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Investments

Week 2: Forwards,
Futures, and Swaps

Fall 2015
Professor Albert Wang

24 Sep 2015 Agenda


Administrative
HW1 due next week in class

Lecture
Current Events Update
CH22-23
Payoff/Profit Diagrams
Forwards/Futures
Forwards/Futures examples
Swaps

Page 2

Current Events
TAIEX Index: 8307.04
S&P500 Index: 1,966.97
Recent financial news
US Federal Reserve no Sept. change in
policy
Volkswagen cheated on US emissions
tests, fines could be huge. Other
countries may follow up.

Page 3

Payoff and Profit Diagrams


Linear Payoffs
Payoff (time T)

Price of underlying

Payoff (time T)

Price of underlying

Page 4

Forwards and Futures


Introduction
Both are contracts to buy / sell an
underlying asset at a specified price
and at a specified time
Both can offer financial exposure to the
same underlying asset
Both (and all derivatives) are zero-netsupply

Differences between Forwards and


Futures are in contract details and
logistics of trading

Page 5

Forwards and Futures


Alternatives
Alternative to Buying Underying
Complications
Indices costly to administer buying/holding each
component
Commodities storage (where would you store pork
bellies and for how long?)

Why trade forwards and futures?


Lower transaction cost
Highly leveraged positions
Easy to close positions by opening another and
netting
Page 6

Forwards
Forwards
Contract set today for delivery of a good
at a set date in the future at a set price.
Forwards are priced to have zero value
today
No money changes hands until maturity when
delivery is taken

Strictly between two private parties


Either side may default. Both sides have risk.
Contracted between two entities so very
flexible and specifiable

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Futures
Futures
Identical in spirit to forwards
Standardized, Regulated forwards
Clearinghouse serves as middle-man
Guarantees delivery of cash and underlying to both
sides of transaction
Regulates and evaluates financial health of members
Provides standardization and a market
Holds diversified portfolio of default risk
Margin account to insure against default

Typically cash settlement

Page 8

Trading Mechanics
Opening positions
Contact broker to trade futures
Contact counterparty directly (or through broker)
to trade forwards

Closing positions
Trade in identical forward/future in opposite
direction with ANY counterparty (not necessarily
original)
Most often positions are closed in this manner
Forward counterparty rarely wants to reverse the trade
Futures counterparty does not need to be known

Take/make delivery of underlying for cash


Broker or exchange arranges netting if needed
Page 9

Non-technical Summary
Summary of key characteristics futures

Standardized contract units


Clearinghouse warrants performance
Secondary trading higher liquidity
Marked to market daily (or more often)
Margin requirement

Forwards or Futures?

Futures pricing has interest rate considerations due to


margin account balance fluctuations

Position marked to market daily and enough cash must be in


margin accounts
Margin balance earns interest

Technically will be using forwards pricing to simplify


calculations, though in practice futures are much more
commonly traded
Remember, both have the same fundamental financial
exposure
Page 10

Forwards and Futures Risks


Price Risk
Only if used as a speculative instrument
Risk-reducing if used as a HEDGE
IMMUNIZES against price risk

Basis Risk
Future and Spot (underlying) values diverge
Depends on interest rate so has the same risk
components.

Default Risk
From counterparty if using forwards
Margin call risk if using futures
Page 11

Possible Underlying
Instruments
Agricultural commodities
Metals and minerals (including energy contracts)
Foreign currencies
Financial securities futures
Interest rate (and bond) futures
Stock index futures
Individual stock futures

ANYTHING!
Futures are exchange-traded and standardized, so what
you see is what you get
Forwards for ANYTHING can be negotiated by any i-bank,
typically at very low cost

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Forwards and Futures


Example 1
You sign a forward contract to buy 100
ounces of gold on March 2, 2016 at
$1130
$1130 is the contracted forward price
It does not matter how much gold is worth
now, a month later, or on 10/2/04. be it
$100, $1130, or $2000. You still have to
buy the gold at $1130 per ounce or else
default on your contract (legal fees, etc.)
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Forwards and Futures


