553.

444/644 Introduction to Financial

Principals
Derivatives
• Teaching Assistant(s)
o Xiaan Zhou xzhou62@jhu.edu
o Office Hours: Thur, 1:00 – 3:00pm WH 212
Forward & Futures Contracts o Jiacheng Wu jwu133@jhu.edu
(M2) o Office Hours: Fri, 1:00 – 3:00pm WH 212
o Chenyang Li cli110@jhu.edu
o Office Hours: Mon, 9:30 – 11:30am WH 212
o Siming Tang si.ming.tang@jhu.edu
o Office Hours: Fri, 7:00 – 9:00am WH 212
o Yi (Alice) Yin yyin21@jhu.edu
o Office Hours: T&Th, 9:00 – 10:00am WH 212
o Shiqing Sun ssun27@jhu.edu
o Office Hours: Wed, 10:00 – Noon WH 212
2.1 1.2

1 2

Schedule Schedule
• Lecture Encounters • Section
o Monday & Wednesday, 3:00 - 4:15pm, o When Assigned: Friday
o Shaffer 3 o 644/S1: Shaffer 2, 3:00pm
o When Assigned: Friday o Xiaan Zhou

o 644/S1: Shaffer 2, 3:00pm o 644/S2: Shaffer 302, 10:00am

o Jiacheng Wu
o 644/S2: Shaffer 302, 10:00am
o 644/S3: Maryland 217, 9:00am
o 644/S3: Maryland 217, 9:00am
o Chenyang Li
o 444/S1: Shaffer 302, 9:00am
o 444/S1 : Shaffer 302, 9:00am
o 444/S2: Shaffer 2, 11:00am o Siming Tang
o 444/S2: Shaffer 2, 11:00am
1.3 o Yi (Alice) Yin 1.4

3 4

1

Date 2019
Thursday, August 29, 2019
Wednesday, September 04, 2019
Friday, September 06, 2019
Monday, September 09, 2019
Wednesday, September 11, 2019
Monday, September 16, 2019
Wednesday, September 18, 2019
Friday, September 20, 2019
Monday, September 23, 2019
Wednesday, September 25, 2019 IR Futures ‐ ED (M5);  MT 1 Rev.
Friday, September 27, 2019
Monday, September 30, 2019
Wednesday, October 02, 2019
Friday, October 04, 2019
Schedule Assignment
Module
Introduction (M1)
Due Comments
Hull: 1 ‐2
• For August 29th & September 4th (M1)
Introduction (M1)
Fwd & Fut Contracts (M2) Hull: 3
• Read: Hull Chapter 1 (Introduction)
Fwd & Fut Contracts (M2) HW 1 • Read: Hull Chapter 2 (Futures Markets)
Interest Rates (M3) Hull: 4
Interest Rates (M3) HW 2 • Homework 1: Problems (Due Sept 11th)
Value of Fwds & Futs (M4) Hull: 5
Value of Fwds & Futs (M4) HW 3 o Chapter 1: 17, 18, 22, 23; 39, 40
IR Futures ‐ ED (M5)
HW 4 Hull: 6
o Chapter 1 (9e): 17, 18, 22, 23; 39, 40
Section: HW Problem Review All HW Returned (NLT) o Chapter 1 (8e): 17, 18, 22, 23; 34, 35
Midterm Sample Q
Midterm 1 Exam M1 ‐ M5 o Chapter 2: 15, 21, 22; 28, 31
Midterm 1 Exam Return o Chapter 2 (9e): 15, 21, 22; 28, 31
o Chapter 2 (8e): 15, 21, 22; 27, 30

