MSc Finance - Derivatives. University of Bristol

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MSc Finance - Derivatives. University of Bristol

© All Rights Reserved

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Вы находитесь на странице: 1из 21

(Pricing Contracts)

Nick Taylor

nick.taylor@bristol.ac.uk

University of Bristol

Table of contents

1 Learning Outcomes

2 General Information

6 Summary

7 Reading

Learning Outcomes

1 Understand the basic mechanics of futures markets.

2 Price various types of forward and futures contracts.

3 Understand why theoretical prices equal market prices (arbitrage proofs).

4 Describe the relationship between futures prices and expected future spot

prices.

5 Understand the concept of hedging.

General Information

The following information is specified in each contract:

The asset (including quality if appropriate).

The contract size.

Delivery arrangements.

Delivery months.

Price quotes.

Price limits and position limits.

General Information

The following process is undertaken when buying futures contracts:

Brokers require investors to deposit funds into a margin account.

When the contract is opened investors deposit an initial margin (equal

to a proportion of the contract size).

The margin account is adjusted at the end of each trading day

(marking to market the account).

A lower limit (the maintenance margin) is placed on the margin

account.

If the balance in the margin account falls below the maintenance

margin then a margin call is made (these extra funds are called

variation margin).

Example

An investor takes a long position in two December gold futures contracts on

June 5. The contract size is 100 oz, the futures price is $600/oz, the margin

requirement is $2000/contract ($4000 in total), and the maintenance margin is

$1500/contract ($3000 in total).

Futures Daily gain Cumulative Margin account Margin

price (loss) gain (loss) balance call

Day ($) ($) ($) ($) ($)

600.00 4000.00

June 5 597.00 600.00 600.00 3400.00

.. .. .. .. ..

. . . . .

June 13 593.30 420.00 1340.00 2660.00 1340.00

.. .. .. .. ..

. . . . .

June 19 587.00 1140.00 2600.00 2740.00 1260.00

.. .. .. .. ..

. . . . .

June 26 592.30 260.00 1540.00 5060.00

General Information (cont.)

Newspaper Quotes

In newspapers (and on webpages; see, e.g., www.nymex.com), you will be

see the following information (in additional to the open, intraday high, and

intraday low prices):

Settlement Price: the trade price immediately prior to the close of

trading.

Open Interest: the total number of contracts outstanding (i.e., the

number of long, or short, positions).

Two types of traders execute trades: commission brokers and locals.

Order Types

A number of different orders can be placed:

Market order: execute immediately at best price available.

Limit order: execute only at specified price or better.

Others: stop-loss, stop-limit, market-if-touched, discretionary,

time-of-day, good-till-cancelled, fill-or-kill orders.

General Information (cont.)

The key differences between forward and futures contracts can be

summarised as follows:

Forwards Futures

Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash settlement usually Contract usually closed out prior to

occurs maturity

Some credit risk Virtually no credit risk

Assumptions

The following assumptions are required:

1 No transaction costs.

2 Short selling is permitted.

3 All investors face the same tax rate on trading profits.

4 Borrowing and lending rates are equal.

Cost of Carry Model (cont.)

The theoretical price of a forward contract on an asset that provides no

income is given by

F = Se rT ,

where F is the (current) forward price at time 0, S is the (current) spot

price at time 0, r is the risk-free interest rate, and T is the maturity date of

the contract.

arbitrage opportunity will exist.

If F > Se rT then:

Terminal Value

Action Initial Value ST F ST > F

Long asset S ST ST

Short forward 0 (ST F ) (ST F )

Borrow S Se rT Se rT

Total 0 F Se rT > 0 F Se rT > 0

If F < Se rT then:

Terminal Value

Action Initial Value ST F ST > F

Short asset S ST ST

Long forward 0 ST F ST F

Lend S Se rT Se rT

Total 0 Se rT F > 0 Se rT F > 0

Cost of Carry Model (cont.)

