Financial Markets and Risk Management Class Sheet 7

1. Explain the four key differences between forward and futures contracts
Forwards Futures
Customised Standardised
OTC Exchange Traded
Settled at Closing arked to arket
!o clearing "ouse Clearing "ouse
#. Explain how margins protect in$estors against the possibility of default.
% margin is a sum of money deposited by an in$estor with a broker. &t acts as a
guarantee that the in$estor can co$er any losses on the futures contract. The balance
in the margin account is ad'usted daily to reflect gains and losses on the futures
contract. &f losses are abo$e a certain le$el( the in$estor is re)uired to deposit a further
margin. The system makes it unlikely that the in$estor will default. % similar system
of margins makes it unlikely that the in$estor*s broker will default on the contract it
has with the clearing house member and unlikely that the clearing house member will
default with the clearing house.
+. Explain what you understand by the term the basis.
The basis is the difference between the cash price of an underlying security and the
price of the futures contract relating to that underlying security. &t is gi$en as,
-asis . Spot price / Futures price
0. 1i$e reasons why a basis is likely to exist and identify the ma'or factor
influencing the si2e of the basis associated with stock index futures.
There may be uncertainty as to the exact date when the asset will be bought or sold.
The hedge may re)uire the futures contract to be closed out well before the expiration
date. %lthough we get spot and futures con$ergence at expiration( in practice most
contracts are closed out prior to the expiration date.
&t exists in stock index futures mainly because the portfolio being hedged( in practice(
isn*t the same as that underlying the futures contract.
&n almost all cases of hedging with stock index futures a cross hedge is in$ol$ed. This
means that the stock portfolio the in$estor wants to hedge differs from the portfolio
underlying the futures contract. 3ou wouldn*t normally hold 144 shares as in the
FTSE5144 or necessarily the same shares. &ndex tracking funds typically contain +45
04 shares. 3ou ha$e considerable basis risk because the portfolio differs from the
hedge. E$en where the portfolio matches the index there is still basis risk.
6. Explain the traditional 7na8$e9( beta( and minimum $ariance hedge ratios and
identify the main drawbacks of the latter.
The traditional hedge ratio in$ol$es taking a futures position which is e)ual in
magnitude but opposite in sign to the stock market position. &f there is perfect positi$e
correlation then all price risk is completely eliminated. -ut in practice there is not
perfect positi$e correlation.
The hedge strategy makes na8$e assumptions about changes in the basis: it assumes
the basis doesn*t change. -ecause the basis changes( the classic approach does not
guarantee a risk minimising position.
The beta hedge in$ol$es using the beta of the portfolio as the hedge ratio. Takes
account of the fact that portfolios may not exactly match the index on which the
futures contract is written. ;here there is perfect correlation and when the portfolio
beta is one( then the traditional( beta( and minimum $ariance hedge ratios are e)ual.
The <"= is the hedge ratio which minimises the $ariance of the hedged position.
That is( the position we hold in spot and futures contracts. ;e assume a pre5
determined stock position so must ad'ust the number of futures.
h> . 5co$7=
S
(=
F
9
$ar=
F

h> is the $alue of h which minimises risk.
The negati$e sign represents the fact that the two markets mo$e together. So( to hold
spot( futures must be sold.
% problem is that it ignores the risk5return trade5off. The aim is to minimise risk.
&mplicit in this is that you would be willing to gi$e up an infinite amount of return for
a tiny reduction in risk. "owe$er( different in$estors will ha$e different re)uirements
for risk and return.
&n practice( h> can be determined by regressing returns in the stock market on returns
in the futures market,
=
St
. a ? b=
Ft
b . 5h>
Slope in a regression e)uation . co$@$ar. This is a short5hand way of calculating the
hedge ratio. &t is backward5looking: what would ha$e been the best $alue of h o$er
that period.
