© paul koch 1-1 chapters 1 & 2: introducing forwards & futures a. mechanics of forwards and...

32
© Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment by 2 parties to exchange particular good for a specific price (F) at a specified future time. Agree on price (F) initially, but exchange nothing until expiration. Either or both parties may have to post Margin. b. Futures Contract - same as forward contract except that profits / losses are computed and settled (marked-to-market) on a daily basis, rather than only at expiration.

Upload: nikolas-decoursey

Post on 14-Dec-2015

234 views

Category:

Documents


3 download

TRANSCRIPT

Page 1: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-1

Chapters 1 & 2: Introducing Forwards & Futures

A. Mechanics of Forwards and Futures.

1. Definitions:

a. Forward Contract - OTC commitment by 2 parties to exchange

particular good for a specific price (F) at a specified future time.

Agree on price (F) initially, but exchange nothing until expiration.

  Either or both parties may have to post Margin.

b. Futures Contract - same as forward contract except that

profits / losses are computed and settled (marked-to-market)

on a daily basis, rather than only at expiration.

  Futures Contracts are traded on Exchanges (not OTC) that set standard terms for contracts, & facilitate trading.

  Financial Futures - a contract in which the good to be delivered is a financial instrument (not a commodity).

Page 2: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-2

A. Mechanics of Forwards & Futures

c. Daily Marking-to-Market for futures:

Consider 1 contract to buy / sell T.Bonds, for delivery in 10 days. - Traded in face amounts of $100,000; Maturity ≥ 15 years. - Prices are quoted in thousands of $; - F = 66 on day -9 means buyer agrees to pay $66,000 in 10

days.

(F) Cash Flow Cash Flow Cash Flow Cash Flow Settlement if Long if Short if Long if Short Day Price 1 Forward 1 Forward 1 Futures 1 Futures .

-9 66 -8 67 0 0 +1000 -1000 -7 68 0 0 +1000 +1000 -6 65 0 0 -3000 -3000 -5 64 0 0 -1000 -1000 -4 66 0 0 +2000 +2000 -3 64 0 0 -2000 -2000 -2 68 0 0 +4000 +4000 -1 67 0 0 -1000 -1000 0 68 +2000 -2000 +1000 +1000

Total Cash Flow: +2000 -2000 +2000 -2000

Page 3: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-3

A. Mechanics of Forwards & Futures

d. Comparison of Forwards versus Futures:

FORWARDS FUTURES__________________________________________________________________

1. Traded between private parties (OTC). Traded on Exchange.

2. Contracts not standardized. Standardized contracts.

3. One specific delivery date. Many delivery dates.

4. Settled at maturity. Marked-to-market daily.

5. Delivery usually occurs. Rarely delivered.__________________________________________________________________

If you buy a futures contract,

agree to buy the asset at today's price (F)

sometime in the future. (long a contract; take delivery).

If you sell a futures contract,

agree to sell the asset at today's price (F)

sometime in the future. (short a contract; deliver).

Page 4: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-4

A. Mechanics of Forwards & Futures

e. Size of OTC Markets versus Exchange-Traded Markets:

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market

Page 5: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-5

A. Mechanics of Forwards & Futures

f. The Lehman Brothers Bankruptcy and the Crash of 2008.

i. Lehman’s filed for bankruptcy on September 15, 2008. Biggest bankruptcy in US history.

ii. Lehman was active participant in OTC derivatives mkts; Got into trouble because it took high risks.

iii. Lost big money on MBS holdings (long term debt);

iv. Found it was unable to roll over its short term funding;

v. It had hundreds of thousands of transactions outstanding,with about 8,000 counterparties;

vi. Unwinding these transactions has been challenging for both the Lehman liquidators and their counterparties;

vii. Precipitated crash of 2008, & slowed growth of OTC mkt.

Page 6: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-6

A. Mechanics of Forwards & Futures

g. Ways Derivatives are used (reasons for trading derivatives).

i. To hedge risks;If you have risk exposure, & use derivatives to ↓ risk.

ii. To speculate (take a view on future direction of market);If you don’t have exposure, &/or use deriv.’s to ↑ risk.

iii. To lock in an arbitrage profit;If Law of One Price (LOP) is violated, buy low & sell high.Arbitrage Portfolio: takes no risk; uses none of your own $.

iv. To change the nature of a liability;

v. To change the nature & risks of an investment (exposure)without incurring the costs of selling one portfolio and buying another.