The theoretical price of a forward contract on an asset that provides a

known income is given by

F = (S I )e rT ,

where I is the present value of the income received during the life of the

contract. When an asset incurs storage costs, then I becomes a negative

income.

arbitrage opportunity will exist.

If F > (S I )e rT then:

Terminal Value

Action Initial Value ST F ST > F

Long asset S ST + Ie rT ST + Ie rT

Short forward 0 (ST F ) (ST F )

Borrow S Se rT Se rT

Total 0 F (S I )e rT > 0 F (S I )e rT > 0

If F < (S I )e rT then:

Terminal Value

Action Initial Value ST F ST > F

Short asset S ST Ie rT ST Ie rT

Long forward 0 ST F ST F

Lend S Se rT Se rT

Total 0 (S I )e rT F > 0 (S I )e rT F > 0

Cost of Carry Model (cont.)

The theoretical price of a forward contract on an asset that provides a

known yield is given by

F = Se (r q)T ,

where q is the (average) yield per annum on an asset during the life of the

forward contract. This yield represents an income (or cost) expressed as a

percentage of the asset price, e.g., a dividend yield.

arbitrage opportunity will exist.

Terminal Value

Action Initial Value ST F ST > F

Long asset Se qT ST ST

Short forward 0 (ST F ) (ST F )

Borrow Se qT Se (r q)T Se (r q)T

Total 0 F Se (r q)T > 0 F Se (r q)T > 0

Terminal Value

Action Initial Value ST F ST > F

Short asset Se qT ST ST

Long forward 0 ST F ST F

Lend Se qT Se (r q)T Se (r q)T

Total 0 Se (r q)T F > 0 Se (r q)T F > 0

Cost of Carry Model (cont.)

A Generalisation

If the risk-free interest rate is constant, and the same for all maturities, then

the forward price of a contract with a certain delivery date is the same as

the futures price of a contract with the same delivery date.

a divergence between forward and

futures prices; viz., taxes, transaction

costs, the treatment of margins, credit

risk, and liquidity. However, for most

purposes, it is safe to assume that

forward and futures prices are equal.

Applications

Stock index futures

This type of contract tracks changes in the value of a hypothetical

portfolio of stocks, e.g., S&P 500, Nikkei 225 Index, and the FTSE 100.

These futures are settled in cash.

Dividends paid by securities in the portfolio are received by the holder

of the portfolio. Therefore, these futures contracts are priced as in Case

Three above.

Cost of Carry Model (cont.)

Applications (cont.)

Stock index futures (cont.)

Example

Consider a 3-month futures contract on the S&P 500. Suppose that the stocks

underlying the index provide a dividend yield of 1% per annum, that the current

value of the index is 1300, and that the continuously compounded risk-free

interest rate is 5% per annum. In this case, r = 0.05, S = 1300, T = 0.25, and

q = 0.01. Therefore, the theoretical futures price is given by

Note that if F 6= 1313.07 then index arbitrage would be undertaken until the

equality held.

Warning: Index arbitrage involves buy or selling all the stocks within the index.

Is this realistic? Can this particular aspect of the arbitrage process be achieved

in a more simplistic manner?

Applications (cont.)

Forward and futures contracts on currencies

This type of contract assumes that the underlying asset is one unit of

the foreign currency.

The current spot price in dollars of one unit of the foreign currency is S.

The forward (or futures) price in dollars of one unit of the foreign

currency is F .

As foreign currency gives the holder of the currency the right to earn

interest at the risk-free rate prevailing in the foreign country, then these

contracts are priced as in Case Three above, with q replaced by the

foreign interest rate rf .

Cost of Carry Model (cont.)

Applications (cont.)

Forward and futures contracts on currencies (cont.)

Example

If the 2-year interest rates in Australia and the United States are 5% and 7%,

respectively, and the spot exchange rate between the Australian dollar (AUD)

and the US dollar (USD) is 0.6200 USD per AUD, then the 2-year forward rate

should be

F = Se (r rf )T = 0.62e (0.070.05)2 = 0.6453.

