifies the quantity and quality of the underlying asset and how it will be delivered.Basics of Futures Contracts3INVESTMENTS | BODIE, KANE, MARCUSBasics of Futures ContractsLong a commitment to purchase the commodity on the delivery date.Short a commitment to sell the commodity on the delivery date.Futures are traded on margin.At the time the contract is entered into, no money changes hands.4INVESTMENTS | BODIE, KANE, MARCUSBasics of Futures ContractsProfit to long = Spot price at maturity - Original futures priceProfit to short = Original futures price - Spot price at maturityThe futures contract is a zero-sum game, which means gains and losses net out to zero.5INVESTMENTS | BODIE, KANE, MARCUSFigure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts 6INVESTMENTS | BODIE, KANE, MARCUSFigure 22.2 ConclusionsProfit is zero when the ultimate spot price, PT equals the initial futures price, F0 .Unlike a call option, the payoff to the long position can be negative because the futures trader cannot walk away from the contract if it is not profitable.7INVESTMENTS | BODIE, KANE, MARCUSExisting ContractsFutures contracts are traded on a wide variety of assets in four main categories:1.Agricultural commodities2.Metals and minerals3.Foreign currencies4.Financial futures8INVESTMENTS | BODIE, KANE, MARCUSTrading MechanicsElectronic trading has mostly displaced floor trading.CBOT and CME merged in 2007 to form CME Group.The exchange acts as a clearing house and counterparty to both sides of the trade.The net position of the clearing house is zero.9INVESTMENTS | BODIE, KANE, MARCUSOpen interest is the number of contracts outstanding.If you are currently long, you simply instruct your broker to enter the short side of a contract to close out your position.Most futures contracts are closed out by reversing trades.Only 1-3% of contracts result in actual delivery of the underlying commodity.Trading Mechanics10INVESTMENTS | BODIE, KANE, MARCUSFigure 22.3 Trading without a Clearinghouse; Trading with a Clearinghouse 11INVESTMENTS | BODIE, KANE, MARCUSMarking to Market - each day the profits or losses from the new futures price are paid over or subtracted from the accountConvergence of Price - as maturity approaches the spot and futures price convergeMargin and Marking to Market12INVESTMENTS | BODIE, KANE, MARCUSInitial Margin - funds or interest-earning securities deposited to provide capital to absorb lossesMaintenance margin - an established value below which a traders margin may not fallMargin call - when the maintenance margin is reached, broker will ask for additional margin fundsMargin and Trading Arrangements13INVESTMENTS | BODIE, KANE, MARCUSTrading StrategiesSpeculatorsseek to profit from price movementshort - believe price will falllong - believe price will riseHedgersseek protection from price movementlong hedge - protecting against a rise in purchase priceshort hedge - protecting against a fall in selling price14INVESTMENTS | BODIE, KANE, MARCUSBasis - the difference between the futures price and the spot price, FT PTThe convergence property says FT PT= 0 at maturity.Basis and Basis Risk15INVESTMENTS | BODIE, KANE, MARCUSBefore maturity, FT may differ substantially from the current spot price.Basis Risk - variability in the basis means that gains and losses on the contract and the asset may not perfectly offset if liquidated before maturity.Basis and Basis Risk16INVESTMENTS | BODIE, KANE, MARCUSSpot-futures parity theorem - two ways to acquire an asset for some date in the future:1.Purchase it now and store it2.Take a long position in futuresThese two strategies must have the same market determined costsFutures Pricing17INVESTMENTS | BODIE, KANE, MARCUSSpot-Futures Parity TheoremWith a perfect hedge, the futures payoff is certain - there is no risk.A perfect hedge should earn the riskless rate of return.This relationship can be used to develop the futures pricing relationship.18INVESTMENTS | BODIE, KANE, MARCUSHedge Example: Section 22.4Investor holds $1000 in a mutual fund indexed to the S&P 500.Assume dividends of $20 will be paid on the index fund at the end of the year.A futures contract with delivery in one year is available for $1,010.The investor hedges by selling or shorting one contract . 19INVESTMENTS | BODIE, KANE, MARCUSHedge Example OutcomesValue of ST 9901,010 1,030Payoff on Short (1,010 - ST) 20 0 -20Dividend Income 20 20 20Total1,030 1,030 1,03020INVESTMENTS | BODIE, KANE, MARCUSRate of Return for the Hedge21INVESTMENTS | BODIE, KANE, MARCUSThe Spot-Futures Parity TheoremRearranging terms22INVESTMENTS | BODIE, KANE, MARCUSArbitrage Possibilities If spot-futures parity is not observed, then arbitrage is possible.If the futures price is too high, short the futures and acquire the stock by borrowing the money at the risk free rate.If the futures price is too low, go long futures, short the stock and invest the proceeds at the risk free rate.23INVESTMENTS | BODIE, KANE, MARCUSSpread Pricing: Parity for Spreads24INVESTMENTS | BODIE, KANE, MARCUSSpreadsIf the risk-free rate is greater than the dividend yield (rf d), then the futures price will be higher on longer maturity contracts.If rf d, longer maturity futures prices will be lower.For futures contracts on commodities that pay no dividend, d=0, F must increase as time to maturity increases.25INVESTMENTS | BODIE, KANE, MARCUSFigure 22.6 Gold Futures Prices26INVESTMENTS | BODIE, KANE, MARCUSFutures Prices vs. Expected Spot PricesExpectations Normal BackwardationContangoModern Portfolio Theory27INVESTMENTS | BODIE, KANE, MARCUSFigure 22.7 Futures Price Over Time, Special Case28