Example 2
You just accept your boyfriend/girlfriends
marriage proposal and decide to marry
him/her in a year.
If you take your engagement commitment
seriously, you have to marry your fianc after a
year, whether in the following year you find out
he/she truly is Prince(ss) Charming or the wicked
(he-)witch.
A serious engagement commitment works like a
forward contract once agreed upon the date
and terms are set, regardless of the outcome
(Luckily?) Unlike most financial contracts, it is not
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legally binding!

Forward/Futures Pricing
There are two ways to acquire an
underlying asset for some future date
1: Purchase it now and store it
2: Take a long position in futures

These two strategies must have the


same costs to avoid arbitrage
If the costs are different, then someone
would arb the difference buy the
cheap one, sell the expensive one
making a profit but holding no risk and
paying no costs
Page 15

Spot-Futures Parity Theorem


With a perfect hedge the futures payoff is
certain there is no risk
A perfectly hedged position should return
the risk-free rate of return
Long the underlying (notional value $X) and
short the futures (costless to enter) or vice versa
Overall return should be identical to holding $X in the
risk-free asset, since underlying will be delivered to the
futures buyer

This relationship can be used to develop a


no-arbitrage futures pricing relationship
Page 16

2 Ways to Get Underlying


Exposure
Buy futures
Time 0
No cost

Time (0,t)
No cost

Time t
Pay F, receive
underlying

Buy underlying
Time 0
Pay S

Time (0,t)
Pay holding costs,
receive dividends

Time t
No cost; already
have underlying

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Spot-Futures Parity
Essentially equates the cash outflow at the
maturity date from the 2 ways to get
underlying exposure
A) long futures: pay F
B) buy underlying: pay FV(S) FV(Div) +
FV(costs)

F S (1 rf ) D C
t

S (1 rf d c)t
Se

( rf ,ccr d ccr cccr ) t

Page 18

Spot-Futures Parity: Notation


Forward price, F: price set today to transact
at maturity
Maturity, t: time at which contract expires
Spot price, S: current price of the underlying
FV(Dividends), D
Dividend yield, d

FV(Costs), C
Cost rate, c

Net convenience yield, ncy: d-c

Net convenience dollar profit = D-C

Riskfree rate, r

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Arbitrage 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 riskfree
rate
If the futures price is too low, go long
futures, short the stock and invest the
proceeds at the riskfree rate
Page 20

Cow Forward Numerical


Example
Example: You plan to open a local restaurant call
Johann Tomas Steakhouse in 1 year. If you
accurately estimate the number of cow forwards
needed on a regular basis, then you can keep the
prices of your steaks almost constant, even if the
price of cows increases or decreases. Knowing you
will have to deliver a cows worth of steak in the
first week of business, you decide to buy a kobe
beef cow forward from an investment bank. The
price of that quality cow is $1000 in the open
market, the continuously compounded risk-free rate
is 5% per year, the PV of the milk the cow would
produce over the year is $30, and the PV of the hay
and water to feed the cow is $10. There are no
other benefits or costs to owning such a cow.
What is the Forward price?

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continued
S = $1000, rccr=5%
PV(Dividends) = $30 (milk)
PV(Cost) = $10 (hay, water)

F Se FV (CF )
rt

1000e [30 10]e


1030.25
.05

.05

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continued
Example continued:
Instantly after going long a single cow
forward, the price of cows increases to
$1100.
What is the VALUE of the long position?
What is the implied cow exposure in
number of cows?

