trimsize:7inx10in · 2017. 9. 7. · ﬁnance not only with a better foundation in understanding...

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DERIVATIVESMARKETSAND ANALYSIS

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The Bloomberg Financial Series provides both core reference knowledge andactionable information for financial professionals. The books are written by expertsfamiliar with the work flows, challenges, and demands of investment professionalswho trade the markets, manage money, and analyze investments in their capacity ofgrowing and protecting wealth, hedging risk, and generating revenue.

Since 1996, Bloomberg Press has published books for financial professionals oninvesting, economics, and policy affecting investors. Titles are written by leading prac-titioners and authorities, and have been translated into more than 20 languages.

For a list of available titles, please visit our website at www.wiley.com/go/bloombergpress.

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DERIVATIVESMARKETSAND ANALYSIS

R. Stafford Johnson

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Copyright © 2017 by R. Stafford Johnson. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, orauthorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com.Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons,Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparingthis book, they make no representations or warranties with respect to the accuracy or completeness of the contentsof this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose.No warranty may be created or extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with a professional where appropriate.Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including butnot limited to special, incidental, consequential, or other damages.

All charts reprinted with permission from Bloomberg. Copyright 2017 Bloomberg L.P. All rights reserved.

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Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included withstandard print versions of this book may not be included in e-books or in print-on-demand. If this book refers tomedia such as a CD or DVD that is not included in the version you purchased, you may download this material athttp://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data is Available

ISBN 978-1-118-20269-2 (Hardcover)ISBN 978-1-118-22828-9 (ePDF)ISBN 978-1-118-24072-4 (ePub)

Cover Design: C. WallaceCover Images: Abstract Background© iStockphoto / jcarroll-images;Chart Courtesy of R. Stafford Johnson

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This book is dedicated to Nancy Shiels—My beacon

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Contents

Preface ix

Acknowledgments xiii

About the Author xiv

PART 1: FUTURES AND FORWARD CONTRACTS 1

CHAPTER 1Futures Markets 3

CHAPTER 2Currency Futures and Forward Contracts 47

CHAPTER 3Equity Index Futures 78

CHAPTER 4Interest Rate and Bond Futures and Forward Contracts 121

PART 2: OPTIONS MARKETS AND STRATEGIES 185

CHAPTER 5Fundamentals of Options Trading 187

CHAPTER 6Non-Stock Options: Equity Index, Futures, OTC,and Embedded Options 224

CHAPTER 7Option Strategies 278

CHAPTER 8Option Hedging 332

PART 3: OPTION PRICING 397

CHAPTER 9Option Boundary Conditions and Fundamental Price Relations 399

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viii Contents

CHAPTER 10The Binomial Option Pricing Model 439

CHAPTER 11The Black-Scholes Option Pricing Model 505

CHAPTER 12Pricing Non-Stock Options and Futures Options 544

CHAPTER 13Pricing Bond and Interest Rate Options 578

PART 4: FINANCIAL SWAPS 625

CHAPTER 14Interest Rate Swaps 627

CHAPTER 15Credit Default and Currency Swaps 673

PART 5: SUPPLEMENTAL APPENDIXES 705

APPENDIX AOverview and Guide to the Bloomberg System 707

APPENDIX BDirectory Listing of Bloomberg Screens by Menu and Function 742

APPENDIX CUses of Exponents and Logarithms 755

Index 761

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Preface

In 1973, the Chicago Board of Trade formed the Chicago Board Options Exchange(CBOE). The CBOE was the first organized option exchange for the trading ofoptions. Just as the Chicago Board of Trade had served to increase the popularity offutures, the CBOE helped to increase the trading of options by making the contractsmore marketable. Since the creation of the CBOE, organized stock exchanges in theUnited States, most of the organized futures exchanges, and many security exchangesoutside the United States also began offering markets for the trading of options. Asthe number of exchanges offering options increased, so did the number of securitiesand instruments with options written on them. Today, option contracts exist notonly on stocks but also on currencies, indexes, futures contracts, and debt andinterest rate-sensitive securities. There is also a large over-the-counter option marketin currency, debt, and interest-sensitive securities and products in the United Statesand a growing over-the-counter option market outside the United States. Just asimpressive as the growth in options trading has been the growth in the futures market.Today, there are futures contracts on commodities, equity indexes, currencies, bonds,and interest rates, as well as such hybrid contracts as swaps. Options, futures, andswaps are derivatives—securities that derive their values from the underlying asset.Derivatives are used by institutional investors, portfolio managers, and corporationsfor speculation and hedging, as well as financial engineering in creating structuredcurrency, equity, and debt positions.