Suppose the 2-year forward rate is say 0.6300, then an arbitrageur can:

Terminal Value

Action Initial Value ST F ST > F

Borrow AUD 0.6200e rf T ST ST

Long forward 0 ST 0.6300 ST 0.6300

Lend USD 0.6200e rf T 0.6453 0.6453

Total 0 0.0153 0.0153

Note: Take reverse positions if the observed (market) forward price is greater

than the theoretical price.

Applications (cont.)

Futures on commodities

This type of contract assumes that the underlying asset is a commodity

(e.g., gold).

They differ from other futures contracts in that the underlying asset

incurs storage costs.

Note that some commodities such as gold and silver earn income when

they are held (referred to as the gold lease rate).

Cost of Carry Model (cont.)

Applications (cont.)

Futures on commodities.

The presence of non-zero storage costs means that the following

formulae must be used to price such futures contracts:

F = (S + U)e rT ,

where U is the present value of all the storage costs (net of income)

during the life of the forward contract.

If storage costs are proportional (to the underlying asset value) then

the following formulae must be used:

F = Se (r +u)T ,

Applications (cont.)

Futures on commodities (cont.)

Example

Consider a 1-year futures contract on an investment asset with no income. It

costs $2 per asset to store, with the payment made at the end of the year.

Assume that the spot price is $450 per unit and the risk-free rate is 7% per

annum for all maturities. The present value of storage costs is

U = 2e (0.071) = $1.8648.

Cost of Carry Model (cont.)

Applications (cont.)

Futures on commodities (cont.)

Example (cont.)

Suppose that the market futures price is $500. In this instance, an arbitrageur

can:

Terminal Value

Action Initial Value ST F ST > F

Long asset 450 ST 2 ST 2

Short futures 0 500 ST 500 ST

Borrow 450 482.6287 482.6287

Total 0 15.3713 15.3713

Note: Take reverse positions if the observed (market) futures price is less than

the theoretical price.

Applications (cont.)

Futures on commodities (cont.)

Owners of consumption commodities may benefit from the ownership

of the physical commodity (as opposed to ownership of the futures

contract associated with the consumption commodity).

This will drive a wedge between the theoretical and market prices of

futures contracts on consumption commodities.

The benefit is referred to as the convenience yield.

Cost of Carry Model (cont.)

Applications (cont.)

Futures on commodities (cont.)

In the presence of known (non-proportional) storage costs, the

convenience yield y is defined such that

Fe yT = (S + U)e rT .

such that

Fe yT = Se (r +u)T .

In both cases, the convenience yield measures the extent to which the

left-hand side is less than the right-hand side in the above equations.

Speculators require compensation for the risks they are taking, while

hedgers are prepared to pay a price to avoid risk.

This leads to the following implication: If hedges tend to hold short

(long) positions and speculators tend to hold long (short) positions

then the futures prices of an asset will be below (above) the expected

spot price (in the future).

The difference between the futures price and the expected spot price is

the compensation to speculators.

Futures Prices and Expectations (cont.)

Speculators will be rewarded for taking on systematic risk.

Let a speculator take a long position in a futures contract in the hope

that the assets price will be above the futures price at maturity.

Assume that the speculator invests the present value of this futures

price in a risk-free asset.

The proceeds of this risk-free investment are used to buy the asset at

maturity (which is then sold immediately at the prevailing market

price).

In equilibrium, the present value of this investment (and indeed all

investment opportunities) is zero, thus

Fe rT + E (ST )e kT = 0,

where k is the investors required rate return for this investment, and

E (.) is an expectations operator. Rearranging,

F = E (ST )e (r k)T ,

Futures Prices and Expectations (cont.)

In the presence of zero systematic risk: k = r F = E (ST ).

In the presence of positive systematic risk: k > r F < E (ST )

(normal backwardation).

In the presence of negative systematic risk: k < r F > E (ST )

(contango).

Basic Principles

The objective of hedgers is to reduce a particular risk they face. If the risk is

completely eliminated then it is referred to as a perfect hedge. Also, hedges

can be categorised as follows:

Short Hedges

E.g. An oil producer negotiates sale of 1 million barrels of crude oil three months in

the future at the prevailing market price. Shorting crude oil futures contracts with a

maturity of three months will hedge the exposure.

