Forward Markets. How Forwards Are Traded. Size of OTC and Exchange-Traded Markets

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1 Forward Markets Prf. José Fajardo Getulio Vargas Foundation 1 How Forwards Are Traded In the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly 2 Size of OTC and Exchange-Traded Markets Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market 3

2 The Lehman Bankruptcy Lehman s filed for bankruptcy on September 15, This was the biggest bankruptcy in US history Lehman was an active participant in the OTC derivatives markets and got into financial difficulties because it took high risks and found it was unable to roll over its short term funding It had hundreds of thousands of transactions outstanding with about 8,000 counterparties Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties 4 Foreign Exchange Quotes for GBP, May 24, 2010 Bid Offer Spot month forward month forward month forward Forward Price The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities (as shown by the table) 6

3 Example On May 24, 2010 the treasurer of a corporation enters into a long forward contract to buy 1 million in six months at an exchange rate of This obligates the corporation to pay $1,442,200 for 1 million on November 24, 2010 What are the possible outcomes? 7 Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into) Profit K Price of Underlying at Maturity, S T 8 Profit from a Short Forward Position Profit K Price of Underlying at Maturity, S T 9

4 Futures Contracts Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange 10 Exchanges Trading Futures CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade) NYSE Euronext BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more 11 Examples of Futures Contracts Agreement to: Buy 100 oz. of US$1400/oz. in December Sell US$/ in March Sell 1,000 bbl. of US$90/bbl. in April 12

5 1. Gold: An Arbitrage Opportunity? Suppose that: The spot price of gold is US$1,400 The 1-year forward price of gold is US$1,500 The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity? Gold: Another Arbitrage Opportunity? Suppose that: - The spot price of gold is US$1,400 - The 1-year forward price of gold is US$1,400 - The 1-year US$ interest rate is 5% per annum Is there an arbitrage opportunity? 14 The Forward Price of Gold If the spot price of gold is S and the forward price for a contract deliverable in T years is F, then F = S (1+r ) T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S = 1400, T = 1, and r =0.05 so that F = 1400(1+0.05) =

6 1. Oil: An Arbitrage Opportunity? Suppose that: - The spot price of oil is US$95 - The quoted 1-year futures price of oil is US$125 - The 1-year US$ interest rate is 5% per annum - The storage costs of oil are 2% per annum Is there an arbitrage opportunity? Oil: Another Arbitrage Opportunity? Suppose that: - The spot price of oil is US$95 - The quoted 1-year futures price of oil is US$80 - The 1-year US$ interest rate is 5% per annum - The storage costs of oil are 2% per annum Is there an arbitrage opportunity? 17 Options vs Futures/Forwards A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price 18

7 Types of Traders Hedgers Speculators Arbitrageurs 19 Dangers Traders can switch from being hedgers to speculators or from being arbitrageurs to speculators It is important to set up controls to ensure that trades are using derivatives in for their intended purpose 20 Hedge Funds Hedge funds are not subject to the same rules as mutual funds and cannot offer their securities publicly. Mutual funds must disclose investment policies, makes shares redeemable at any time, limit use of leverage take no short positions. Hedge funds are not subject to these constraints. Hedge funds use complex trading strategies are big users of derivatives for hedging, speculation and arbitrage 21

8 Types of Hedge Funds Long/Short Equities Convertible Arbitrage Distressed Securities Emerging Markets Global macro Merger Arbitrage 22 Mechanics of Futures Markets 23 Futures Contracts Available on a wide range of assets Exchange traded Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered Settled daily 24

9 Convergence of Futures to Spot Spot Price Futures Price Futures Price Spot Price (a) Time (b) Time 25 Margins A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract 26 Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 oz. futures price is US$1250 initial margin requirement is US$6,000/contract (US$12,000 in total) maintenance margin is US$4,500/contract (US$9,000 in total) 27

10 A Possible Outcome Day Trade Price ($) Settle Price ($) Daily Gain ($) Cumul. Gain ($) Margin Balance ($) 1 1, , , ,800 1,800 10, , ,340 9, , ,760 9,240 Margin Call ($) 7 1, ,260 4,020 7,980 4, , ,840 12, , ,620 15,180 Options, Futures, and Other Derivatives, 8th Edition, Copyright John C. Hull Margin Cash Flows When Futures Price Increases Clearing House Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader 29 Margin Cash Flows When Futures Price Decreases Clearing House Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader 30