1.5 1.6

5 6

Assignment Assignment
• For September 6th & 9th (M2) • For September 11 & 16th (M3)
• Read: Hull Chapters 3 (Hedging w/ Futures) • Read: Hull Chapter 4 (Interest Rates)
• Homework 2: Problems (Due Sept 16th) • Homework 3: Problems (Due Sept 23rd)
o Chapter 3: 4, 7, 10, 17, 18, 20, 22; 32 o Chapter 4 (9e): 5, 8, 9, 11, 12, 14, 16, 22; 34
o Chapter 3 (9e): 4, 7, 10, 17, 18, 20, 22; 32 o Chapter 4 (8e): 5, 8, 9, 11, 12, 14, 16, 22; 32
o Chapter 3 (8e): 4, 7, 10, 17, 18, 20, 22; 26 o Chapter 4 (7e): 5, 8, 9, 11, 12, 14, 16, 22; 27

2.8
1.7

7 8

2
 Where we are Types of Traders

o Previously o Hedgers
o Introduced some general ideas & concepts in o Speculators
Options, Forwards, & Futures (Chapter 1, OFOD)
o Looked at some basic ideas/mechanics of Futures o Arbitrageurs
Markets (Chapter 2, OFOD)
o Now
Some of the largest trading losses in derivatives have
o Hedging Approaches/Techniques using Futures
occurred because individuals who had a mandate to be
o The basis and basis risk (Chapter 3, OFOD)
hedgers or arbitrageurs switched to being speculators (For
o Next example, SocGen (Jerome Kerviel) and others in Business
o Interest Rates and the Present Value of Future Snapshot 1.4, page 18)
Cash (Chapter 4, OFOD)
2.10 2.11

10 11

Hedging Examples (pages 11-13) Hedging Example

• A US company will pay £10 million for imports
from Britain in 3 months and decides to hedge
using a long position in a forward contract
• An investor owns 1,000 shares currently worth
$28 per share. A two-month put option with a
strike price of $27.50 costs $1. The investor
decides to hedge by buying 10 put contracts
2.12
• A US company will pay £10 million for imports
from Britain in 3 months and decides to hedge
using a long position in a forward contract
• Possible strategies:
o Buy £ now, deposit in bank, withdraw £10 million in 3
months, pay for imports
o Buy £10 million forward in 3 months, deposit USD, use
deposit proceeds to settle and pay for imports
o Do nothing now and buy £10 million in the spot FX
market in 3 months
• First 2 are riskless, third has currency risk.
• Which makes most sense?
2.13

12 13

3
 Value of Shares with and without Hedging Speculation Example
40,000 Value of
Holding ($)
• An investor with $2,000 to invest feels that a
35,000 stock price will increase over the next 2 months.
No Hedging The current stock price is $20 and the price of a
30,000
@$28/share
Hedging 2-month call option with a strike of 22.50 is $1
25,000
Put w/K=27.50 • What are the alternative strategies (& outcomes
Stock Price ($)
if price goes to $27)?
20,000
20 25 K=27.50 30 35 40
o Buy 100 shares for $2000 (+$700) or
o Buy 20 Calls for $2000 (on 100 shares each) (+7000)
• An investor owns 1,000 shares currently worth $28 per
share. A two-month put option with a strike of $27.50 costs • What happens if price drops to $15?
$1. The investor decides to hedge by buying 10 contracts. o Loose $500 vs. wiped out!
2.14 2.15

14 15

Arbitrage Example Accounting & Tax

• Ideally hedging profits (losses) should be
• A stock price is quoted as £100 in London and
recognized at the same time as the losses
$140 in New York (profits) on the item being hedged
• The current exchange rate is 1.4410 o Then there is the exchange (LTCM)
• What is the arbitrage opportunity? • Ideally profits and losses from speculation
should be recognized on a mark-to-market
basis
• Buy 100 shares in NY; sell 100 in London: The
• Roughly speaking, this is what the accounting
net money is and tax treatment of futures in the U. S. and
o = $ proceeds from sale in London net the cost in NY many other countries attempts to achieve
o = 100 [(1.441 x 100) – 140] = 410
2.16 2.17