Long Hedges

E.g. A copper fabricator requires 100000 tons of copper in three months time.

Taking a long position in copper futures contracts with a maturity of three months

will hedge the exposure.

Hedging Using Futures (cont.)

Basis Risk

Perfect hedges are rare because

1 The asset (price) to be hedged may not be the same as the asset

underlying the futures contract.

2 The hedger may be uncertain about the date when the asset will be

bought/sold.

3 The hedge may require that the futures contract be closed out before

its maturity.

These issues give rise to basis risk.

The basis is defined as the spot price of the asset to be hedged minus

the futures price of the contract used.

The basis converges to zero. However, if the hedge position is closed at

t2 and the value of the basis at t2 was not known when the position

was initiated (say at time t1 ) then basis risk occurs.

For instance, consider a hedger who

knows that the asset will be sold at

time t2 and takes a short futures

position at time t1 . The price realised

for the asset is S2 and the profit on

the futures position is F1 F2 . So, the

effective price obtained for the asset

with hedging is S2 + F1 F2 =

F1 + b2 . The basis risk is the

uncertainty associated with b2 .

Hedging Using Futures (cont.)

Cross Hedging

Cross hedging occurs when the asset underlying the futures contract is

different from the asset whose price is being hedged. The following

quantities are important:

The Hedge Ratio: the ratio of the size of the position taken in futures

contracts to the size of the exposure.

The Minimum Variance Hedge Ratio: the proportion of the exposure

that should optimally be hedged is

S

h = ,

F

where S is the standard deviation of S (the change in the spot price

during the hedging period), F is the standard deviation of F (the

change in the futures price during the hedging period), and is the

coefficient of correlation between S and F .

Cross Hedging (cont.)

The Minimum Variance Hedge Ratio (cont.): this is the slope of the

ordinary least squares regression of S on F , with the R 2 value from

this regression representing the hedging effectiveness.

The Optimal Number of Contracts: the number of futures contracts

required is given by

h QA

N = ,

QF

where QA is the size of the position being held (units), and QF is the

size of one futures contract (units).

Note that if you wish to adjust for

daily settlement (referred to as tailing

the hedge), then QA and QF are

replaced by VA and VF , respectively,

where VA is the dollar value of the

position being traded, and VF is the

dollar value of one futures contract.

Hedging Using Futures (cont.)

Consider the following hedging scenarios:

Equity Portfolio Hedging: to hedge the risk in a portfolio, the number

of contracts that should be shorted is

VP

N = ,

VF

where VP is the value of the portfolio, is its beta, and VF is the

value of one futures contract.

Equity Portfolio Hedging (cont.):

Example

An owner of a portfolio worth $5050000 with a of 1.5, wishes to hedge

his/her exposure. The current S&P 500 futures price is 1010; therefore, the

value of one futures contract is $250 1010 = $252500. It follows that the

number of futures contracts that should be shorted to hedge the portfolio is

5050000

N = 1.5 = 30.

252500

does not work as well because only the systematic risk is hedged (the

unsystematic risk that is unique to the stock is not hedged).

Hedging Using Futures (cont.)

If the expiration date of the hedge is later than the delivery dates of all

available futures contracts then we can use a series of futures contracts to

increase the life of a hedge.

Note that each time we switch from

one futures contract to another we

incur a type of basis risk.

Summary

Specifics, daily settlement, forward vs. futures contracts.

The Cost of Carry Model

Investment assets under various income and storage cost assumptions, and

consumption commodities with convenience yields.

Expectations and Futures Prices

The traditional and modern approaches to the relationship between futures

prices and expected future spot prices.

Hedging Using Futures

Various concepts relating to hedging.

Reading

Essential Reading

Chapters 3 and 5, Hull (2015).

Further Reading

Petersen, M., and R. Thiagarajan, 2000, Risk management and hedging:

with and without derivatives, Financial Management 29, 530.

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