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Futures Trading Strategies


ZERO initial cost to enter a standard forward
(margin balance required for futures)
High leverage makes for convenient tool to
adjust exposure to underlying instruments

Speculation/Leveraging increase exposure


long - believe price will rise
short - believe price will fall

Hedging decrease exposure


long hedge - protecting against a rise in price
short hedge - protecting against a fall in price

Page 24

Profit Diagram: Futures Buyer


Futures
Buyer

Profit

Fo

Price
Page 25

Profit Diagram: Futures Seller


Profits

Futures Seller

Fo

Price
Page 26

Futures Payoff/Profit Diagram


Thought Questions
What is the difference between a
payoff and profit diagram for a forward
contract?
None initial cost to enter is 0

What is the payoff diagram to a holder


of any underlying who hedges with the
appropriate notional value of futures?
Riskfree along x-axis (i.e. price risk of
underlying)
Page 27

Hedge Example
Investor owns an index fund that has a
current value of $900
Assume dividends of $20 will be paid on the
fund at the end of the year
Assume futures contract that calls for
delivery of one index unit in one year is
available for $925
Assume the investor hedges by selling or
shorting one contract
What is the riskfree rate?
Page 28

Hedge Example Potential


Outcomes
Value of ST

885

925

965

Payoff on Short
(925 - ST)

40

-40

Dividend Income 20

20

20

Total

945

945

945

Page 29

Rate of Return for the Hedged


Position
( F0 D) S 0

S0
(925 20) 900
5%
900

Page 30

Tools to Adjust Exposure


Underlying

Often difficult or expensive to obtain


Little leverage allowed

Forwards/Futures

Easy and cheap to obtain (I-Bank for customized


solutions, exchanges for many)
Extreme leverage allowed

When possible, use forwards/futures to


adjust amount of exposure to underlying
Linear changes in payoff diagram possible
Examples of linear changes possible

Page 31

Hedge: Lock In Profits


I own a widget machine that produces
widgets at a marginal cost of $3 each. My
widget machine will output 1 million widgets
all at the same time, in 3 months. The
current spot price of widgets is $5, but there
is no guarantee that the price of widgets will
not fluctuate. There are no costs or
dividends to holding widgets, and the
riskfree rate is 4% per year. What is the
present value of the profit can I lock in if
there exists a fairly priced 3 month futures
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contract for widgets?

Hedge: Lock In Profits


continued
F S (1 r )
5(1 .05)
5.06

.25

If I hedge with futures, I can lock in a


price of $5.06 per widget. Discounted
at the riskfree rate, that nets $5 per
widget. My profit is $2 per widget, for
a total PV of $2 million locked in.
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Hedge: Reduce Exposure


Hums grandmother Deedle left him 1
million shares of DUM stock (the family
business) which trades at $10 per
share, but with a restriction that he
cannot sell the shares for 10 years.
Hum is no dummy, and wants to
reduce his exposure in DUM to 10% of
his current exposure. You are a savvy
investment manager at MCUBank, the
broker where Hum holds his shares of
DUM. What do you offer Hum?

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Hedge: Reduce Exposure


continued
Allow Hum to sell a customized forward
contract for 900,000 shares of DUM stock
with expiration in 10 years.
Considerations for Hum?
1) Counterparty Risk: Hum may reasonably
request that a special account be placed in his
name for any marked gains (i.e. if HUM price
decreases), in case MCUbank goes bankrupt
within 10 years
Though MCUbank is a better credit, Hums shares are
held as collateral.
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Hedge: Reduce Exposure


continued
More considerations for Hum?
2) Cost for Customization: MCUbank has to make
a profit on this non-standard forward, so should
offer a price based on spot-futures parity plus a
profit
In this case, MCUbank buys at a lower price than fair
If F = 15 according to spot-futures parity, then forward
contract will specify a lower price maybe 14.50
Hum has hedged stock exposure on 900K shares will
receive 14.50/share on 900K shares regardless of what
happens to DUM stock price
MCUbank has locked in a profit above fair price of
0.50/share, but is now exposed to the stock SO
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Hedge: Reduce Exposure


continued
More considerations for Hum?
3) Risk Sharing: MCUbank is not in the business
of holding individual stock risk, and will need to
unload that risk
Sell forward to another Jbank
But only at a Forward price above 14.50 maybe 14.75
MCUBank will pay 14.50/share on 900K shares to Hum
MCUBank will receive 14.50/share on 900K shares
from Jbank

