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Forwards, Futures and Swaps

(BKM 22, 23)





BUFN 740: Capital Markets
Topic 6
BUFN 740: Capital Markets Topic 6 1
A forward contract is an agreement today to buy or sell an asset
on a fixed future date for a fixed price.
--The fixed future date is called the maturity date.
--The fixed price is called delivery price. The delivery price is
to be paid at maturity.
Example: On Mar 31, a farmer and a miller could enter into a
forward contract: On June 30, the miller will buy 5,000
bushels of wheat from the farmer at the price of 600 cents
per bushel.
The contract is an over-the-counter agreement between two
companies.
The delivery price is chosen so that the initial value of the
contract is zero.
No money changes hands when the contract is initiated.

Forwards Contract
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A futures contract is an agreement to buy or sell an asset for a
certain price at a certain time.
Similar to a forward contract
The delivery price is chosen such that the value of the contract
is zero
-- No money changes hands at initiation
Special features of a futures contract
Standardized contracts create liquidity
Exchange mitigates credit risk
Settled daily by marking to market




Futures Contract
3 BUFN 740: Capital Markets Topic 6
Types of Futures Contracts
Futures contracts fall into two categories: commodities and
financials.
--The commodities: e.g., wheat, soy bean, cattle, gold, electricity.
--The financials: e.g., futures on Treasury Bill, British Pound,
S&P 500.
Example: Corn futures on CBOT
--Trading unit: 5,000 bu
--Deliverable grades: No. 2 Yellow at par and substitutions at
differentials established by the exchange
--Price quote: cents and quarter-cents/bu
http://www.cmegroup.com/trading/agricultural/grain-and-
oilseed/corn_contract_specifications.html


4 BUFN 740: Capital Markets Topic 6
Basics of Futures Contracts
The party who agreed to buy in a futures contract is said to have a
long position. The party who agreed to sell is said to have a short
position.
Open interest is the number of contracts outstanding.
The futures contract is a zero-sum game, which means gains and
losses net out to zero.
Profit to long = spot price at maturity (P
T
) - original futures price
(F
0
)
Profit to short = original futures price - spot price at maturity
Example: Mark buys 10 gold futures at $350/oz with maturity in 250
days (contract size 100 oz). Suppose the gold futures price goes
down $0.1 every day for 250 days. Will Mark lose or gain?

5 BUFN 740: Capital Markets Topic 6
Figure 22.2 Profits to Buyers and Sellers
of a Futures Contract
Profit is zero when the ultimate spot price, P
T
equals the initial
futures price, F
0
.
Profit rises or falls one-for-one with changes in the final spot
price.
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How Clearinghouse Works
The exchange acts as a clearing house and counterparty to both
sides of the trade.
The net position of the clearing house is zero.
Example: George buys 2 December corn futures contracts from
Susan at the futures price 2820 cents/bu. At 11am on June 10.
--When will George have an incentive to default?
--Immediately after the initiation, clearinghouse becomes the
seller to George and the buyer to Susan at the same futures price.
-- Susan and George no longer face credit risk from counterparty.

7 BUFN 740: Capital Markets Topic 6
Margin and Marking to Market
Initial Margin cash or near-cash securities deposited by an investor
with his or her broker (5%-15% of the total value of the contract)
Marking to Market - each day the profits or losses from the new
futures price are paid over or subtracted from the account
Maintenance Margin - an established value below which the trader
receives a margin call
Example: An investor takes a short position in one December Coffee
futures contracts at noon on June 3
--Contract size is 37,500 lb and futures price is $1.60/lb
--Initial margin is $6,000/contract (10% of the contract value)
--Maintenance margin is $4,000/contract
How far could the price rise before the investor gets a margin call?
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A Coffee Futures Example (Cont.)

9 BUFN 740: Capital Markets Topic 6
How to Close a Futures
How to close a futures?
--Enter into an offsetting trade
Long position, then short to close
Short position, then long to close
--Most futures contracts are closed out before maturity. Only 1-3%
of contracts result in actual delivery of the underlying commodity.
Example: Suppose Kathy bought 10 December gold futures at
$290/0z on January 2. The contract size is 100 oz. At 11:30am on
March 25, the futures price is $295/oz and she decides to close. So
she sells 10 December gold futures at the market price $295/oz. The
settlement price (the price just before the final bell each day) on
March 25 is $296.50/oz. The settlement price on March 24 was
$294/oz.
10 BUFN 740: Capital Markets Topic 6
What will happen then?
At the settlement time on March 25, the 10 long contracts margin
account will get credited (296.50-294)10010=$2,500.