A. ;hat is the difference between entering into a long forward contract when the
forward price is B64 and taking a long position in a call option when the strike
price is B64C
&n the case of the forward( the in$estor has an obligation to buy the asset for B64. 7The
in$estor does not ha$e a choice.9 &n the other case( the in$estor has an option to buy
the asset for B64. 7The in$estor does not ha$e to exercise the option.9
D. % trader enters into a short cotton futures contract when the futures price is 64
pence per kilo. The contract is for the deli$ery of 64(444 kilos. "ow much does
the trader gain or lose if the cotton price at the end of the contract is 7a9 0E.# pence
per kilo: 61.+ pence per kiloC
7a9 The in$estor is obliged to sell for 64p per kilo something that is worth 0E.#p
per kilo. 1ain . 74.64 5 4.0E#964(444 . BF44
7b9 The in$estor is obliged to sell for 64p per kilo something that is worth 61.+p
per kilo. Goss . 74.61+ 5 4.64964(444 . BA64
E. Suppose that you enter into a A5month forward contract on a non5di$idend5paying
stock when the stock price is H+4 and the risk5free interest rate 7with continuous
compounding9 is 1#I per annum. ;hat is the forward priceC
The forward price is,
F . Se
rT
. +4e
74.1#x4.69
H+1.EA
F. % 15year5long forward contract on a non5di$idend5paying stock is entered into
when the stock price is B04 and the risk5free rate is 14I per annum with
continuous compounding.
7a9 ;hat are the forward price and the initial $alue of the forward
contractC
The forward price( F . Se
rT
( is,
F . 04e
4.1
. 00.#1
The initial $alue of the forward contract is 2ero.
7b9 Six months later( the price of the stock is B06 and the risk5free interest
rate is still 14I. ;hat are the forward price and the $alue of the
forward contractC
The deli$ery price( J( in the contract is B00.#1. The $alue of the
contract( f( after six months is gi$en by,
f . S / Je
5r x T
f . 06 / 00.#1e
54.1 x 4.6
. B#.F6
The forward price is gi$en by,
F . 06e
4.1 x 4.6
. B0D.+1
14. % stock is expected to pay a di$idend of B1 per share in # months and again in 6
months. The stock price is B64 and the risk5free rate of interest is EI per annum
with continuous compounding for all maturities. %n in$estor has 'ust taken a short
position in a A5month forward contract on the stock.
7a9 ;hat are the forward price and the initial $alue of the forward
contractC
The present $alue( &( of the income from the security is gi$en by,
& . Ke
5rT
. e
54.4E x 4.1AAD
? e
54.4E x 4.01AD
. 1.F604
The forward price is gi$en by,
F . 7S / &9e
r x T
. 764 / 1.F609e
4.4E x 4.6
. B64.41
The fact that the forward price is $ery close to the spot price should come as no
surprise. ;hen the compounding fre)uency is ignored the di$idend yield on the stock
e)uals the risk5free rate of interest. The initial $alue of the contract is 7by design9
2ero.
7b9 Three months later( the price of the stock is B0E and the risk5free rate
of interest is still EI per annum. ;hat are the forward price and the
$alue of the short position in the forward contractC
&n three months
& . e
54.4E x 4.1AAD
. 4.FEAE
The deli$ery price( J( is 64.41.The $alue of the short forward contract( f( is gi$en by,
f . 57S / & / Je
5r x T
9
f . 570E / 4.FEAE / 64.41e
54.4E x 4.#6
. #.41
%nd the forward price F is gi$en by
F . 7S / &9e
r x T
F . 70E / 4.FEAE9e
4.4E x 4.#6
. B0D.FA
11. The risk5free rate of interest is DI per annum with continuous compounding and
the di$idend yield on a stock index is +.#I per annum. The current $alue of an
index is 164. ;hat is the A5month futures priceC
Lsing the following e)uation we can work out the A5month futures price,
F . Se
7r5)9T
F . 164e
74.4D54.4+#9x4.6
. B16#.EE