Short shares in the spot market


Use options to create short position
Other
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Speculate on Margin
Your third cousin Jeeesper from Timbucktoo has a
dead-end job and no education. He has managed
to save $10000 and is on the way to the gas station
to buy lottery tickets. Knowing that lottery tickets
are priced to return about 50 cents on the dollar,
you suggest speculating in the crude oil market
where at least the odds are even. Each crude oil
futures contract represents 1000 barrels, and each
barrel currently trades at $68. Exposure to each
futures contract requires $1000 to be placed in a
margin account. How much exposure to oil can
Jeesper obtain? Assuming he sells the maximum
amount of futures and the price of oil decreases to
$45 per barrel, what is his profit? At what price
would he be wiped out (assuming no maintenance
margin)?
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Speculate continued
He can obtain exposure to 10 contracts:
10 contracts x $68/barrel x 1000 barrels/contract
= $680,000 of spot crude oil exposure

If he shorts 10 contracts and the price


decreases to $45/barrel, then he makes

$23/barrel x 10 contracts x 1000 barrels/contract


=$230,000

He can lose up to $10,000

$10,000 = $N/barrel x 10 contracts x 1000


barrels/contrac
N=1
If the price of a barrel of crude rises $1 to $69,

Page 39

Futures and Expected Spot


Futures prices
Price: Theories
Contango
Expectations Hypothesis

Normal Backwardation

Time
Delivery date
F converges to S as T approaches

If F= E(S), expectations hypothesis


If F>E(S), contango: F decreases as T approaches
If F<E(S), normal backwardation: F increases as T
approaches

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F vs E(S)
Normal Backwardation
Economists Keynes and Hick said, its normal
for farmers to hedge commodity outputs by
shorting futures.
Entice non-hedgers to buy futures: lower F below
E(S)

Contango
Opposite to Normal Backwardation
There are more natural buyers of the commodity
than sellers; they need to buy futures
Entice non-hedgers to sell futures:increase F
above E(S)

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Swaps
A swap is a pair of forwards
Long one forward
Short another forward
What is the total cost to enter a swap???

Since swaps are comprised of fully


customizable forwards, they may be
specified for anything
Unspecified term swap often refers to
fixed for floating interest rate swap (or
bond swap)
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Swaps
OTC so there is default risk.

But amount at risk is difference in the swapped values, not full


notional

Total Return Swaps

Swap the total return on ANY 2 securities, for the same notional
amount for each securities
Only the difference b/w the total return of securities actually
changes hands, NOT the notional amount
No forward pricing necessary just exchange total return
The fair value of $1mm notional in S&P500 is the same as the fair
value of $1mm notional in IBM bonds. Its $1mm notional! Just
exchange the cash flows to each

Interest Rate Swap: fixed for floating

Swap the coupon payment of 2 identical risk bonds, one of which


is fixed rate and one of which is floating rate
Principal and fixed coupon will always be identical; floating rate
will change

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Swap Pricing
Swap pricing is based on the fact that
a swap is simply a series of 2 (or
more) forward contracts
Applicable when a fixed amount should be
paid each period (i.e. not necessary in a
swap of index total return swaps)
Start by pricing individual forwards, which
leads to floating values per period
Set fixed amount such that discounted
value equals discounted value of separate
forwards
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Assignment
Read CH6
Form Project Groups
Each HW group may do the following:
Search online or print news

ANY source
Real stories only
No timetable (any current or historical example)

Bring a printed or copied article about a case where


futures/forwards are being used to hedge, speculate, or
lock in profits
Identify which of the 3 strategies is being used
Write a short summary (guideline 100 words) of the story,
highlighting the use of futures/forwards

This assignment is for participation credit only


Due next class
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