IX - Futures FORWARD AND FUTURES CONTRACTS. Soybean Contract: Soybean Contract:

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1 IX - Futures FORWARD AND FUTURES CONTRACTS Forward and Future contracts are legal agreements for the delivery of goods, services, or assets at a specified price, under specified conditions, where the specified date of delivery and payment is sometime in the future. G Spot Contract 6 A Spot contract is a contract for the delivery of goods, services, or assets at a specified price for immediate delivery and payment. G Forward Contract 6The terms of a forward contract reflect the specific needs of the buyer and seller and exposes both parties to default risk. The secondary market is almost non-existent. Forward contracts are generally delivered. G Futures Contract 6 Futures contracts are standardized as to quantity, quality, and delivery date. Futures trade through the exchange or clearinghouse on which they are listed and there is no default risk in the contract. Most futures contracts are reversed prior to delivery; less than 1% of futures contracts are delivered. Listed futures contracts involve agricultural products (wheat, corn, pork bellies, Orange juice, etc.), natural resources (aluminum, copper, gold, silver, oil, natural gas, etc.), foreign currencies (marks, yen, etc.), fixed income securities (Treasury Bonds etc.) and market indices (S&P 500 etc.). Soybean Contract: I promise to Buy 5,000 bushels #2 yellow soybeans with a maximum of 14% moisture for delivery November 2003 (November 23, 2003, 10:01 am) at per bushel Soybean Contract: I promise to Sell 5,000 bushels #2 yellow soybeans with a maximum of 14% moisture for delivery November 2003 (November 23, 2003, 10:01 am) at per bushel When we buy soybean futures we buy a contract to buy soybeans on November 23, When we sell soybean futures we buy a contract to sell soybeans on November 23, 2003.

2 2 FINANCIAL MARKETS FUTURES QUOTES This quote states that futures on soybeans are traded on the Chicago Board of Trade, that each contract is for 5,000 bushels, and that prices are quoted in cents per bushel. There are eight different futures contracts for soybeans, each one for the same quantity of the same quality soybeans, but each for a different delivery date. FUTURES PRICES Open Hi Low Settle Change Lifetime Hi Soybeans (CBT) 5,000 bu.; cents per bu. Low Open Interest Nov ¾ 430½ 437¼ ½ 355½ 8,046 Jan ¼ 4447¾ 440½ 446¾ +6½ ½ 69,140 Mar ¼ ½ +6¾ ¾ 28,910 May 451¾ ¾ ½ 17,739 July ½ 454¼ 460½ +5¾ ½ 18,730 Aug 453¼ 459½ 453¼ ½ ,059 Sep 439½ ½ ,070 Nov ½ 427¾ 431¼ ½ 9,035 Est vol 70,000; vol Wed 63,192; open int 155,797, Financial Pages G Open, Hi, Low 6 The quote shows that the November 2002 contract opened at $4.32 per bushel. During the day's trading the November contracts hit a high of $ and a low of $ G Lifetime Hi, Low 6 Lifetime high and low indicate the full range of prices reached on this future since inception. The price on the November 2002 contract ranged from $3.555 to $5.575 since trading first opened. G Settle 6 The settle or settlement price is the representative price over the closing period designated by the exchange. For example, the average of all trades executed in the last two minutes of trading. The settlement price is up 7 from yesterday, at $ per bushel. In markets where liquidity is low the last trade may not reflect the closing value of the future. In these markets the settle is calculated from a specific formula based on the spot price of the underlying asset. G Open Interest 6 Open interest is the number of contracts outstanding as at the close of trading. The open interest generally increases until a month before the contract matures, and then declines rapidly as investors reverse their positions. (Few investors really want 5,000 bushels of soybeans delivered to their Wall Street offices.).the soybean quotes show that at the time of this quote there was an open interest of 8,046 contracts on November 02 soybeans. If this were the last day of trading then million (8,046 * 5,000) bushels of soybeans would actually be delivered.

3 IX - FUTURES SOYBEAN FUTURES The soybeans futures contract is 5,000 bushels of US No. 2 yellow soybeans with a maximum of 14% moisture. If you deliver US No. 1 soybeans with a maximum of 13% moisture you get 3 per bushel over the contract price. No. 3 fetches 4 per bushel under the contract price. Soybeans trade from 9:30 to 1:15 Chicago time. Trading takes place up to the eighth last business day of the month in which the futures deliver (notice the terminology: spot month) On the last day of trading the closing bell is rung at noon. These conditions are specific to soybeans. The CBOT web page provides particulars for each contract traded. Trading Unit Deliverable Grades Price Quote Tick Size Daily Price Limit Contract Months Contract Year Soybean Futures 5,000 bu No. Yellow at par and substitutions at differentials established by the exchange Cents and quarter-cents/bu 1/4 cents/bu ($12.50/contract) 30 cents/bu ($1,500/contract) above or below previous day's settlement price (expandable to 45 cents/bu). No limit in the spot month (limits are lifted two business days before the spot month begins). Sep, Nov, Jan, Mar, May, Jul, Aug Sep to Aug Last Trading Day Last Delivery Day Trading Hours Ticker Symbol Seventh business day preceding the last business day of the delivery month Last business day of the delivery month 9:30 a.m. - 1:15 p.m. Chicago time, Mon-Fri. Trading in expiring contracts closes at noon on the last trading day. S FUTURES TRADING Taken from Futures are traded on the floor of a futures exchange. The Chicago Board of Trade is the largest futures exchange in the world. Investors can place market, limit, or stop orders. The order is transmitted to the exchange floor, and is taken to the designated pit for execution by a member of the exchange. The pit is circular with a set of descending steps on which members stand. Floor or pit brokers are members that execute client orders. They each keep their own record of client limit or stop orders that cannot be executed immediately. Floor traders, also known as locals or scalpers, trade on their own accounts. Floor traders are similar to market makers in that they hold an inventory of futures contracts, but they are not obligated to make a market in a specific contract. Orders are announced in the pit by open outcry. The method of open outcry ensures that the order is exposed to everyone in the pit, thereby leading to the best possible execution price.

4 4 FINANCIAL MARKETS THE CLEARINGHOUSE The clearinghouse takes on the responsibility of ensuring that every contract traded on the exchange is honored. To ensure that no buyer or seller ever reneges on his contract, the clearinghouse takes the opposite side of every contract. EXAMPLE: Susan Q. Speculator places an order to buy ten November soybean contracts. George Q. Farmer places an order to sell 10 November soybean contracts. Their brokers trade at 431. The contract specifies that George Q. Farmer will sell to Susan Q. Speculator 10 * 5,000 bushels of soybeans in November and that she will pay him $4.31 * 50,000 or $215,500. The open interest is 10 contracts. Although it looks very much as though Susan Q. Speculator has a contract with George Q, Farmer, she actually has a contract with the clearinghouse. The clearinghouse splits the contract in two such that they each have a contract with the CBT. Susan Q. 431 [$215,500] Susan Q. 431 [$215,500] BUY <-> SELL becomes George Q. 431 [$215,500] BUY <-> SELL BUY <-> SELL 431 [$215,500] 431 [$215,500] George Q. 431 [$215,500] EXAMPLE: Suppose that by November the price of soybeans drops to $4.00 per bushel. The futures contract obliges Susan to pay $4.31 per bushel. This constitutes a loss of $15,500. Since payment is made at delivery Susan decides to renege on the contract. Since futures contracts are with the clearinghouse, George Q. Farmer is unaffected by Susan's unethical behavior; the clearinghouse honors its contract with George on Susan's behalf by selling soybeans on the spot market at $4.00 per bushel and taking the $15,500 loss. The clearinghouse would then take legal action against Susan. EXAMPLE: On the other hand, suppose that by November the price of soybeans increases to $5.00 per bushel. Since George is obliged to sell at $5.31 per bushel, this constitutes a loss of $34,500. George decides to renege on the contract. Since Susan's contract is with the clearinghouse, she is unaffected. The clearinghouse buys the soybeans on the spot market at $5.00 per bushel and sells them to Susan at the contracted price of $4.31, taking a loss of $34,500. The clearinghouse would then take legal action against George. In order to limit these potential losses, the clearinghouse