Page 7: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-7

A. Mechanics of Forwards & Futures

h. Why use Derivatives to speculate? (Why not trade spot?)

i. Derivatives offer leverage (multiply winnings or losses):

(E) (D) What if (D) (E) (∆E / E)

If Value ↑: Invest own owe ↑ 50% owe own ROE%

No Leverage $10,000 $10,000 $0 $15,000 $0 $15,000 +50%

Leverage $10,000 $1,000 $9,000 $15,000 $9,000 $6,000 +500%

(E) (D) What if (D) (E) (∆E / E)

If Value ↓: Invest own owe ↓ 50% owe own ROE%

No Leverage $10,000 $10,000 $0 $5,000 $0 $5,000 -50%

Leverage $10,000 $1,000 $9,000 $5,000 $9,000 -$4,000 -500%

Page 8: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-8

A. Mechanics of Forwards & Futures

2. Institutional Features of Futures Markets.

  a. Role of Exchange.

i. Serves as a Clearinghouse:

1. Comes between buyers & sellers of futures contracts.Buyer & seller do not know each other; have claims against Exchange.

2. Requires both parties in a trade to post Margin (more later).

Collateral deposit to insure integrity of market & protect middleman.

3. Reconciles all trades at close every day.

Daily marking - to - market; Transfers winnings / losses across accounts;

Manages margin accounts, makes margin calls, etc.

*** 4. Similar Clearinghouse arrangements have been instituted

for some OTC forward markets, since 2008 crash.

Known as Central Clearing Parties (CCPs). --- More later.

Page 9: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-9

A. Mechanics of Forwards & Futures

2. Institutional Features of Futures Markets.

  a. Role of Exchange, continued.

ii. Specifies Terms of the Contract in detail:

1. Asset to be delivered:Commodities – must stipulate grades / qualities acceptable;

Financial Assets – it depends:

Foreign Currency; no need to specify quality of £ or ¥ or € .

T.Bonds; any T.Bond with ≥ 15 years to maturity …

T.Notes; any T.Note with 6.5 to 15 years to maturity …

2. Contract Size: specifies amount to be delivered for 1 contractIf too large, will exclude many smaller participants;

If too small, will need more contracts, & have to pay more commission.

3. Price quotes: depends on contract

Oil, ¢ / barrel; T. Bonds, 1/32 of $; etc.

Page 10: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-10

A. Mechanics of Forwards & Futures

4. Maturity - Delivery arrangements: Where, How, When to deliver?

a. Important for commodities; transportation & storage costs are high.

b. Contract is referred to by delivery month; Exchange specifies when.

c. Actual delivery rarely takes place in futures markets.

Almost always settled by closing out position with offsetting trade.

However, the possibility of delivery drives the futures price.

d. Delivery Period.

When contract matures, exchange specifies a range of dayswhen seller can announce intent to deliver.

Exchange chooses a long position to assign delivery (must buy …).

If long, close position before maturity to avoid being assigned!

e. Implied Delivery Option.

Seller has right to declare intent to deliver.

– has some leeway in where, when, & what to deliver.

Seller will deliver where, when, & what is cheapest!

f. A few contracts (e.g., on stock indexes & ED) are settled in cash.

Page 11: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-11

A. Mechanics of Forwards & Futures

2. Institutional Features of Futures Markets, continued.

b. Margin (collateral).

i. Good faith deposit, to ensure fulfillment of obligations.

ii. Initial Margin - deposit when a position is first taken;

Usually 5-10% of total value of contract.

Effect of trading on margin is to leverage position.

Varies across markets, by size of contract & daily volatility (σF).

iii. Maintenance Margin - minimum amount of equity allowed;

Usually 75-80% of initial margin.

If F ↓ to this, margin call. If you don't meet margin call, will liquidate.

If F moves in your favor, can skim off excess margin.

iv. Two reasons for margin requirements:

- Protect the integrity of Exchange and the middleman from default.

- Regulators argue higher margin ↓ volatility (σF) from speculators.