16 17

4
 Forward Contracts vs Futures Contracts –
Futures Contracts
Recap
• Available on a wide range of underlying
FORWARDS FUTURES
• Exchange traded
Private contract between 2 parties Exchange traded
• Specifications need to be defined:
Non-standard contract Standard contract
o What can be delivered,
Usually 1 specified delivery date Range of delivery dates
o Where it can be delivered, &
Settled at end of contract Settled daily
o When it can be delivered
• Settled daily (Margin) Delivery or final cash Contract usually closed out
settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

2.18 2.19

18 19

Margin Key Points About Futures

• Margin is cash or marketable securities • They are settled daily

deposited by an investor with the broker • Closing out a futures position
o Initial Margin involves entering into an offsetting
o Maintenance Margin
trade
• Most contracts are closed out before
• The balance in the margin account is adjusted to
maturity
reflect daily settlement
• Margin minimize the possibility of a loss through
• Differences from Forwards
a default on a contract

2.20 2.21

20 21

5
 Collateralization in OTC Markets Another Detail for Cash and Carry Arbitrage

• It is becoming increasingly common for • Contract price changes with longer term
derivatives contracts to be collateralized in the o Higher or Lower
OTC markets • To this point we have neglected storage cost
• They are then similar to futures contracts in that • Lets re-visit no-arbitrage equation
they are settled regularly (e.g. every day or every F(t0,T) - S(t0) x [(1+r )T ] = Storage (T)
week)
• Storage costs ignored in earlier gold example
• No storage costs for FX
• Convenience Yield for holding commodity:
F (t0 )  (1  c)T  S (t0 ) (1  r )T   Storage(T )
2.22 2.23

22 23

Another Detail for Cash and Carry Arbitrage 1. Oil: An Arbitrage Opportunity?

• Contract price changes with longer term Suppose that:

o Higher or Lower - The spot price of oil is US$95
• To this point we have neglected storage cost - The quoted 1-year futures price of
oil is US$125
• Lets re-visit no-arbitrage equation
F  t0 , T   S  t 0  x[(1  r )T ]  Storage T  
- The 1-year US$ interest rate is
5% per annum
F  t0 , T   S  t 0  x[(1  r )T ]  Storage T  - The storage costs of oil are 2% per
• Storage costs ignored in earlier gold example annum
• No storage costs for FX Is there an arbitrage opportunity?

2.24 2.25

24 25

6
 2. Oil: Another Arbitrage Opportunity? Futures Prices for Gold on Jan 8, 2007:
Prices Increase with Maturity
Suppose that:
- The spot price of oil is US$95 650

- The quoted 1-year futures price of

Futures Price ($ per oz)

640

oil is US$80 630

- The 1-year US$ interest rate is 620

610
5% per annum Contract Maturity Month

- The storage costs of oil are 2%

600
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

per annum
Is there an arbitrage opportunity?

2.26 2.27

26 27

Futures Prices for Orange Juice on Jan 8, Convergence of Futures to Spot

2007: Prices Decrease with Maturity

210
Futures Price (cents per lb)

205
200
195 Futures
Spot Price
190 Price
185
180 Spot Price Futures
175 Contract Maturity Month
Price
170
Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07
Time Time

(a) (b)

2.28 2.29

28 29

7
 Delivery Some Terminology
• If a futures contract is not closed out before • Open interest: the total number of contracts
maturity, it is usually settled by delivering the outstanding
assets underlying the contract. When there are o equal to number of long positions or
alternatives about what is delivered, where it is number of short positions
delivered, and when it is delivered, the party with • Settlement price: the price just before the final
the short position chooses. bell each day
• A few contracts (for example, those on stock o used for the daily settlement process
indices and Eurodollars) are settled in cash
• Volume of trading: the number of contracts
traded in 1 day

2.30 2.31

30 31

Questions Questions
• When a new trade is completed what • On the floor of the exchange, one futures
are the possible effects on the open contract is traded where both the long and
interest? short parties are closing out existing positions.
What is the change in open interest?
• Can the volume of trading in a day be A. No Change
greater than the open interest?
B. Decrease by One
C. Decrease by Two
D. Increase by One