5 IX - FUTURES imposes initial margin requirements on both buyers and sellers, marks to market at the close of business on each trading day, and imposes daily maintenance margins on both buyers and sellers. INITIAL MARGIN Whenever a futures contract is signed both the buyer and the seller are required to make security deposits. This initial or performance margin is intended to guarantee that the obligations under the contract will be fulfilled. The minimum margin is set by the exchange, though the margins required by the broker may be higher. Generally, higher margins are set on futures contracts with a greater price volatility since the clearinghouse faces larger losses on more volatile assets. EXAMPLE: Under regulation of the CBT, [Board of Trade of the City of Chicago - Rules and Regulations, section ] the minimum initial margin on soybeans is $810 per contract: both Susan and George must deposit $8,100 in cash, cash equivalents (such as a Treasury Bond), or a bank line of credit. Note that $8,100 would not cover the loss under either of the above scenarios. This is where marking to market comes in. MARKING TO MARKET The initial margin represents your equity. Adjusting the equity to reflect the settlement price at the end of every trading day is referred to as marking to market. Essentially, marking-to-market is equivalent to unwinding your position at the closing price and re-opening your position at that same closing price, at the end of every trading day. G Equity 6 The equity in your account represents what your broker would return to you if your position was unwound at the closing price. Equity can be calculated in two ways (both should give you the same answer)

6 6 FINANCIAL MARKETS 1) Calculate the market value of the futures contract if the position would be closed out at the settlement price (cumulative profit) and add total deposits to margin. 2) Calculate the change in the market value of the futures contract (daily profit) and add this to the previous day's equity. EXAMPLE: Assume that on the day following the initial trade, the price of soybeans increases to 441. All contracts are marked to market. Susan Q. Speculator has a futures contract to buy November soybeans at 431. If Susan closes out her position by selling November soybeans at the closing price of 441 this transaction would give you a profit of $5,000 [50,000 * ($ $4.31)]. Susan's broker would return her margin deposit of $8,100 (since the broker would no longer need it to ensure her good behavior) and the profit of $5,000. Thus her equity is $13,100. If on the following day the settlement price on November soybean contracts had been 442 then Susan's equity would increased by another $500 to $13,600. If Susan closes out her position by selling November soybeans at the closing price of 442 this transaction would give you a profit of $5,500 [50,000 * ($ $4.31)]. Susan's broker would return her margin deposit of $8,100 and the profit of $5,500 for a total of $13,600. On the other hand, George would have lost another $5000 as the price of soybeans increased to 441and another $500 as the price of soybeans increased to 442. His equity would decrease to $2,600. ($8,100 - $5,500) Now the clearinghouse might get a bit nervous. This is where the maintenance margin comes in. MAINTENANCE MARGIN The equity in an account must be maintained above a prescribed minimum. When the equity falls below this minimum the investor must bring his equity back up to the initial margin requirement: he receives a margin call from the broker. G Margin Call 6 notification that the money and assets you have deposited with your broker in your margin account is no longer enough to satisfy margin requirements. A margin call or variation margin must be met with a cash deposit (no other assets are acceptable on margin calls). If the investor cannot make the margin call then the broker will close out the position by entering a reversing trade in the investor's account.

7 IX - FUTURES EXAMPLE: The minimum maintenance margin on soybeans is $600 per contract. The following table reflects the activity in two accounts: Susan Q. Speculator who buys 10 soybean contracts at 431 George Q. Farmer who sells 10 soybean contracts at 431. (Long Soybean Futures) (Short Soybean Futures) G Day 1 6 trade at 431 Susan Q. Speculator buys 10 soybean contracts at 431. The contracts specify that she will buy 50,000 bushels soybeans at 431 per bushel for a total of $215,500. To guarantee this contract she deposits $8,100 to her margin account. George Q. Farmer sells 10 soybean contracts at 431. The contracts specify that he will sell 50,000 bushels soybeans at 431 per bushel for a total of $215,500. To guarantee this contract he deposits $8,100 to his margin account. G Day 2 6 settlement price = 441 Susan Q. Speculator bought soybeans and watched the price go up 10 per bushel. On 50,000 bushels this means that she made a profit of $5,000 today. Her equity increases to $13,100. $8,100 + $5,000 = $13,100. George Q. Farmer sold soybeans and watched the price go up 10 per bushel. On 50,000 bushels this means that he has lost $5,000 today. His equity decreases to $3,100. This equity of $3,100 is below the maintenance margin of $6,000 ($600 per contract) so George is issued a Margin Call. In order to keep the contract he must deposit a further $5,000 to his margin account, thereby bringing his equity back up to the initial margin requirement of $8,100. $8,100 - $5,000 = $3, $5,000 = $8,100. G Day 3 6 settlement price = 442 Susan Q. Speculator watched the price go up another 1 per bushel. On 50,000 bushels this means that she made a profit of $500 today. Her equity increases to $13,600. $13,100 + $500 = $13,600. The contract she bought at 431 for a total of $215,500 is now worth 442 for a total of $221,000. Susan's total profit to date is $5,500. So her total equity is $13,600. $8,100 + $5,500 = $13,600. George Q. Farmer watched the price go up another 1 per bushel. On 50,000 bushels this means that he has lost $500 today. His equity decreases to $7,600. This is above the maintenance margin of $6,000 ($600 per contract) so George receives no Margin Call today. $8,100 - $500 = $7,600.

8 8 FINANCIAL MARKETS The contract he sold at 431 for a total of $215,500 is now worth 442 for a total of $221,000. George's total loss to date is $5,500. So his total equity is $7,600. $8,100 + $5,000 (margin call) -$5,500 = $7,600. G Day 4 6 settlement price = 430 Susan Q Speculator watched the price of soybeans drop 12 today. On 50,000 bushels this means she lost $6,000 in one day. Her equity drops to $10,750. $13,600 - $6,000 = $7,600. The contract she bought at 431 for a total of $215,500 is now worth 430 for a total of $215,000. Susan's total loss to date is $500. So her total equity is $7,600. This is above the maintenance margin of $6,000 so Susan receives no Margin Call. $8,100 - $500 = $7,600. George Q Farmer watched the price of soybeans drop 12 today. On 50,000 bushels this means he made a profit of $6,000 in one day. His equity increases to $13,6000. $7,600 + $6,000 = $13,600. The contract he sold at 431 for a total of $215,500 is now worth 430 for a total of $215,000. George's total profit to date is $500. So his total equity is $16,750. $8,100 + $5,000 (margin call) + $500 = $13,600. G Day 5 6 settlement price = 436 Susan Q Speculator watched the price of soybeans increase 6 today. On 50,000 bushels this means she made a profit of $3,000 today. Her equity increases to $13,750. $7,600 + $3,000 = $10,600. The contract she bought at 431 for a total of $215,500 is now worth 436 for a total of $218,000. Susan's total profit to date is $2,500. $8,100 + $2,500 = $10,600. George Q Farmer watched the price of soybeans increase 6 today. On 50,000 bushels this means he lost $3,000 today. His equity decreases to $10,600. He would like to withdraw some of this money from his margin account. He cannot bring his equity below the initial margin so George withdraws $2,500. $13,600 - $3,000 (loss) - $2,500 (withdrawal) = $8,100. The contract he sold at 431 for a total of $215,500 is now worth 436 for a total of $218,000. George's total profit to date is a loss of $2,500. So his total equity is $8,100. $8,100 + $5,000 (margin call) -$2,500 (withdrawal) - $2,500 (loss) = $8,100.