Page 12: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-12

A. Mechanics of Forwards & Futures

2. Institutional Features of Futures Markets, continued.

b. Margin (collateral), continued.

v. Margin Cash Flows when Futures Price Decreases:

Page 13: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-13

A. Mechanics of Forwards & Futures

2. Institutional Features of Futures Markets, continued.

b. Margin (collateral), continued.

vi. Margin Cash Flows when Futures Price Increases:

Page 14: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-14

A. Mechanics of Forwards & Futures

2. Institutional Features of Futures Markets, continued.

c. Liquidity.

i. Volume - amount of trading activity in those contractsover some period of time.

ii. Open Interest - total number of outstanding contractsat a given point in time in a contract’s life cycle.

Open Interest|| | | | || | | | || | | | || | | | || | | | ||________ |__________ |___________|___________|____ time

exp. 1 exp. 2 exp. 3 exp. 4

Page 15: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-15

A. Mechanics of Forwards & Futures

d. Types of Traders.

  i. Commission brokers follow instructions of their clients, for a commission.

ii. Locals trade for their own account.

e. Types of Orders.i. Market order – executed immediately at best price available.

ii. Limit order – only execute at a certain price or one better.

iii. Stop loss order – execute immediately at best price available,

once a trade occurs at the specified price or a worse price;

Becomes market order once certain price is reached. To limit losses.

  iv. Stop limit order – combines stop loss order & limit order.

Becomes a limit order once a bid or offer is made

at a price equal to, or less favorable than, the stop price.

  v. Market-if-touched (MIT) order – execute immediately at best price available,

once a trade occurs at the specified price or a better price.

Becomes a market order once certain price is reached.

Used to take profits are taken if favorable price move occur

(thus differs from stop loss order).

  vi. Discretionary order – market order, but broker may delay to try for better price.

Page 16: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-16

A. Mechanics of Forwards & Futures

f. Regulation.

i. CFTC (1974) – responsible for licensing futures exchanges.

New contracts & changes to existing contracts need CFTC approval.

To be approved, contract must have some useful economic purpose.

CFTC looks after public interest:

- ensure prices are communicated.

- ensure futures traders report outstanding positions,

if above certain levels.

- license all individuals serving public in futures area.

- deal with complaints.

ii. National Futures Association (NFA, 1982)

Organization of participants in futures industry.

Purpose, prevent fraud & ensure market operates in public interest.

- requires members to pass exam (minimum competence).

- monitors trading

- deals with complaints.

NFA has shifted some responsibilities of CFTC to the industry.

Page 17: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-17

A. Mechanics of Forwards & Futures

iii. Other bodies with regulatory authority:

SEC, Fed, Treasury.

Concerned about effect of futures markets on spot markets

in stocks, T. Bills, T. Bonds, etc.

SEC has veto power over new futures contracts involving stocks, bonds.

iv. Trading irregularities.

Cornering the market; Short Squeeze.

(Hunt brothers, silver, 1979; Sumitomo, copper, 1996).

Investor group takes big futures position, tries to corner supply,

& squeeze short futures positions.

If # futures contracts outstanding > supply of spot, S & F .Regulators can deal with this – margin, position limits…

v. Abuse on floor of exchange:

- exchange members over-charging customers.

- front-running.

FBI sting, 1989, agents as moles in CME & CBOT.

Page 18: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-18

A. Mechanics of Forwards & Futures

g. Hedge Accounting for derivatives gains / losses.

IRS distinguishes between hedgers & speculators for tax purposes.

Hedgers - futures positions are part of "normal operations";futures gains/losses treated as ordinary income.

Speculators - the rest; ... treated as capital gains/losses.

FAS #133 established hedge accounting standards in U.S.

This statement requires changes in value to be recognized when they occur, unless the contract qualifies as hedge.

If the contract qualifies as a hedge, gains / losses from hedge can be deferred and recognized in same period as gains / losses from item being hedged.

Firm must demonstrate that it is hedging, to qualify.

FAS #133 describes what firm must do to show it is hedging!

Page 19: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-19

A. Mechanics of Forwards & Futures

g. Hedge Accounting for derivatives gains / losses, continued.