The 10 short contracts margin account will get debited
(296.50-295)10010=$1,500.

In the net, she gained $1,000 at the settlement on March 25.

Now the 10 long contracts and short contracts are identical and thus
offset each other.



11 BUFN 740: Capital Markets Topic 6
Hedging and Speculation
Speculators
Seek to profit from price movement
short - believe price will fall
long - believe price will rise
Example: If you believe that crude oil prices would increase, then
you can purchase crude oil futures. Why not buy the underlying
asset directly?
Seek protection from price movement
long hedge - protecting against a rise in purchase price
short hedge - protecting against a fall in selling price
Example: An oil distributor needs to sell oil in a few months and
faces the risk that price might fall. The firm can sell oil futures.
12 BUFN 740: Capital Markets Topic 6
Hedgers
Example 22.5 Hedging with Oil Futures
An oil distributor plans to sell 100,000 barrels of oil in February
and wishes to hedge against a possible decline in oil prices.
Each contract calls for delivery of 1,000 barrels. It would sell 100
contracts. The current futures price is $71.86.
13 BUFN 740: Capital Markets Topic 6
Oil Price in February, P
T

$69.86 $71.86 $73.86
Revenue from oil sale:
100,000P
T

$6,986,000 $7,186,000 $7,386,000
+ Profit on futures:
100,000(F
0
-P
T
)
200,000 0 -200,000
Total
$7,186,000 $7,186,000 $7,186,000
The variation in the price of the oil is precisely offset by the profits
or losses on the futures position.
Example of a Long Hedge
Suppose miller Mary will have to buy 5,000 bushels wheat from
the spot market on December 1. The December futures is quoted at
$2.75 per bu.
Buy 1 Dec. futures (the size of wheat futures contract is 5,000 bu.)
If the Dec. 1 spot price is $2.80 per bu., then Mary buys at $2.80
per bu. from the spot market.
Mary gains about $0.05 per bu. from the futures contract. The net
cost is $2.75 per bu.
If, on the other hand, the Dec. 1 spot price is $2.60 per bu., then
Mary buys at $2.60 per bu. She loses about $0.15 per bu. from the
futures contract. The net cost is again $2.75.
Good hedging does not always improve the ex post outcome, but it
always decreases the fluctuation in the possible outcome.
14 BUFN 740: Capital Markets Topic 6

Hedging Example: Section 22.4
Investor holds $1000 in a mutual fund indexed to the S&P 500.
A futures contract with delivery in one year is available for $1,010.
The investor hedges by selling one futures contract .
0 0
0
1, 010 1, 000
1%
1, 000
F S
S


15 BUFN 740: Capital Markets Topic 6
Value of S
T
990 1,010 1,030
Payoff on
Short(1,010 - S
T
)
20 0 -20
Total 1,010 1,010 1,010
Futures Pricing
Spot-Futures Parity Theorem
With a perfect hedge, the payoff of the asset-plus-futures is certain
-- there is no risk.
A perfect hedge should earn the riskless rate of return.
This can be used to develop the futures pricing relationship.
16 BUFN 740: Capital Markets Topic 6
0 0
0 0 0 0
0
(1 ), , (1 )
T
f f f
F S
r F S r for T periods F S r
S


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.
Futures Pricing (Cont.)
17 BUFN 740: Capital Markets Topic 6
Futures Pricing (Cont.)
18 BUFN 740: Capital Markets Topic 6
Strategy Initial Cash Flow Cash Flow at Time T
Buy the future 0
Borrow and buy the
share
To get one share of the stock, we have two ways:
(1) borrow to buy one share of the stock now and keep it to T
(2) buy one future contract

Lets compare the cash flow of these two strategies:

Futures Market Arbitrage
Suppose the risk-free rate is 0.5% , the futures price should be
$10001.005=$1005.
The actual futures prices is $1010. The spot-futures parity is
violated. An arbitrage opportunity exists!
Buy low sell high-- sell overpriced futures and buy the stock using
borrowed money.
The Cash Flow of Cash and Carry
19 BUFN 740: Capital Markets Topic 6
Strategy Initial Cash Flow Cash Flow in 1 year
Borrow $1000 +1,000 -1,0001.005=-$1,005
Buy stock for $1000 -1,000 S
T