9 Clearinghouse Records Day Settlement Price [Value] Action Susan Q. Speculator (long soybean futures) George Q. Farmer (short soybean futures) Profit Deposit Action Profit Deposit to Margin Equity to Margin Daily Cum A/C Daily Cum A/C Equity [$215,500] Buy 10 contracts@431: Initial Margin $8,100 $8,100 Sell 10 contracts: Initial Margin $8,100 $8, [$220,500] Mark to Market $5,000 $5,000 $13,100 Mark to Market -$5,000 -$5,000 $3,100. Margin Call $5,000 $8, [$221,000] Mark to Market $500 $5,500 $13,600 Mark to Market -$500 -$5,500 $7, [$215,000] Mark to Market -$6,000 -$500 $7,600 Mark to Market $6,000 $500 $13, [$218,000] Mark to Market $3,000 $2,500 $10,600 Mark to Market -$3,000 -$2,500 $10,600. Withdrawal -$2,500 $8, [$218,000 ] Sell to close $2,500 -$10,600 $0 Mark to Market $0 -$2,500 $8,100.

10 10 FINANCIAL MARKETS This example simplifies the mechanics of trading somewhat. Actually only members of the clearinghouse have accounts that are marked to market at the end of every trading day. In turn each brokerage house acts as a clearinghouse for its own clients. FIGURE IX - 1: GRAPH OF SUSAN S AND GEORGE S EQUITY $14,400 Equity $13,600 $13,600 $12,300 $13,100 $10,200 Susan $10,600 Withdrawal $8,100 $8,100 $8,100 $7,600 $7,600 Initial Margin $6,000 Maintenance $3,900 George $1,800 Margin Call Days UNWINDING A FUTURES POSITION Susan decides that she has speculated enough and decides to unwind or reverse her position. However, George does not want to reverse his side of the contract. The only way out is for Susan to sell 10 November soybean contracts to someone else, - John Q. Investor for example. This closes out or unwinds Susan's position in November soybeans. This is where the advantages of dealing through a clearinghouse can be seen. Without the benefit of the clearinghouse Susan Q. Speculator would be obliged to wait til November, take delivery of 50,000 bushels of soybeans from George Q. Farmer and pay him $215,500; then deliver these soybeans to John Q. Investor in return for $218,000. Susan would therefore get her profit of $2,500 in November. But because futures trade through a clearinghouse, offsetting positions in November soybeans are immediately canceled. More importantly, Susan does not have to wait until November to take her $2,500 profit. As soon as the offsetting trade is executed she can withdraw the amount of her outstanding equity, so she get her profit immediately.

11 IX - FUTURES BUY <-> SELL Contract #1 BUY <-> SELL Susan 431 [$215,000] 431 [$215,500] 431 [$215,500] George 431 [$215,500] BUY <-> SELL Contract #2 BUY <-> SELL John 436 [$218,000] 436 [$218,000] 431 [$218,000] Susan 431 [$218,000] The clearinghouse gives Susan her profit of $2,500 [$318,000 - $315,500] and the two contracts collapse into one: Clearinghouse profit = - $2,500. BUY <-> SELL Contract 1&2 BUY <-> SELL John 436 [$218,000] 436 [$218,000] 431 [$215,500] George 431 [$215,500] Clearinghouse profit = $2,500 Students often have difficulties with the concept of margin. Margin exists because the actual transaction takes place in the future. Think of placing a bet that the Fighting Illini win the next football game. The bet is $10 per point difference. If I win then you might become hard to find; if you win then I might become hard to find. So we pick a stakeholder. We each give him $200 to hold until the game is over. The stakeholder plays the role of the clearing house - he's not a party to the bet, - but an impartial judge and banker. If the final score is Illini 21, Wolverines 7 then I win the bet by 14 points or $140. The stakeholder gives me my $200 back plus my $140 winnings for a total of $340. The stakeholder gives you back your $200 less $140 so you get back $60. This $60 equity is what keeps you from skipping town after the game. Things-To-Do: IX - 1 In April George sold 10 November Soybean contracts at 431. Since then he has deposited to his margin account a total of $10,600 in initial and maintenance margin. If November soybeans settle at 436 on the last day of trading. A. What is George's final position if he delivers on his contracts? B. What is George s final position if he unwinds his futures position on the last day of trading at 436?

12 12 FINANCIAL MARKETS PRICE LIMITS Price limits are set by the futures exchange subject to approval by the Commodity Futures Trading Commission. The CBT price limit on soybeans is 45. This means that if November soybeans closed at 436 on the previous day then November contracts for less than 391 or more than 481 are not permitted to trade on the exchange. If a major news item hits (Hurricane Elisabeth wipes out the entire Illinois soybean crop) and investors think that 600 is a perfectly reasonable price for soybeans (after all, without their tofu, Californians are nothing more than tanned New Yorkers) then investors can do one of two things: They can trade off exchange, foregoing the advantages of dealing through a clearing house, or he can wait until the next day when the price limits would be 436 to 526 (481 ±45 ). One result of the limit move to 481 is that there are days when nothing trades at all because all investors are unwilling to sell soybeans for less than 481. There can be limit moves for a number of successive days, with no trading taking place until the series of limit moves places the relevant price within reach. Futures exchanges impose price limits in the belief that both clients and dealers overreact to new information, and that price limits reduce the price volatility of futures contracts. Things-To-Do: IX - 2 In April George sold 10 November Soybean contracts at 431. Since then he has deposited to his margin account a total of $10,600 in initial and maintenance margin. In May John Q. Investor bought 10 November Soybean contracts at 436 and deposited to his margin account a total of $8,100. On August 1 November Soybeans settle at 436. A. On August 2 Hurricane Elisabeth destroys the entire Illinois soybean crop and nobody is willing to sell soybean futures for less than 600. With a 45 daily price limit, how many days will pass before trading resumes? B. Assuming that the broker marks to margin at the theoretical limit on each day, calculate the daily and cumulative paper profit, deposit to margin, and equity position for George Q. Farmer from day to day until trading resumes at 600. C. Assuming that the broker marks to margin at the theoretical limit on each day, calculate the daily and cumulative paper profit, deposit to margin, and equity position for John Q. Investor from day to day until trading resumes at 600.

13 IX - FUTURES FUTURES POSITIONS: SPECULATION & HEDGING The principal function of futures markets is to transfer price risk from hedgers to speculators. The market thus facilitates the optimal allocation of risk. G Speculators 6 Speculators buy and sell futures as financial investments, intending to unwind the position without ever taking delivery of the underlying asset. G Hedgers 6 Hedgers buy and sell futures to offset an otherwise risky position in the spot market. Hedgers also unwind their positions without ever taking delivery of the underlying asset. EXAMPLE: George Q. Farmer uses a short hedge. He knows that if he gets less than 400 per bushel he will be ruined. Therefore he sells November soybeans at 431 per bushel now, to avoid the possibility of being forced to sell a bumper crop of soybeans in the spot market at a lower price next November. EXAMPLE: Tofu Inc is a long hedge. The purchasing department knows that if Tofu Inc waits until November to buy soybeans on the spot market and the price goes up above 500, the company's tofu would be priced out of the market. BASIS The basis is the difference between the spot or cash price and the futures price. EXAMPLE: If the futures price for soybeans is 431 and the spot price is $4.20 per bushel, then Basis = Spot Price - Futures Price = $ $4.31 = - 11 Typically the basis narrows over time until it equals zero on the delivery date.