2.32 2.33

32 33

8
 Questions Regulation of Futures
• Can the volume of trading in a day be • Regulation is designed to protect the
greater than the open interest? public interest
A. True o CFTC – the Feds
B. False • Regulators try to prevent questionable
trading practices by either individuals
on the floor of the exchange or outside
groups
o NFA – the industry

2.34 2.35

34 35

Accounting & Tax Foreign Exchange Quotes

• Ideally hedging profits (losses) should be
recognized at the same time as the losses
(profits) on the item being hedged
o Then there is the exchange (LTCM)
• Ideally profits and losses from speculation
should be recognized on a mark-to-market
basis
• Roughly speaking, this is what the accounting
and tax treatment of futures in the U. S. and
many other countries attempts to achieve
• Futures exchange-rates are quoted as the
number of USD per unit of the foreign currency
• Forward exchange rates are quoted in the same
way as spot exchange rates. This means that
GBP, EUR, AUD, and NZD are quoted as USD
per unit of foreign currency. Other currencies
(e.g., CAD and JPY) are quoted as units of the
foreign currency per USD.

2.36 2.37

36 37

9
 Arguments in Favor of Hedging Arguments against Hedging

• Shareholders are usually well diversified and can

Companies should focus on the main
business they are in and take steps to
minimize risks arising from interest rates,
exchange rates, and other market variables
make their own hedging decisions
o Assumes shareholders have as much information
about a company as management
• It may increase risk to hedge when competitors
do not
• Explaining a situation where there is a loss on the
hedge and a gain on the underlying can be
difficult

2.41 2.42

41 42

Basis Risk Convergence of Futures to Spot

(Hedge initiated at time t1 and closed out at time t2)
• Basis is the difference between spot & futures
• Basis risk arises because of the uncertainty
about the basis when the hedge is closed out Futures
Price
• Basis risk is also about the reality that the
asset to be hedged may not be the same as
that underlying the futures Spot
Price

Time

t1 t2

2.44 2.45

44 45

10
 Long & Short Hedges
• A long futures hedge is appropriate when you
know you will purchase an asset in the future
and want to lock in the price
• A short futures hedge is appropriate when you
know you will sell an asset in the future & want
to lock in the price
Short Hedge – Basis Risk
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S1 : Initial Asset Price
S2 : Final Asset Price
• You hedge the future sale of an asset (one in which you now
might be long) by entering into a short futures contract
P/L = – (S1 – F1) + (S2 – F2) = (S2 – S1) – (F2 – F1)
= [S2 – (F2 – F1)] – S1 = [F1 + (S2 – F2)] – S1
• Price Realized @ t2 (w/hedging) when selling the long asset
= F1 + (S2 – F2) = F1 + Basis (at 2)
• Basis increase equals basis strengthening

2.46 2.47

46 47

Long Hedge – Basis Risk Convergence of Futures to Spot

(Hedge initiated at time t1 and closed out at time t2)
• Suppose that
F1 : Initial Futures Price
F2 : Final Futures Price
S1 : Initial Asset Price Futures
Price
S2 : Final Asset Price
• You hedge the future purchase of an asset (one you now
might be short) by entering into a long futures contract
P/L = (S1 – F1) – (S2 – F2) = (S1 – S2) – (F1 – F2) Spot
= S1 – [S2 – (F2 – F1)] = S1 – [F1+ (S2 – F2)] Price
• Price Paid @ t2 (w/hedging) to buy-in short asset
= F1+ (S2 – F2) = F1 + Basis (at 2) Time

t1 t2

2.48 2.51

48 51

11
 Choice of Contract – to Minimize Basis Risk Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2)

• Choose a delivery month that is as close as

possible to, but later than, the end of the life of
Futures
the hedge Price
• When there is no futures contract on the asset
being hedged, choose the contract whose futures
Spot
price is most highly correlated with the asset Price
price. This is known as cross hedging.
Time