Example: In September, year 1 trader buys March - corn futures; F0 = $1.50/bu. At the turn of year 1 (Dec. 31), price has risen; F1 = $1.70/bu. In February, year 2 trader closes position; F2 = $1.80/bu. One contract is for the purchase of 5000 bushels.

If trader is hedging expected purchase of corn in year 2,

the entire gain is realized in year 2; 5000 x (+$.30) = +$1500.

Effect of futures contract is to ensure price paid in year 2 is close to $1.50.Hedge accounting reflects fact that $1.50 is the price paid in year 2.Accounts in year 1 are unaffected by this futures trade.

If trader is speculating,

accounting gains are recognized as follows: year 1; 5000 x (+$.20) = +$1000;

year 2; 5000 x (+$.10) = +$500.

Note: even though contract is still open, gains are realized at year-end.Law: For speculators, all futures positions must be marked-to-market at year-end.Then 40% of gains / losses treated as short term, 60% as long term.This law eliminates use of tax straddles as a loophole (since 1982).

Page 20: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-20

A. Mechanics of Forwards & Futures

h. Taxation.

Two issues:

i. Nature of taxable gain/loss; Cap gain / loss or Ordinary Income.

ii. Timing of recognition.

First consider the Nature.

For corporate taxpayer: Capital gains are taxed at same rate as ordinary income;

Ability to deduct losses is restricted.

Capital losses are deductible only to extent of capital gains.

Corporation may carry back capital loss for 3 years,

and may carry it forward up to 5 years.

For noncorporate taxpayer:

Short-term capital gains taxed at same rate as ordinary income;

Long-term capital gains taxed at lower rate.

(Taxpayer Relief Act of 1997 widened this rate differential.)

Capital losses are deductible to extent of capital gains plus

ordinary income up to $3000; can be carried forward indefinitely.

Page 21: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-21

A. Mechanics of Forwards & Futures

Second consider the Timing.

For speculators, futures gains/losses must be marked-to-market at

year-end; then 40% treated as short-term, & 60% as long-term.

Hedging transactions are exempt from this rule.

The definition of a hedge transaction for tax purposes is different from

that for accounting purposes. Tax regulations define a hedging

transaction as one entered into in the normal course of business:

i. to reduce the risk of price changes or currency fluctuations with respect to property held to produce ordinary income;

ii. to reduce risk of price changes or currency fluctuations with respect to borrowings made by taxpayer.

For hedgers, gains/losses are realized in the same period

as gains/losses from the item being hedged.

Page 22: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-22

B. Collateralization in OTC Markets

1. It is becoming increasingly common for transactionsto be collateralized in OTC markets.

a. Consider bilateral clearing between companies A and B.

b. These might be governed by an ISDA Master agreement with a credit support annex (CSA).

c. The CSA might require A to post collateral with B equal to the value (to B) of A’s outstanding transactions with B, when this value is positive.

d. If A defaults, B is entitled to take possession of the collateral.

e. The transactions are not settled daily.

f. Interest is paid on cash collateral

Page 23: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-23

B. Collateralization in OTC Markets

2. Central Clearinghouses and OTC Markets

a. OTC transactions have traditionally been cleared bilaterally in OTC markets.

b. Following the crisis of 2007-2009, regulators are developing a new requirement for most standardized OTC trades to be cleared centrally through clearinghouses.

c. Standardized trades would include:

i. Basic Interest rate Swaps;

ii. Credit Default Swaps (CDS);

iii. Basic Forwards; etc.

d. Standardized trades would NOT include other OTC trades tailored by financial institutions to meet customer’s needs.

Page 24: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-24

B. Collateralization in OTC Markets

3. Bilateral Clearing vs Central Clearinghouse

a. Bilateral: Losses by one party affect all parties.

b. Central Clearinghouse: Losses by one party affect only clearinghouse.

Bilateral Clearing Central Clearing

Page 25: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-25

B. Collateralization in OTC Markets

4. Since the crash, regulators are more concerned withsystemic risk from OTC markets.

a. Lehman Brothers, AIG, … OTC counterparties lost billions.

b. Losses by one party can spread, endanger financial system.

c. Regulators are developing new Legislation that requires standardized OTC trades to go thru Central Clearing Parties.

d. CCPs are similar to the exchange clearinghouse.

i. Once a standard OTC trade is agreed upon by parties A & B,the OTC trade is presented to a CCP.

ii. If CCP accepts trade, it becomes counterparty to A & B.

iii. The CCP operates like an exchange clearinghouse: --- Takes on credit risk of both parties; --- Requires margin from both A & B; --- Settles trades; marks - to - market daily; ...