14 14 FINANCIAL MARKETS CONSTRUCTING A HEDGE A Hedge is constructed by setting up an investment that offsets an initial risk exposure. Essentially we take a long position in one asset and a short position in a similar asset; the gains in one position should offset the losses in the other position. EXAMPLE: George Q. Farmer expects to harvest 50,000 bushels of soybeans in October. It is now April and the spot price for soybeans is $4.20/bushel. George has a long position in soybeans and therefore faces a price risk - he will lose money if the spot price of soybeans goes down by October. This is the risk he wishes to hedge. The key to setting up a hedge is to counteract the long position (soybeans growing in the field) with a short position in an investment whose price will move in the same direction. Initial Risk Exposure: Long (Soybeans growing in the field) Spot price increases Spot price decreases Hedge Short (Futures Contracts) Total Portfolio long spot & short hedge Futures price increases Futures price decreases George hedges his long position by selling 10 November soybean contracts. The trade goes through at 431 per bushel. He now has a contract to sell 50,000 bushels of soybeans in for a total of $215,500., delivery and payment in November.

15 IX - FUTURES TEXTBOOK HEDGE A Perfect or Textbook Hedge results when the basis remains unchanged. When George is ready to harvest his soybeans in October, the spot price for soybeans has fallen from $4.20 to $4.00 per bushel (this is exactly the risk against which George set the hedge) and the futures price has fallen from 431 to 411. George can now lift the hedge by buying 10 November soybean contracts at the current price of 411. The buy and sell cancel each other out and George receives his equity of $18,100. The equity consists of the $8,100 initial margin plus the $10,000 profit earned on his short position. With his futures contract negated George is now free to sell his soybeans on the spot market at $4.00 per bushel. George Q. Farmer - Hedge Position April: (Hedge is set) October: (Hedge is lifted) Sell November Futures: 6 10 contracts at 431 [$215,500] Margin: - $8,100. Buy November Futures: 6 10 contracts at 411 [$205,500] Profit: Margin: + $10, $8,100. Sell Soybeans on the spot market at $ $200,000. Net Position: Effective price per bushel: + $410,000. $4.20 The effective price is George s net position per bushel of soybeans. It equals the spot price when we set the hedge. When the effective price exactly equals the initial spot price (the spot price when the hedge was set) we have a textbook hedge. Initial Risk Exposure: Long (Soybeans growing in the field) Spot price decreases 20 unhappy $4.20 to $400 Futures price decreases 431 to 411 Hedge Short (Futures Contracts) 20 happy Total Portfolio long spot & short hedge completely neutral The textbook hedge derives because the change in the spot price was matched exactly by the change in the futures price. In other words, the basis remained unchanged. When George set the hedge the basis was - 11 ; when George lifted the hedge the basis was still -11.

16 16 FINANCIAL MARKETS BASIS RISK Not all Hedges are perfect. Suppose that in October, when George harvests his soybeans, the spot price for soybeans is $5.00 and the November futures price is 508. George lifts the hedge by buying 10 November soybean contracts at the current price of 508. Since George is losing money on his futures position he will have dealt with a number of margin calls over the past few months. When his equity is returned to him, George will realize a $38,500 loss on his futures position. With his futures contract negated George is now free to sell his soybeans on the spot market at $5.00 per bushel. George Q. Farmer - Hedge Position April: (Hedge is set) Sell November Futures: 6 10 contracts at 431 [$215,500] Margin: - $8,100. October: (Hedge is lifted) Buy November Futures: 6 10 contracts at 708 [$354,000] Profit: Margin: - $38, $8,100. Sell Soybeans on the spot market at $ $250,000. Net Position: Effective price per bushel: + $211,500. $4.23 The effective price of $4.23 per bushel is 3 higher than the $4.20 spot price when we set the hedge. This is no longer a textbook hedge. Initial Risk Exposure: Long (Soybeans growing in the field) Hedge Short (Futures Contracts) Total Portfolio long spot & short hedge Spot price increases $4.20 to $ happy Futures price increases 431 to unhappy 3 happy The effective price increases by 3 because the basis changes by 3. When George set the hedge the basis was -11 ; when George lifted the hedge the basis had narrowed to -8. When George hedges his soybeans he is trading a price risk for a basis risk. It is immaterial to George whether the price of soybeans is $1 or $10; it matters only whether the basis narrows, remains the same, or widens.

17 IX - FUTURES FIGURE IX - 2: THE VALUE OF GEORGE S SOYBEAN HARVEST (LONG) IS AT RISK BECAUSE GEORGE FACES A PRICE RISK $233,500 Value of Soybeans $215,500 Payoff: Long Frequency Risk $197, Price Price 467 FIGURE IX - 3: GEORGE S SHORT FUTURES POSITION GUARANTEES A SALE PRICE OF 431 AT DELIVERY $18,000 Value of Futures $ Price Frequency Risk ($18,000) Payoff: Short Price 467 FIGURE IX - 4: GEORGE S HEDGED POSITION. IF GEORGE LIFTS THE HEDGE BEFORE DELIVERY HE FACES A BASIS RISK $233,500 Payoff: Hedged Basis Basis Risk $215,500 delivery: basis=0 0 textbook: basis= $197, Price 467 Frequency

18 18 FINANCIAL MARKETS Things-To-Do: IX - 3 Tofu Inc. plans to buy 50,000 bushels of soybeans in October. Tofu Inc would like to hedge its price risk exposure on soybeans but there are no October futures in soybeans. The current spot price for soybeans is $4.20 and the price for November soybeans is 431. Initial margin is $810 and maintenance is $600 per contract. A. Construct a hedge strategy for Tofu Inc. B. In October the spot price for soybeans is $4.00 and the November futures price is 411. What is the basis on November soybeans? What is the net position and effective price per bushel for Tofu Inc? C. In October the spot price for soybeans is $5.00 and the November futures price is 508. What is the net position and effective price per bushel for Tofu Inc? Why is there a difference between this situation and the one in part B. G Long hedge 6 A long hedge is the buy of a futures contract to hedge against an increase in the price of the asset that exposes you to a risk. G Short hedge 6 A short hedge is the sale of a futures contract to hedge against a decrease in the price of the asset that exposes you to a risk. G Spreads 6 Spreads are differences between similar but not identical instruments (soybeans and soybean oil or July and August soybeans). Investors who hedge on a spread eliminate the risk associated with general price movements (as they do with a basis hedge), and face the risk associated with the change in the differences between the two similar investments. G Cross Hedge 6 When the future contract used to construct a hedge is on a related, but not identical, asset. For a cross hedge to work the price movements of the underlying commodities must be similar.

19 IX - FUTURES Things-To-Do: IX - 4 George Q. Farmer produces squash: about 5,000 bushels per year, which he intends to sell to Kankakee Canning Corporation in October. George was so impressed with the hedge that you advised on his soybeans that he now asks you to construct a hedge for his October squash. There are no squash futures. George assures you that squash trades at 120% of the price of soybeans. Sure enough, squash is currently at $5.04 (120% of the $4.20 spot price in soybeans). There is no October contract on soybeans but there is a November contract The current spot price for soybeans is $4.20 and the price for November soybeans is 431. Initial margin is $810. per contract. A. Construct a cross hedge for George. B. In October the spot price is $4.00 for soybeans and $4.84 for squash. The November futures price is 411. How does George make out? How would he have made out had he had not hedged? C. In October the spot price is $4.00 for soybeans and $4.85 for squash. The November futures price is 411. Now how does George make out in this scenario? Why is there a difference between this situation and the one in part B. Things-To-Do: IX - 5 The Kankakee Canning Corporation plans to purchase 5,000 bushels of squash in October. You are hired to construct a hedge. However, there are no squash futures. Your client assures you that squash trades at 120% of the price of soybeans. Sure enough, squash is currently at $5.04 (120% of the $4.20 spot price in soybeans). There is no October contract on soybeans but there is a November contract. The current spot price for soybeans is $4.20 and the price for November soybeans is 431. Initial margin is $810. per contract. A. Construct a cross hedge for the Kankakee Canning Corp. B. In October the spot price is $4.00 for soybeans and $4.84 for squash. The November futures price is 411. How does the Kankakee Canning Corp. make out? How would they have made out had they had not hedged? C. In October the spot price is $4.00 for soybeans and $4.85 for squash. The November futures price is 411. Now how does the Kankakee Canning Corp. make out? Why is there a difference between this situation and the one in part B.