t1 t2

2.52 2.53

52 53

Choice of Contract – to Minimize Basis Risk Optimal Hedge Ratio

• Hedging using Futures
• Choose a delivery month that is as close as
possible to, but later than, the end of the life of
the hedge
• When there is no futures contract on the asset
being hedged, choose the contract whose futures
price is most highly correlated with the asset
price. This is known as cross hedging.
o Proportion of the exposure in a cash position that
should optimally be hedged when cross hedging is

 S
F
where
o S is the standard deviation of S, the change in the spot
price (for the cash instrument) during the hedging period,
o F is the standard deviation of F, the change in the
futures price during the hedging period
o  is the coefficient of correlation between S and F.
o How is this so?

2.58
2.57

57 58

12
 Optimal Hedge Ratio – Minimum Variance Optimal Hedge Ratio – Minimum Variance
Result Result
• The number of futures, NF, in ratio h (the hedge ratio, or NF = h • Minimizing the variance (Var) of the P/L
x NA), required to hedge NA units of an asset between times t1
and t2 follows from the P/L of the hedged position over that time:
P/L = NA x (ΔS – h ΔF)
P/L = (NAS2 – NFF2) – (NAS1 – NFF1) • Is equivalent to
(long asset, hedge w/short futures) min [Var(ΔS – h ΔF)]
= NA ΔS – NF ΔF = NA x (ΔS – h ΔF) ( NF = h x NA ) where S1 , where the variance of this linear combination of F & S ,
F1 and S2 , F2 ( ΔS & ΔF ) are the spot price of the asset, S, and ν = Var [ΔS – h ΔF] = S2 + h2 F2 – 2 h S F
the futures, F, at t1 and t2 , respectively (or their respective
• We minimize ν when h is such that dν/dh = 0 if d2ν/dh2 > 0
changes, Δ) 
• The minimum variance hedge ratio (the optimal) can be found or 2 h F2 – 2 S F = 0 which implies h S
F
by minimizing the variance of the P/L (w/r to the hedge ratio)

2.59 2.60

59 60

Optimal Hedge Ratio Optimal Hedge Ratio – Minimum Variance

Result
• Regressing on the change in asset • Example 3.3 (Pg 61) Minimum Variance Hedge on Jet
Fuel using Heating Oil Futures Change in  Change in Fuel 
price to the change in the futures Month 
(=i)
Futures price per price per gallon 
gallon (=xi) (=yi)

price o HR = .78 (see below right)

1
2
0.021
0.035
0.029
0.020

• Optimized to minimize variance o Heating oil contract = 42,000 gal

3
4
‐0.046
0.001
‐0.044
0.008

o Jet Fuel to be Hedged = 2 mm gal 5

6
0.044
‐0.029
0.026
‐0.019
7 ‐0.026 ‐0.010
8 ‐0.029 ‐0.007
o Number of Contracts (#Contr) 9
10
0.048
‐0.006
0.043
0.011
• Optimal Hedge Ratio is 11 ‐0.036 ‐0.036
 2, 000, 000  12 ‐0.011 ‐0.018
the minimum variance #Contr  0.78   42, 000   37.14  37 13 0.019 0.009
  14 ‐0.027 ‐0.032

hedge
15 0.029 0.023

stddev 0.0313 0.0263

correl 0.928 S .0263
HR 0.78 h*    .928  .78
F .0313
2.61 2.64

61 64

13
 Tailing the Hedge Tailing the Hedge

• Two ways to determine the number of contracts to use • For the Jet Fuel Example the “tail” suggests
for hedging are h*  VA
N* 
VF
o Compare the exposure to be hedged with the exposure of
o Where we need to know the fuel (A) price ( = $1.94)
the assets underlying one futures contract (previous slide)
and the futures (F) price ( = $1.99)
o Compare the value to be hedged, VA , with the value of one
futures contract, VF ( = futures price times the size of one o Now we have for value VA  2, 000, 000 1.94  3,880, 000
futures contract ) (next slide) VF  42, 000 1.99  83,580