11 Some Terminology Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of trades in one day 31 Key Points About Futures They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity 32 Crude Oil Trading on May 26, 2010 Open High Low Settle Change Volume Open Int Jul , ,902 Aug , ,305 Dec , ,033 Dec , ,674 Dec ,258 70,126 Options, Futures, and Other Derivatives, 8th Edition, Copyright John C. Hull

12 Collateralization in OTC Markets It is becoming increasingly common for transactions to be collateralized in OTC markets Consider transactions between companies A and B These might be be governed by an ISDA Master agreement with a credit support annex (CSA) The CSA might require A to post collateral with B equal to the value to B of its outstanding transactions with B when this value is positive. 34 Collateralization in OTC Markets continued If A defaults, B is entitled to take possession of the collateral The transactions are not settled daily and interest is paid on cash collateral 35 Clearing Houses and OTC Markets Traditionally transactions have been cleared bilaterally in OTC markets Following the crisis, there has been a requirement for most standardized OTC derivatives transactions to be cleared centrally though clearing houses. 36

13 Bilateral Clearing vs Central Clearing House 37 Delivery If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash 38 Regulation of Futures In the US, the regulation of futures markets is primarily the responsibility of the Commodity Futures and Trading Commission (CFTC) Regulators try to protect the public interest and prevent questionable trading practices 39

14 Accounting & Tax Ideally hedging profits (losses) should be recognized at the same time as the losses (profits) on the item being hedged 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 attempt to achieve 40 Forward Contracts vs Futures Contracts FORWARDS Private contract between 2 parties Non-standard contract Usually 1 specified delivery date Settled at end of contract Delivery or final cash settlement usually occurs Some credit risk FUTURES Exchange traded Standard contract Range of delivery dates Settled daily Contract usually closed out prior to maturity Virtually no credit risk 41 Determination of Forward and Futures Prices 42

15 Consumption vs Investment Assets Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver) Consumption assets are assets held primarily for consumption (Examples: copper, oil) 43 Notation for Valuing Futures and Forward Contracts S 0 : Spot price today F 0 : Futures or forward price today T: Time until delivery date r: Risk-free interest rate for maturity T 44 The Future Price If the spot price of an investment asset is S 0 and the futures price for a contract deliverable in T years is F 0, then F 0 = S 0 e rt where r is the T-year risk-free rate of interest. If, S 0 =40, T=0.25, and r=0.05 so that F 0 = 40e =

16 When an Investment Asset Provides a Known Income F 0 = (S 0 I )e rt where I is the present value of the income during life of forward contract 46 When an Investment Asset Provides a Known Yield F 0 = S 0 e (r q )T where q is the average yield during the life of the contract (expressed with continuous compounding) 47 Valuing a Forward Contract A forward contract is worth zero (except for bid-offer spread effects) when it is first negotiated Later it may have a positive or negative value Suppose that K is the delivery price and F 0 is the forward price for a contract that would be negotiated today 48

17 Valuing a Forward Contract By considering the difference between a contract with delivery price K and a contract with delivery price F 0 we can deduce that: the value of a long forward contract, ƒ, is (F 0 K )e rt the value of a short forward contract is (K F 0 )e rt 49 Forward vs Futures Prices When the maturity and asset price are the same, forward and futures prices are usually assumed to be equal. (Eurodollar futures are an exception) When interest rates are uncertain they are, in theory, slightly different: A strong positive correlation between interest rates and the asset price implies the futures price is slightly higher than the forward price A strong negative correlation implies the reverse 50 Futures and Forwards on Currencies A foreign currency is analogous to a security providing a yield The yield is the foreign risk-free interest rate It follows that if r f is the foreign risk-free interest rate ( F S e r r f ) T 0 = 0 51

18 Futures Prices & Expected Future Spot Prices Suppose k is the expected return required by investors in an asset We can invest F 0 e r T at the risk-free rate and enter into a long futures contract to create a cash inflow of S T at maturity This shows that rt kt F e e = E( S ) 0 or F = E( S ) e 0 T T ( r k) T 52 Futures Prices & Future Spot Prices (continued) No Systematic Risk k = r F 0 = E(S T ) Positive Systematic Risk k > r F 0 < E(S T ) Negative Systematic Risk k < r F 0 > E(S T ) Positive systematic risk: stock indices Negative systematic risk: gold (at least for some periods) 53