20 20 FINANCIAL MARKETS Things-To-Do: IX - 6 You are asked to provide a hedge strategy for Nescafé (world wide producers of Coffee) Nescafé will buy 3,750,000 pounds of coffee in early August. The spot price today is $2.50/lb. Use the futures quote below. A. Over the last 18 months the price of September futures ranged from a low of $. /lb to a high of $. /lb. Construct a hedge portfolio for Nescafé. Use September futures. Make sure the hedge covers the entire planned purchase in August. B. To set up the hedge we should (buy / sell) September contracts. In August, when Nescafé is ready to purchase it's coffee the spot price is $4.00 per pound and the September futures contract is trading at C. The basis on September futures has (widened / narrowed) by /lb (from /lb. to /lb). D. Calculate the cash flows when the hedge is set in May and the hedge is lifted in August. E. The effective price Nescafé must pay for its coffee is $ /lb. FUTURES PRICES Open Hi Low Settle Change Lifetime HiLow Open Interest Coffee (CSCE) 37,500 lbs; cents per lb. May July ,119 Sept ,042 Dec Mar ,924 May July Est vol 7,623; vol Wed 9,527; open int 30,082, -79. Financial Pages Initial Margin: $1,000/c

21 IX - FUTURES Things-To-Do: IX - 7 You are asked to provide a hedge strategy for Droste (worldwide producers of those lovely chocolate oranges). Droste will buy 60,000 pounds of Frozen Concentrated Orange Juice in early February. The spot price today is $1.10/lb. Initial margin is $500 /contract. If all the currently outstanding March futures are delivered then how many pounds of FCOJ will be delivered? What is the basis on March futures? Over what range has the price of March futures ranged over the last several months? What happened to the July, September, and November futures? Construct a hedge portfolio for Droste. Make sure the hedge covers the entire planned purchase in February. In February, when Droste is ready to purchase it's FCOJ, the spot price is $1.20 per pound and the March futures contract is trading at What happened to the basis on March futures? Is this is a textbook Hedge? Calculate the cash flows when the hedge is set today and the hedge is lifted in February. What is the effective price Droste must pay for its FCOJ? How does this differ from the spot price when we set the hedge? Why? FUTURES PRICES Open Hi Low Settle Change Lifetime Hi Frozen Concentrated Orange Juice (CTN) 15,000 lbs; cents per lb. Low Open Interest Jan ,193 Mar ,706 May ,697 July ,535 Sept Nov Est vol 1,8503; open int 23,081, Financial Pages

22 22 FINANCIAL MARKETS SPOT-FUTURES ARBITRAGE The futures price reflects the spot price of the underlying asset plus the carrying charges necessary to carry the underlying asset forward to delivery. G Arbitrage 6 the simultaneous buying and selling of closely related securities designed to take advantage of different prices of essentially the same asset. EXAMPLE: Suppose that in January 2003 the spot price of gold is $370 and the January 2004 gold futures are trading at $400. The risk free rate of interest is 5%. Storage and insurance are $1.20 per ounce. Gold trades on the CBT. One contract is 100 troy ounces. The initial margin is $1,800 per contract. The following arbitrage opportunity exits: January 2003 Cash Flow per ounce 6 Buy 100 troy ounces of gold on the spot market - $37, $ Storage and insurance - $ $ Sell 1 Jan 04 gold futures 400 Initial Margin - $1, Borrow at 5% for 12 months + $38,920. Initial Investment 0. January Deliver gold at futures price of $400 + $40, $ Withdraw Margin + $1, Pay off debt principle: - $38,920. interest: -$1, $19.46 Profit + $934. +$9.34 If the arbitrage is to be successful then the futures price must be high enough to make a profit when we sell the gold: the futures price must be greater than or equal to the spot price plus the carrying charges necessary to carry the gold to delivery. P Future $ P Spot + [ Costs of Carry ] P Future $ $370 + [ ] P Future $ $390.66

23 IX - FUTURES EXAMPLE: Suppose that in January 2003 the spot price of gold is $370 but the January 2004 gold futures are trading at $340. Our broker charges $3600 to borrow 100 ounces of gold for the 12 month period The following arbitrage opportunity exits: January 2002 Cash Flow per ounce 6 Short 100 troy ounces of gold on the spot market borrowing fee 6 Buy 1 Jan 03 gold futures $37, $3,600. Initial Margin - $1, Invest at 5% for 12 months - $31,600. Initial Investment 0. January Take delivery of gold at futures price of $350 cancel the short position 6 Withdraw Margin + $1, Cash in Investments principle: + $31, $ $ $34, $ interest: + $1, $15.80 Profit + $980. +$9.80 If the arbitrage is to be successful then the futures price must be low enough to make a profit when we buy the gold: the futures price plus the carrying charges necessary to carry the gold backwards in time must be less than or equal to the spot price. P Future + [ Costs of Carry ] # P Spot P Future + [ ] # $370 P Future # $ FIGURE IX - 6: FUTURES PRICE RANGE $370 Given these conditions the January 1999 gold futures price must be: $ # P Gold Future # $ or arbitrageurs will jump into the market and, through their buying and selling, force the futures price back into the $ to $ range

24 24 FINANCIAL MARKETS Things-To-Do: IX - 8 The gold futures contract is defined as 100 ounces and the initial margin is $600 per contract. The spot price of gold is $370/oz. Gold storage and insurance is 0.10 per ounce per month. Your broker will lend you gold for $3 per ounce per month. You may borrow or lend at 5% per annum. A. What is the price range for 12 month gold futures (at what prices do the arbitrage opportunities disappear) if the interest rate at which you can borrow or lend is 5%? B. What is the price range for 12 month gold futures it the interest rate increases to 15%? C. What is the price range for 6 month gold futures it the interest rate is 15%? D. What is the price range for 3 month gold futures it the interest rate is 15%? E. What is the expected price range for gold futures if the interest rate is 15% and the delivery date is tomorrow. Things-To-Do: IX - 9 It is December 2001 and the introduction of the Euro is causing some markets to behave in a peculiar fashion. Gold is trading in the spot market at $300/ounce but your Bridge terminal shows that one year Gold Futures are trading at $320/ounce. You check up on the Gold contract: Gold futures trade on the CBOT. One contract is defined as 100 troy ounces. Initial Margin is $1800 per contract; maintenance margin is $1200 per contract. You check with your commodities brokers and find that: Storage and insurance is $1 per ounce for the year your brokers would charge you $200/ounce to lend you gold for a year. your brokers will also borrow or lend at 5% simple interest per year Would you be able to profit by arbitraging between the two markets?