• The second approach incorporates an adjustment that o So the optimal number of contracts is
could be said to accommodate for the daily settlement N* 
h*  VA 0.78  3,880, 000
  36.22  36
VF 83,550
of futures

2.65 2.66

65 66

Hedging Using Index Futures Example

To hedge the risk in a portfolio the number Value of S&P 500 Index is 1,000
of contracts that should be shorted for the $Value of Portfolio is $5 million
corresponding index is Beta of portfolio is 1.5
P

A What position in futures contracts on the S&P 500
where P is the value of the portfolio, is its is necessary to hedge the portfolio?
beta to the index, and A is the value of the
assets underlying one futures contract on
(1 S&P futures contract has $value ≜ $250 x index)
the index

2.69 2.70

69 70

14
 Example Changing Beta
Value of S&P 500 Futures is 1,000 x 250 dollars
• What position is necessary to reduce the beta of
$Value of Portfolio is $5 million the portfolio to 0.75? (15)
Beta of portfolio is 1.5
• What position is necessary to increase the beta
What position in futures contracts on the S&P 500 of the portfolio to 2.0? (long 10)
is necessary to hedge the portfolio?
P 5,000,000
N *    1.5   1.5  20  30 • How so?
A 1000  250
Short 30 contracts
2.71 2.72

71 72

Changing Beta Hedging Price of an Individual Stock

• What position is necessary to reduce the beta
• Similar to hedging a portfolio
of the portfolio to 0.75?
• Does not work as well because only the
• What position is necessary to increase the beta
systematic risk is hedged
of the portfolio to 2.0?
• The “un-systematic” (idiosyncratic) risk that is
• If we change the beta of the PF from    *
   *; then short (    *) 
P unique to the stock is not hedged
A
P
   *; then long (  *   ) 
A
• With   1.5 its short 15 or long 10, respectively
(P/A = 20, from 2 slides earlier)
2.73 2.74

73 74

15
 Why Hedge Equity Returns Rolling The Hedge Forward

• May want to be out of the market for a while. • We can use a series of futures contracts to
Hedging avoids the costs of selling and increase the life (term) of a hedge
repurchasing the portfolio – but not for free
• Each time we switch from 1 futures contract
• Suppose stocks in your portfolio have an average
beta of 1.0, but you feel they have been chosen to another we incur a type of basis risk
well and will outperform the market in both good
and bad times. Hedging ensures that the return
you earn is the risk-free return plus the excess
return of your portfolio over the market.

2.75 2.76

75 76

The End for Module 2 Hedging with Futures

• In October 2017 a company anticipates it will buy 1mm
• Questions pounds of copper in each of the following months:
Feb 2018, Aug 2018, Feb 2019, & Aug 2019

o CME contract is for 25,000 pounds

o Initial margin $2,000 per and maintenance margin is $1,500
per contract
o Liquidity demands contracts of 13 months or shorter
o Hedge to 80% of exposure
o What is a possible hedging strategy?

1.77 3.78

77 78

16
 Hedging with Futures
• Assume mkt. price in cents per pound today and at
futures dates are as follows:
Date Oct 2017 Feb 2018 Aug 2018 Feb 2019 Aug 2019
Spot Price 372.00 369.00 365.00 377.00 388.00
Mar 2018 Futures Price 372.30 369.10
Sep 2018 Futures Price 372.80 370.20 364.80
Mar 2019 Futures Price 370.70 364.30 376.70
Sep 2019 Futures Price 364.20 376.50 388.20

• What is the impact of the hedging strategy on the price

the company pays for copper?
• What is the initial margin requirements?
• Is the company subject to any margin calls?
• HW 3.32
3.79

79

17