Page 26: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-26

C. Futures Price Patterns

1. Futures Prices can be:a. An ↑ ing function of maturity: F > S; Contango; Normal.

b. A ↓ ing function of maturity: F < S; Backwardation; Inverted.

2. Futures Price converges to Spot Price at maturity, if the spot asset is the same asset underlying the futures contract.

Time Time

a. Contango b. Backwardation

FuturesPrice

FuturesPrice

Spot Price

Spot Price

Page 27: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-27

D. Uses of Financial Futures

Three important features of financial futures:

i. liquid,

ii. low transactions costs, and

iii. low margin requirements.

These features make financial futures attractive for several uses.

1. Hedging various forms of risk. Examples:

a. Farmer will wish to sell wheat in July;

can sell wheat futures to avoid risk of price decline.

Effectively locks into current (Forward) price of wheat.

Page 28: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-28

D. Uses of Financial Futures

b. Financial Futures hedging is analogous.

Treasurer may plan to issue bonds in near future;

Risk is that interest rates might increase before issue!

Can hedge this risk by selling a T. Bond futures.

Effectively locks into current long term interest rates.

If rates rise, corporation must pay higher rates,

but short futures position will increase in value to offset loss.

i. Basis Risk - that the spot price of corporate bond

and the futures price of T. bond may not move together.

Correlations are high; hedge is quite effective.

Page 29: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-29

D. Uses of Financial Futures

c. Treasurer has a receivable in Euros due in 3 mo;

Wishes lock into today's exchange rate & T. Bill rate.

Can sell Euros forward, and buy T. Bill futures.

If Treasurer delivers Euros & takes delivery of T. Bills,

return is certain.

d. Investor near retirement; worried that stock market crash

might hurt the value of pension in equities.

Can sell stock index futures now, and hedge against

risk that market will decline before retirement.

Page 30: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-30

D. Uses of Financial Futures

2. Changing Investment Policy. Examples:

a. Futures can be used to change various risk exposures.

Futures have 3 advantages for accomplishing this:

i. Transactions Costs are usually lower for futures

than for the underlying assets;

ii. Futures allow the firm's selection decision to be

independent of the market exposure decision;

iii. Profits & Losses on futures allow a direct measure of

managers' ability to anticipate timing of opportunities;

Use of futures separates performance due to selection

from performance due to market timing.

Page 31: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-31

D. Uses of Financial Futures

b. Changing market risk exposure of stock portfolio.

To decrease the market beta of a stock portfolio,

i. Can sell high-beta stocks & buy low-beta stocks, or

ii. Can sell stock index futures, to reduce the portfolio's beta to any level desired.

c. Changing interest rate risk exposure on bond portfolio.

Duration - measure of sensitivity of a bond portfolio to changes in interest rates.

Bond managers are interest rate forecasters (timers);

If they feel interest rates will rise, want to shorten the duration of their portfolio so the decline in bond values will be mitigated.

To decrease the duration of a bond portfolio,

i. Can sell long-term bonds & buy short-term bonds, or

ii. Can sell T. Bond futures, to reduce the portfolio's duration to any level desired.

Page 32: © Paul Koch 1-1 Chapters 1 & 2: Introducing Forwards & Futures A. Mechanics of Forwards and Futures. 1. Definitions: a. Forward Contract - OTC commitment

© Paul Koch 1-32

D. Uses of Financial Futures

3. Creating new products.

a. Alpha Fund - a 'zero beta' fund.

If your firm has expertise in identifying undervalued assets,

you can make your selections in some asset category or mkt,

and then use futures to make the 'beta' of your

combined portfolio of assets and futures equal to zero.

The idea is to capture the selection abilities of your firm

without being subject to any kind of market risk.

b. Portfolio Insurance - futures can be used to replicate payoffs

of stocks, bonds, puts, or calls. Possibilities are limitless.