25 IX - FUTURES FINANCIAL FUTURES Financial Futures are futures contracts where the underlying asset itself is a financial instrument. Since the future is a financial instrument based on another financial instrument it falls under the category of derivative instruments. The underlying assets are standardized by the exchange on which the future trades. EXAMPLE: The Board of Trade of the City of Chicago, Rules and Regulations specifies the Long Term T-Note future as a future on U.S. Treasury Notes with semi-annual coupon which have an actual remaining term to maturity of not less than 6½ years and not more than 10 years. All notes delivered against a futures contract must be of the same issue and the issue is then priced to yield 8%. There are futures on Government securities of various maturities, GNMAs and other mortgage backed securities, Various Indices (S&P 500 (CME), S&P OTC 250 (CME), MMI (Major Market Index) (CBT), NASDAQ 100 (CME), NYSE Composite (NYFE), and even the Value Line Index Futures contract which is traded in Kansas City Board of Trade. There are also futures on options. HEDGING WITH INTEREST RATE FUTURES Futures on fixed income securities such as Treasuries are referred to as interest rate futures. FUTURES PRICES - Interest Rate Open Hi Low Settle Change Yield Settle Treasury Bonds (CBT) $100,000 pts 32nds of 100% Change Open Interest Dec 103:12 103:27 102:23 103: ,957 March 102:10 102:24 101:22 102: ,398 June 101:08 101:20 100:26 101: ,431 Treasury Notes (CBT) $100,000 pts 32nds of 100% Dec 106:05 106:27 105:17 106: ,522 March 104:30 105:19 104:10 105: ,324 Treasury Bills (CME) $1million pts of 100% Dec ,659 Financial Pages, December 28, 2001

26 26 FINANCIAL MARKETS G Short hedge 6 A short hedge is the sale of a financial futures contract to hedge against a increase in interest rates (a decrease in the price of the asset). EXAMPLE: You own a $1m 15 year 8d% T-Bond which is now trading at 103:08. It thus yields 8.00% You strongly suspect that the interest rates will rise in the next three months, causing the value of your bond to drop. We construct the hedge in much the same way as we did for George Q. Farmer. (You should be able to verify the bond prices and yields; the futures prices are given in the market and reflect the increase in yields) Jan 1 $1m 8.375% 15 year 103:08 MV= $1,032, Set Hedge Sell 10 Sept Bond 101:27 [$1,018,437.50] basis = 1:13 ($ ) - margin Bond Yields increase to 9% Lift Hedge Buy 10 Sept Bond 93:20 [$936,250.00] basis = 1:10 ($1.3125) + margin B = 82, Apr 1 $1m 8.375% 14¾ year 94:30 MV decreased by $83,125. MV = $949, Market Value of Portfolio: $1,031, In this example the loss on the bond was not quite offset by the profit on the future because the basis narrowed by 3/32 (from 1 13/32 to 1 10/32). The portfolio decreased in value by $ ($1m * (3/32)/100). Without the hedge the value of the portfolio would have decreased by $83,125. Note that the bond we own is 15 year 8¾ T-Bond and that the futures contract is for a 20 year 8% T-Bond. The exchange lays down equivalence rules so that equivalent bonds can be delivered in lieu of the theoretical 20 year 8% T-Bond but, in general, interest rate futures are reversed before delivery. G Long hedge 6 A long hedge is the purchase of a financial futures contract to hedge against a decrease in interest rates (an increase in the price of the asset).

27 IX - FUTURES EXAMPLE: You are the investment manager of a pension fund and you know that a pension contribution of somewhere in excess of $1m will be deposited to the fund in three months. You plan to buy a $1m 8¾% 15 year T-Bond which now trades at 103:08 You strongly suspect that the interest rates will fall, making the planned investment in the targeted T-Bond that much more expensive. We construct the hedge in much the same way as we did for Tofu Inc and Kankakee Canning. (You should be able to verify the bond prices and yields; the futures prices are given in the market and reflect the decrease in yields) Jan 1 $1m 8.375% 15 year 103:08 costs $1,032, but the money won't come into the fund until April 1 Set Hedge Buy 10 Sept Bond 101:27 [$1,018,437.50] basis = 1:13 ($ ) - margin Bond Yields decrease to 7% Lift Hedge Sell 10 Sept Bond 111:06 [$1,111,875.00] basis = 1:10 ($1.3125) + margin B = 93, Apr 1 Buy $1m 8.375% 14¾ year 112:16 cost increased by $92, $1,125, Total Effective Cost of the Bond: - $1,031, In this example the increase in the price of the bond was not entirely offset by the gain on the future because the basis narrowed by 3/32 (from 1 13/32 to 1 10/32). The effective price of the bond increased by $ ($1m * (3/32)/100). Without the hedge the price of the bond would have increased by $92,500 before we had a chance to buy it. In both these examples we have conveniently ignored the $3,000 initial margin requirement on each futures contract. The cost of carrying the margin must be worked into the hedge.

28 28 FINANCIAL MARKETS SPECULATING WITH INTEREST RATE FUTURES Speculation on interest rates is easier in the futures market than in the spot market. It is as easy to sell as to buy futures, (so the problem of borrowing T-Bonds to sell short doesn't arise) and because we trade on margin, speculators derive all the benefits and risks of substantial leverage. EXAMPLE: Long term interest rates are at 8.00%. You expect them to decline to 7% within six months. G Strategy A: 6 buy $1m 20 year 8% T-Bonds on the run at Jan buy 20 yr 8% T-Bonds at $1,000,000 - $1,000,000 July If the interest rates are: 7% 9% coupon [$1,000,000 * 0.08 * ½] + $40,000 + $40,000 sell 19½ yr 8% T-Bonds at 7% [110:18] + $1,105,625 sell 19½ yr 8% T-Bonds at 9% [ 90:28] + $908,750 Profit + $145,625 - $51,250 Rate of Return (semi-annual) % % The asymmetric rates of return derive because we get the $40,000 coupon in both scenarios. We also have the opportunity to extend the speculation over additional months, taking the chance that our prediction of lower interest rates will simply take longer than we thought. G Strategy B: 6 buy July T-Bond futures at On an assumed margin of $2,500 you can buy 400 September T-Bond contracts. Initial margin is $1,000,000. You are now long T-Bond futures with a face of $40m. You must unwind your position prior to the delivery date because if you go to delivery you will be required to purchase a portfolio of T-Bonds for which you must pay $39.6 million. This means that, not only must you be right about the decline in interest rates, you must be right within a fairly short period of time.

29 IX - FUTURES Jan buy 400 July T-Bond [-$39,600,000.] margin: - $1,000,000 - $1,000,000 July If interest rates are: 7% 9% sell 400 July T-Bond futures at 109:14 [B = $43,775,000 - $39,600,000] broker returns margin: + $4,175,000 + $1,000,000 sell 400 July T-Bond futures at 89:31 [B = $35,987,500 - $39,600,000] broker returns margin: - $3,612,500 + $1,000,000 Profit + $4,175,000 - $3,612,500 Rate of Return (semi-annual) % % Not all your profit/loss would be realized on the date of the final trade. If your interest rate predictions were right then you could withdraw from your margin account whenever the equity was above $1m and if you were wrong then you would have had to meet margin call from time to time. Things-To-Do: IX - 10 After attending a dinner party at which Alan Greenspan was also a guest, you become convinced that interest rates are going up in the near future. You decide to sell 100 September 20 year T- Bond futures. The sale is executed at 101:18. Margin requirements are $2,500 initial and $2,000 maintenance per contract. Each contract is defined as $100,000. A. Your futures contracts require you to sell how much in T-Bonds at delivery? For what total amount? B. How much are you required to deposit in initial margin? At the end of the following three days T-Bond futures settle at 101:00, 102:02, and 102:12 C. Calculate your profit and equity on each date. Do you receive a margin call? If so, for how much? Greenspan is discovered to have thousands of outstanding futures contracts. He is impeached and replaced by George Akerlof. The market goes into a tailspin and rates plummet. You phone your broker in a panic. Your broker closes you out at 109:31 D. What is your total loss on this investment?

