Risk Management and

Derivatives
Lecture 06:
Forwards and Futures 2

Unit Content
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures 1
Week 7: Forwards and Futures 2
Week 8: Mid-Semester Exam and Reflective Practices
Week 9: Forward Rate Agreement (FRAs) and Swaps
Week 10: Options: introduction and pricing with the binomial
model
Week 11: Options: pricing with the Black-Scholes model
Week 12: Options: trading strategies and risk management
Week 13: Derivative Disasters
2
Week 14: Revision

Lecture Outline

Forward Pricing
Forward Value
Futures Value
Fixed Income Review
Interest Rate Futures
Hedging
Risk Management

Readings:
Hull et al. (2013) Fundamentals of Futures and Options,
Ch. 5 (not 5.10) and Ch. 6

Forward Pricing
Preliminaries:
Investment Assets
held primarily for investment (stocks, bonds)

Consumption Assets
held primarily for consumption (oil, pork)

Short Selling (covered short selling)

Selling an asset that you do not own by borrowing it first. By
borrowing, you have the obligation to return the asset in the future.
Usually performed through a full-service broker. Note that the
shorter must pay any dividends or interest normally earned on the
security.

Assumptions
No transactions costs, homogenous tax rate, risk-free rate for
borrowing and lending, and the law-of-one-price holds (no arbitrage).

Forwards vs. Futures

At present, Im treating them as the same.
4

Forward Pricing
Notation
0

F0,T

Ft,T

FT,T

S0

St

ST

ft

f0

fT

F0,T is the current price of the forward contract with delivery at T

Ft,T is the forward price after 0 but before T; at day t
FT,T is the price at maturity (T) of the forward contract with delivery at
T
S0, St and ST are the spot prices at 0, t and T, respectively.
f0, ft and fT represent the value of the forward contract at 0, t and T,
respectively.
r is the continuous compounding, annual risk-free rate. A common
practice is to use LIBOR as this reference rate (London Interbank Offer
Rate).
5

Forward Pricing
Non-Dividend Paying Stock:
S0 = 40.00, r = 5.00%, F0,T = 43.00 and T = 3/12
Given this information, an arbitrage exists
NOW
1. Borrow $40 to purchase the stock 40.00
2. Purchase the stock (40.00)
3. Short (sell) the forward
0.00
0.00
THEN
4. Deliver stock through forward 43.00
5. Repay loan, 40e(0.05/4)
(40.50)
2.50

Note that the transactions associated with arbitrage remove the

ability to continue arbitrage as buying the stock will increases its
price while
selling the forward will decrease its price.
6

Forward Pricing
Non-Dividend
Paying Stock:

S0 = 40.00, r = 5.00%, F0,T = 39.00 and T = 3/12

Given this information, an arbitrage exists
NOW
1. Short sell the stock
40.00
2. Invest short sale proceeds at
(40.00)
3. Long (buy) the forward
0.00
0.00
THEN
4. Investment matures, 40e(0.05/4)
40.50
5. Purchase stock through forward
(39.00)
6. Return stock to broker
0.00
1.50

Forward Pricing
No
arbitrage forward price:

because of the cost of the financing the asset during the

life of the forward contract. This is why this model is
referred to as the cost-of-carry model.

What if no short sales were allowed

Result will still hold:
, shorting not required to arbitrage
, the investors who own the asset will sell the asset, invest the
proceeds to earn and buy the forward. As such that the amount they
purchase the asset back for at , is less than the amount the will
receive from their investment to earn ,
8

Forward Pricing
Dividend
Paying Stock with Known Dividends

The forward contract will provide the stock at T but will

not return the dividends paid up to time T.

where is the future value of divs and is the present value of

divs.

Example:
, months, , at 3, 6 and 9 months.
D0 = 0.75e-(0.08x3/12) + 0.75e-(0.08x6/12) + 0.75e-(0.08x9/12) = 2.162
F0,T = (50 2.162) e (0.08x10/12) = 51.14

Forward Pricing
Dividend
Paying Stock with Known Dividend Yield

Stock pays a continuous compounding dividend yield of

Simply subtract dividend from the cost-of-carry as dividend

yield reduces the cost-of-carry.