Sell the futures 0 $1,010- S
T

Total 0 $5
Futures Market Arbitrage (Contd)
What if the actual futures price is $980. The spot-futures parity is
violated. An arbitrage opportunity exists!
Buy low sell high-- buy underpriced futures
--sell the stock and lend the proceed
The Cash Flow of Reverse Cash and Carry
20 BUFN 740: Capital Markets Topic 6
Strategy Initial Cash Flow Cash Flow in 1 year
Buy the futures 0 -980+ S
T

Short sale stock 1,000 -S
T

Lend -1,000 $1,005
Total 0 $25
Relationship between Forward and Futures Prices
In the previous example, we assume for convenience that the
entire profit to the futures contract accrues on the delivery date.
The parity theorems apply strictly to forward pricing because
contract proceeds are realized only on delivery.
When interest rate is uncorrelated with the price of the
underlying asset, forward and futures prices are the same.
Even if interest rate IS correlated with the price of the
underlying asset, forward and futures prices are still very close.
In real data, generally, the difference between forward price and
futures price is indeed insignificant and thus will be ignored
throughout this course.
BUFN 740: Capital Markets Topic 6 21
Swaps
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A swap is an exchange of periodic cash flows between two
parties. The cash flows may vary in terms of currency
denomination, interest rate basis and/or other financial features.

Examples:
1. Interest Rate Swap - exchange of fixed-rate interest
payments for floating-rate interest payments
2. Currency Swap - exchange of one stream of cash flows
denominated in one currency for another stream of cash flows
denominated in another currency.



Plain Vanilla Interest Rate Swap
BUFN 740: Capital Markets Topic 6 23
A plain vanilla interest rate swap is a widely used interest rate swap.
Party B agrees to pay party A cash flows equal to interest at a fixed interest
rate on a notional principal for a number of years. At the same time, party A
agrees to pay party B cash flows equal to interest at a floating interest rate on
the same notional principal for the same number of years.



The notional principal does not change hand. The cash flows are in the same
currencies.
It involves two companies that have different comparative advantages in the
debt market: one company may be relatively more competitive in the fixed-
rate market, while the other may be relatively more competitive in the
floating-rate markets.



Example
Suppose BUD wants to borrow $100 million at a floating rate for 5 years
and IBM wants to borrow $100 million at a fixed rate for 5 years. Costs of
funds are as the following




The central question in the analysis of a swap is: can both companies be
better off by contracting a swap agreement?
Even though the rates IBM can borrow at in both markets are higher than
those for BUD, IBM's disadvantage (the difference in rates) is smaller in the
floating rate market.
So we say that IBM has a comparative advantage in borrowing at floating
rates and BUD has a comparative advantage in borrowing at fixed rates.
24 BUFN 740: Capital Markets Topic 6
Total Gains From Swap
Assume interest is paid semiannually.
If a swap market does not exist, then BUD has to borrow at
LIBOR and IBM has to borrow at 12%. The total amount of
each interest payment BUD and IBM have to pay is 100(LIBOR
+12%)/2 m.
Now if BUD and IBM enter into a swap contract and let BUD
borrow at fixed rate of 10% and IBM borrow at LIBOR + 0.5%,
The total amount of each interest payment BUD and IBM have
to pay is only 100(LIBOR +10.5%)/2 m.
The difference for each payment is 100(LIBOR +12%)/2 -
100(LIBOR +10.5%)/2=$0.75million.

BUFN 740: Capital Markets Topic 6 25
Mechanics of Swap
Step 1: BUD and IBM sign a swap contract which specifies that
every 6 months, BUD pays IBM 100 LIBOR/2 million and
IBM pays BUD 100 11%/2=$5.5 million. Only the net
payment change hands.

Step 2: BUD borrows $100m for 5 years, paying 10% annually.
IBM borrows $100m for 5 years, paying LIBOR+0.5%
annually.

The net cost of fund for BUD is LIBOR-1% each year (1%
better). The net cost of fund for IBM is 11.5% each year (0.5%
better).
BUFN 740: Capital Markets Topic 6 26

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