30 30 FINANCIAL MARKETS Things-To-Do: IX - 11 Assume that in September, a 270 day T-Bill is quoted at 3.00%. You can borrow or lend at 3.00% What is the price range of a March future on 90 day T-Bills? (HINT: by March 2002 the 270 day T-Bill will be a 90 day T-Bill) Margin is $1,200 per contract. One contract is defined as $1m and your broker charges you $200 borrowing fee to short sell his $1m T-Bill INDEX FUTURES Index Futures are based on an underlying index rather than on underlying assets. Therefore delivery is not of a financial instrument (or, CME forbid, a whole basket of shares in the 500 issues that make up the S&P 500) but as a cash settlement. FUTURES PRICES Open Hi Low Settle Change Lifetime Hi S&P 500 Index (CME) $250 times index Low Open Interest Dec ,524 March ,574 Est vol 135,008; Index: Dow Jones Industrial Average (CBOT) $10 times index Dec ,711 Mar Est vol 23,000; Index: Financial Pages, November 28, 2001 The Nikkei 225 is also traded on the CME. The New York Exchange Composite Index future is traded on the New York Futures Exchange (NYFE) and the Major Market Index, traded on the CBT, closely resembles the Dow Jones Industrial Average (multiplied by 5).

31 IX - FUTURES G Contract Definition 6 The S&P 500 index futures trade on the CME (Chicago Mercantile Exchange,- also known as the Merc'). A contract is defined as $250 times the S&P 500. Contracts are written for March, June, September, and December. Settlement is on the third Thursday of the delivery month. EXAMPLE: Suppose that on this date you purchased one March S&P500 future at and that on the third Thursday of March the S&P 500 closed at November 28, 2001 March 21, 2002 Buy 1 March 02 S&P500 future [$250 * = - $288,075.00] - $margin. take delivery in cash equivalent [$250 * = + $300,000.00] B = + $11, $margin. EXAMPLE: Suppose that on this date you sold one March DJIA future at 9883 and that on the third Thursday of June the Dow Jones closed at November 28, 2001 March 21, 2002 Sell 1 March 02 DJIA future [$10 * 9883 = $98,830.00] - $margin. deliver cash equivalent [$10 * = $90,000.00)] B = - $8, $margin. Things-To-Do: IX - 12 You speculate that the market will crash before December. Use 100 S&P500 contracts to set up this speculation. A. The market ends the year at exactly the same value as it was on November 28. What is your profit or loss on this speculation? B. If the market had crashed and the S&P500 had lost 30% of its November 28 value by delivery date, what would have been your profit on this speculation?

32 32 FINANCIAL MARKETS USING STOCK INDEX FUTURES DIVERSIFICATION AND INDEXING: Stock Index Futures provide relatively inexpensive and highly liquid positions similar to those obtained with diversified stock portfolios. EXAMPLE: You have $1m to invest. Rather than investing in 500 separate stocks in order to track the S&P 500, you buy a $1m Treasury Bill and use the Treasury Bill itself to fulfill margin requirements on the purchase of S&P 500 futures. Note that in this example, as in the example with T-Bond Futures, you are fully leveraged. The risk increases accordingly. If the index declines then you must make margin call in cash. PORTFOLIO VOLATILITY: By putting part of your portfolio in index futures you can alter the volatility (aggressiveness) of your portfolio. Since the market portfolio has a $ = +1 buying stock index futures increases the portfolio's $ and selling stock index futures decreases the portfolio's $. Index futures can be used to create a $=0 portfolio. This means that its return is totally un-correlated with the market. This does not mean that there is no risk, it means that there is no systematic risk portfolio returns depend on the unsystematic risk exposure. Things-To-Do: IX - 13 You have a portfolio of $150,000 to invest. You select a number of stocks based on their individual firm specific characteristics, but you calculate the portfolio's beta at 1.8. Show that by selling two S&P futures contracts at , you reduce the portfolio's $ to Assume a $5,000 initial margin requirement per contract on the S&P 500. (Hint: let the S&P 500 decrease by 10% and then see what happens to the market value of your portfolio.) DYNAMIC HEDGING:

33 IX - FUTURES Investors make money when they buy low and sell high. Strategies designed to make sure that portfolios are mostly stock when the market goes up and mostly cash when the market goes down are insured or hedged by computer based trading that automatically generate buy and sell orders when pre-specified conditions are met. Dynamic hedging involves buying futures (or stocks) when the market is rising and selling futures (or stocks) when the market is falling. This is similar to the strategy of buying high $ stocks when the market is rising and low $ stocks when the market is falling. The SEC has expressed concern that dynamic hedging by a significant number of investors would trigger the cascade effect. A cascade occurs when the market begins to fall. Dynamic hedgers begin selling futures as well as stocks. The proceeds from the sale of stocks are used as margin requirement to sell even more futures. Arbitrageurs would take offsetting positions by buying index futures and selling stocks, thereby depressing the price of stocks even further. Eventually value-oriented investors would buy up these stocks when their prices fall below their fundamental values. Whether the volatility increases or decreases as a result of dynamic hedging depends on the balance of investors in the market. INDEX ARBITRAGE & PROGRAM TRADING: Arbitrage is defined as the purchase of assets in one market for the immediate resale in another. Index arbitrage is the simultaneous sale of an overpriced index future and purchase of the underlying stock, with a view to reversing the transactions when the future is no longer overpriced, or vice versa. Institutional Investors and market professionals have computer systems that continuously monitor the differences between index futures and the underlying index. Whenever it detects a significant variation (greater than the carry) the computer immediately issues market orders to the stock and futures exchanges to lock in nearly riskless returns. Because institutions use computers to coordinate these purchases and sales this is called program trading. Things-To-Do: IX - 14 It is February. Tardis Intertemporal is trading at $50. Tardis Intertemporal May futures are trading at $45. The carry is estimated at 5% of the spot price. A. What is the expected range of the futures price? B. Set up an arbitrage trade strategy using ten futures contracts. One contract is for 1000 shares. Initial Margin is $1,000 per contract and your broker reminds you that Regulation T requires that you deposit margin of 150% on a short sale. You may borrow money at 10% per annum simple interest. By April the price of Tardis Intertemporal has fallen to $20. The May future is now trading at $20.50.

34 34 FINANCIAL MARKETS C. If you close your position now what is the profit on your arbitrage trades? By the May delivery date Tardis Intertemporal has risen to $72 and the May futures close at $72 as well. D. What is the profit on your arbitrage trade? E. Should I have aborted the arbitrage in April? F. Why is this type of transaction virtually risk free? CURRENCY FUTURES Currency futures are traded on the Chicago Mercantile Exchange (CME), London International Financial Futures Exchange (LIFFE), Toronto Futures Exchange, and on the Singapore, Sidney, and New Zealand Futures Exchanges. Things-To-Do: IX - 15 You enter into a contract with Ferari to Import 100 top of the line sports cars. Payment of 12m Euros is to be made February 15. Using the information in the table below, set up a hedge against possible revaluation of the Euro. A. Suppose that on February 15 the Euro is trading at and the March futures contract is trading at What happens to the basis? What is the result of the hedge? B. Suppose that on February 15 the Euro is trading at and the March futures contract is trading at What happens to the basis? What is the result of the hedge? FUTURES PRICES Open Hi Low Settle Change Lifetime Hi Euro Fx (CME) Euro 125,000; $ per Euro Low Open Interest Dec ,588 March ,744 Est vol 14,673; Spot Price DM =.8834 Financial Pages, November 28, 2001