Example:
, months, yield is 4% semi-annual.
Need to find the continuous compounded rate,

F0,T = 25 e (0.1 0.0396) x6/12 = 25.13

10

Forward Value
To
value a forward contract
Additional Notation

is the forwards delivery price at T

is value of the forward contract today.

Value of long forward contract

Note:
At the beginning of the life of the contract as .
As time passes, can become positive or negative as
11

Forward Value
Value
using

This can be repeated for known income

and known yield

12

Forward Value
Example:

, , and months

If

Remember, forwards have the obligation

13

Forwards vs. Futures

Are forward and futures prices the same?
Theoretically, no. Because of daily settlement of
futures contracts, prices are not the same.
However, this difference requires that the change in
futures prices is correlated with a change in interest
rates.
e.g. if futures returns are positively correlated with
interest rates, the long futures position gains you make
gains when interest rates are relatively high (investing)
and make losses when interest rates are relatively low.

Even then the time periods are usually too short to

cause any major differences.
Other factors such as credit risk, transaction costs
and margin requirement also play their part.
14

Futures Value
Stock Index Futures

The underlying asset (stocks in the index) pay an income - dividends.

Index Arbitrage Example:

or
Buy the cheaper and sell the more expensive. Note that you do not
need to buy or the sell the whole physical index per se. You just need
to construct a portfolio of stocks that closely tracks the index.
How valuable is arbitrage? Read Michael Lewis book Flash Boys,
which provides insights into the practices of high frequency trading
firms (e.g. Getco) post the GFC.

15

Futures Value
Commodity Futures

where: is the storage cost

is the convenience yield
both are treated as proportional to the underlying spot price
Storage Cost, : if you hold the physical asset, e.g. grain, it costs
you to store that asset from day 0 to day T.
Convenience Yield, : a benefit from owning the physical asset over
the holding the futures contract.
e.g. oil: by holding the physical, an oil refiner (they refine oil) will
ensure they have adequate reserves to run their plant and may be
able to benefit from potential price spikes associated with future
supply shortages in the commodity.
16

Futures Value

The futures prices are decreasing

If r > 0 and u > 0, which they should b

should increase with maturity, but
it doesnt. Why? Because of the
convenience yield.
17

Fixed Income Review

Preliminaries:
Day Count Conventions and Pricing Conventions:
no. of days between dates/no. of days in
reference period
actual/actual: used for AUS government bonds
actual/365: used for money market instruments
Actual/360: applies to US money market and some
LIBOR

Example: $100,000, 91-day Bank Accepted Bill with

y = 8.00%.

18

Fixed Income Review

Preliminaries

Pricing and Australian Commonwealth Government

Bonds:
semi-annual coupons, , with remaining
semi-annual compounding,
price for days to next coupon and days in current
coupon period.

Prices the
Prices the Coupons at the next
coupon. This is the annuity due Face Value at
the next
formula.
coupon.
Discounts the price from next coupon to today

19

Fixed Income Review

Example:
Currently 28 Jan. 2012, ACGB matures 15 June 2015, C =
5%, y = 4.85%, n = 7
d = 183
f = 139

28/1/12 15/6/12
C/2

15/12/11

15/12/12
C/2

15/6/13 15/12/13
C/2

C/2

15/6/14

15/12/14

15/6/15

C/2

C/2

C/2

Note that bonds go ex-coupon o

the 9th of the coupon month! So
youd have to drop the next cou
from your price calculations if
20
pricing 9-15 Jun or Dec.