35 IX - FUTURES OTHER FUTURES Futures can be constructed on almost anything. All you really need is a robust contract built on a measurable outcome and enough buyers and sellers to generate a fair market. WEATHER FUTURES On February 4, 1999 the Chicago Mercantile Exchange announced that it intended to trade futures contracts based on the weather in Chicago and seven other major US cities. The contract would be based on indices of Heating Degree Days and Cooling Degree Days. EXAMPLE: The Savoy Chicago is a luxury hotel. When the summer is very hot and humid the entire hotel runs their air conditioning system full blast, day and night. This tends to get expensive. To hedge against these additional cooling costs the Hotel's Financial Manager buys weather futures. Assume that the weather future contract is defined as $100 times Cooling Degree Days and that the current settlement price is 400. Scenario one: The summer is very hot and humid. At delivery the official index of Cooling Degree Days is at 512. The Hotel makes a profit on the weather future of $11,200 (buy at 400 and sell at 512 so $100 * ( ) = $11,200). This profit goes to offset the higher costs of cooling the rooms in the hotel. Scenario two: The summer is rather cool and rainy. At delivery the official index of Cooling Degree Days is at 320. The Hotel makes a loss on the weather future of $8,000 (buy at 400 and sell at 320 so $100 * ( ) = $8,000). This loss comes out of the air conditioning budget which we can afford because we didn't use it to cool the rooms in the hotel. FINANCE GPA FUTURES Assume that the University of Illinois begins trading Finance GPA futures contracts. Each contract is defined as $100 times the final GPA of the graduating class. Obviously the outcome must be between 0.0 and 5.0 so the initial margin is set at $5000 so that we don t have the bother of marking to market and margin calls. Contracts are traded every weekday from noon til 1pm in the Business Quad. Contracts are cleared through the Dean s office. One sunny afternoon in March we observe two students, Kevin and Joe trading 10 contracts at 4.0

36 36 FINANCIAL MARKETS Kevin buys 1 Finance GPA 4.0 Joe sells 1 Finance GPA 4.0 I promise to buy 1 Finance GPAs on Graduation Day I promise to sell 1 Finance GPAs on Graduation Day Price per GPA: 4.0 Signature Kevin Price per GPA: 4.0 Signature Joe Kevin deposits $5,000 margin Joe deposits $5,000 margin. The Dean s office collects $10,000 in initial margin and the open interest is one. The final GPA is announced on Graduation Day by the Dean. This year it comes in at 4.3 The contracts come to delivery. Essentially Kevin buys at 4.0 GPAs worth 4.3 so he makes a profit of $300 ($1000 * 0.3) Essentially Joe sells at 4.0 GPAs worth 4.3 so he makes a loss of $300 ($1000 * 0.3) Buy: $1000 ( 4.0 & $4,000 a GPA worth: $1000 ( 4.3 $4,300 Profit $300 Kevin collects his equity of $5,300 from the Dean s office. The $5,300 consists of his $5000 initial margin plus his $300 profit. Sell: $1000 ( 4.0 $4,000 a GPA worth: $1000 ( 4.3 & $4,300 Profit & $300 Joe also goes to the Dean s office to collect his equity of $4,700. The $4,700 consists of his $5000 initial margin less his $300 loss. The Dean s office collected $10,000 (2*$5,000) in initial margin when Kevin and Joe entered into this contract and the Dean s office paid out $10,000 ($5,300 + $4,700) when the contract delivered. Reading Assignment: Read "As the U of Iowa goes, so goes the nation?" Business Week, November 11, 1996 about the Presidential election futures traded at the University of Iowa. A copy of this article is included at the end of the chapter.

37 Iowa seems an unlikely spot for the financial world to focus its attention. But the University of Iowa is host to what is arguably today s hottest market - an electronic exchange that allows traders to bet on the outcome of the national election. What began as an Ivory Tower experiment in remote Iowa City is beginning to have an impact on stocks and bonds. When trading at the Iowa Electronic Market on Oct. 23 suggested that Congress might fall to the Democrats, the Dow Jones industrial average took it on the chin. The capital markets are paying attention because the IEM has forecast election results with surprising accuracy since its formation in It predicted the vote totals of the past two Presidential elections within two tenths of a percentage point, outperforming national polls. It also has closely tracked elections overseas, never wavering from Boris Yeltsin, for instance, as he won reelection in Russia. The market operates like a strippeddown model of the Chicago futures pits, except that all trading is conducted on the World Wide Web at Participants can open accounts with up to $500 and trade any of 16 contracts. Some 7,000 players have more than $200,000 riding on them. The most popular play is the winner-takeall bet on Clinton vs. Dole. Each contract has a Clinton unit and a Dole unit, which together costs $1 to buy. Traders make their bet by selling the unit they think will lose. When the contracts expire on election day, the winning candidate s units pay $1 and the loser s are worthless. Lately, traders have been snapping up Clinton and dumping Dole. In the lively aftermarket for units, Clinton was selling IX - FUTURES As The U. of Iowa goes, so goes the Nation? The election futures market may be more accurate than polls for 95 as of Oct. 29 and Dole for 5. So if Dole pulls an upset, his supporters in the market can win a dollar for every nickel they wager. That s not the only Presidential contract. Traders in the vote-share market are betting Clinton to win on Nov. 5 by a wide margin - though not as wide as some polls indicate. From early March to late October, Clinton units have climbed from 51% to 57%. Rather than winner-take-all, traders who paid 51 would realize 57 per unit at expiration if Clinton gets that much of the vote. On the other hand, Dole voters have watched their contracts sag from 49% to 43% over the same period. In contracts involving House and Senate control, Iowa traders riled the stock and bond markets by bidding up the value of Democrats-take-the-House units to 44 - suggesting a 44% chance of Gingrich & Co. losing control of the next session. As of Oct.29, though, the IEM s view on Democrats seizing power had retreated to 37%. Track Record. Interesting, but is it a legitimate indicator? Some major-league traders think so. The idea that markets work better than polls appeal to folks toiling on trading floors. Bond analysts at Merrill Lynch & Co. and Lehman Brothers Inc. follow the Iowa exchange, and some market professionals have joined in the betting. At heart, traders see value in subjecting political winds to market forces, and even Iowa s small stakes are an improvement on mere poll responses: They re putting their money on the line, and that means something, says Chicago Board of Trade Chairman Patrick Arbor. Pollsters, meantime, typically have problems predicting turnout and getting representative samples, explains Robert Forsythe, associate dean at Iowa s business school and a driving force behind the market. Voters who answer polls sometimes lie about their preferences or whether they vote at all. Even as advocates hail free markets in action, critics attack the ballot box bourse for it s short history, thin capitalization, and alleged tendency to veer out of sync early on in the election cycle. Yet those gripes hardly matter if the market s overall performance is good - and so far, the record favors Iowa. We ve yet to be disappointed, Forsythe boasts. While the Iowa market is no doubt unrepresentative, it rewards those who are good at predicting elections. The basic idea is right. People will do what s economically rational, notes Martin S. Fridson, chief high-yield bond strategist at Merrill Lynch. So if the Iowa market is gaining credibility, isn t it also inviting manipulation? Why not sell short stockindex futures, then bet your Iowa account on Democrats retaking the House in the hope that your order will change the political odds and frighten Wall Street again? To be sure, the potential risks have caused the market s founders some jitters. In 1992, they invited the Commodity Futures Trading Commission to regulate it. They also take comfort in the $500 trading limit, which curtails the ability of single players to move prices: an avid Perot supporter tried it in 1992, but the market swung back within hours. In the beginning, the IEM was aimed at providing hands-on experience to students hindered by their school s geographic disadvantage - a polite way of saying that, market-wise, it s in the middle of nowhere. Today, the political market is set to grow. While its founders scoff at the Brazilian hedge-fund manager who tried to open an account with $12 million, they see nothing wrong with raising the stakes to, say, $5,000 per account. And since demand is strong for the Iowa approach in Russia, Turkey, and other nations where polling remains primitive, You re naturally inclined to think global, says Gary C. Fethke, Iowa s B-school dean.

38 38 FINANCIAL MARKETS Today, Iowa, tomorrow, the world. By Greg Burns in Iowa City