Fixed Income Review

21

Interest Rate Futures

Treasury
Bond Futures

Underlying: a basket of ACGBs

Maturity:
3-years and 10-years
Coupon:
6.00%
Face Value: $100,000.00
Quote:
,
Maturity Months: March, June, September and
December
Last Trade: 12:00 noon of 15th day of delivery
month
http://
Settlement: Cash or Delivery
www.asx.com.au/documents/products/3-and-10-year-treasury-bon
d-futures-factsheet.pdf
22

Interest Rate Futures

Treasury
Bond Futures Pricing

1000 bond
Coupon
= FV of 100,000 = 3 S/A

FV
= 100

20 for 10-year futures and

6 for the 3 year futures

Example: 3-year Treasury Future where ,

23

Interest Rate Futures

mportant Note: I have ignored the rounding conventions applied by the

24

Interest Rate Futures

90-day
Bank Accepted Bill (BAB) Futures

Contract
Underlying: Suitable Bank Accepted Bills (BAB) and
Negotiable Certificates of Deposit
(NCD)
Face Value: $1,000,000.00
Quote:
,
Maturity Months: March, June, September and
December
Settlement Day:
Second Friday of delivery month
http://
Settlement:
Delivery
www.asx.com.au/documents/products/90-Day-bank-bill-fu
tures-factsheet.pdf
25

Interest Rate Futures

90-day
BAB Pricing

10 BABs
= FV of 1,000,000

90 days to
maturity

Example: 90-day BAB where ,

26

Hedging
By entering into a futures position, you are trying to lock-in a
future interest rate hedging interest rate risk.
For example, 90-day BAB
0
Enter into Futures

T+90

Settle Futures
Transact Physical

Once again, the rule do in futures now what you plan to do in the
physical later holds. That is, if you plan to buy (sell) securities in
the physical market at a later date, you buy (sell) futures contracts
now.
Note that the hedge will not be perfect because of basis-risk,
which is generally associated with the maturity, size and assets
underlying the futures not matching the physical exposure.
27

Hedging
Example:
0

T+90

Invest $100m
for 90-days

Exposur
e:

Between 0 and T, the yield received

For T to T+90 can change risky!

Hedge:

Buy futures at 0

Sell futures at T

If yield declines, price of futures

will increase and I will profit from hedge
to offset the loss in the physical
If yield increases, price of futures
will decrease and I will lose on the hedge
which will offset the gain in the physical
T

T+90
28

Hedging
Scenario

Now: Buy Sept. 90-day BAB Futures, ,

102 x 984,225.43
= (100,390,993.86)
Sept: Buy Sept. 90-day BAB Futures, ,

102 x 985,900.28
=

= 100,123,709.12
(267,284.74)
29

Hedging
Scenario, Final Payoff
Total Dollar Return

Total Percentage Return of $100,000,000

30

Risk Management
Duration defined

A measure of the average life of a bond. It is also an

approximation to the ratio of the proportional change in
the bond price to the absolute change in its yield (Hull
et al., 2013, p. 546).
From earlier weeks,

time weighted present value of cash flows

from this equation, the bond price change can be

approximated by

31

Risk Management
Bond
Portfolio Duration:

The duration of the portfolio is the weighted average

Following from the concept of Beta targeting, we can

undertake duration targeting and solve for :

32

Risk Management
Bond
Portfolio Duration Target:

Portfolio:
,

Ten-year T-Bond Futures:

By selling futures: If rates increase, the futures price will decrease and the portfo
manager will profit. Note that this profit will offset losses on the physical portfol
theyre hedging

tfolio immunisation is the process of matching the duration of assets and liabiliti
h that the duration of the portfolio is zero. Note that duration only works for para
the yield curve alternative hedging approaches can be employed e.g. 33
Gap an

Risk Management
Scenario:
Rates decrease!

Physical Profit
= 11,500,000 10,000,000
= 1,500,000.00
Futures Profit
= 97 x (93,029.62 107,876.25)
=
(1,440,123.11)
Overall
= 1,500,000 1,440,123.11
=
59,876.89

34

Risk Management
Bond
Portfolio Duration Target:

Portfolio:
,

Ten-year T-Bond Futures:

By buying futures: If rates decrease, the futures price will increase and portfol
manager will profit. Note that this profit will add to the gains on the physical portf
theyre speculating
35

Risk Management
Scenario:
Rates decrease!

Physical Profit
= 11,500,000 10,000,000
= 1,500,000.00
Futures Profit
= 45 x (107,876.25 93,029.62)
=
668,098.35
Overall
= 1,500,000 1,440,123.11
= 2,168,098.35
If rates had increased, this gamble would have resulted in
losses in both the physical and futures positions
36