Over the past 50 years, the investment industry has seen not only the proliferationof derivative securities and markets, but also academic contributions to the study ofderivatives: The Black-Scholes Option Pricing Model, index arbitrage, financial engi-neering, and dynamic portfolio insurance. The growth in the derivative markets andthe academic contributions together point out the challenges in mastering an under-standing and developing a knowledge of derivatives. The purpose of this text is toprovide professionals and finance students with an exposition on derivatives that willtake them from the basic concepts, strategies, and fundamentals to a more detailedunderstanding of the markets, advanced strategies, and models.

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x Preface

Derivative Markets and Analysis is the last in a three-part series on securities fromBloomberg Press’s Financial Series. The first, Debt Markets and Analysis, coveredfixed-income securities, and the second, Equity Markets and Analysis, focused on stockand stock portfolios. This book covers subjects presented in many derivative texts:futures and forward markets, the carrying-cost model for pricing futures, optionstrategies, the Black-Scholes and Binomial Option Pricing models, futures options,and swaps.

Today, many practitioners manage their securities and portfolios using a Bloom-berg terminal. Bloomberg is a computer information and retrieval system providingaccess to financial and economic data, news, and analytics. Bloomberg terminals arecommon on most trading floors and are becoming more common in universitieswhere they are used for research, teaching, and managing student investment funds.Given this widespread use of the Bloomberg system, the text also provides guides forusing Bloomberg data and analytical functions for the topics covered in each chapter.There are also supplemental appendices with detailed descriptions of the Bloombergsystem and a listing of many of the analytical functions that can be applied toinvestment analysis.

It is my hope that the synthesis of fundamental and advanced topics withBloomberg information and analytics will provide professionals and students offinance not only with a better foundation in understanding the complexities andsubtleties of derivatives, but also with the ability to apply that understanding toreal-world investment decisions—to grasp how “it is done on the street.” It is alsomy hope that the integration of Bloomberg with derivative concepts and theoriesenhances the readers’ intellectual depth and understanding of finance. Finance andeconomics professors frequently require that students explain a theory, strategy, oridea mathematically, graphically, and intuitively. By so doing, students’ depth ofunderstanding, as well as retention, of the theory and idea is often enhanced. It hasbeen my experience in using Bloomberg in my derivatives classes that it too enhancesa student’s depth and knowledge of derivatives.

The book is designed for professors offering a one-semester derivatives course.TheBloomberg material is presented at the end of each chapter, allowing the material tobe presented separately. The book is also written for professionals in the investmentindustry. For professionals, the text can be used as an instructional source and as a guideon how to apply Bloomberg to derivative markets and analysis, as well as a review offundamental derivative concepts and theories.

Content

The book is comprehensive, covering derivative securities and markets, the majortheories and models, and the practical applications of the models. The book is dividedinto five parts: Part 1 deals with the markets and strategies associated with futures andforward contracts; Part 2 examines options markets and strategies; Part 3 examines thepricing of options; Part 4 examines financial swaps; and Part 5 provides supplementalappendices.

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Preface xi

Part 1 consists of four chapters. Chapter 1 examines the markets, uses, and pricingof commodity futures contracts. Chapter 2 covers futures and forward contracts oncurrency. Chapter 3 focuses on equity index contracts, and Chapter 4 covers interestrate and bond contracts.

Part 2 consists of four chapters. Stock options are examined in Chapter 5 interms of fundamental option strategies and the functions and operations of the optionexchange. The markets and uses of non-stock options are explored in Chapter 6:equity-index options, futures options, over-the-counter options, convertible securi-ties, and embedded options. In Chapter 7, option analysis is expanded with a moredetailed examination of the fundamental strategies and an analysis of other strategies.Finally, in Chapter 8, the hedging uses of options are explored.

Part 3 consists of five chapters. In Chapter 9, the fundamental option pricingrelationships and option boundary conditions are presented. The Binomial OptionPricing model is derived in Chapter 10, and the seminal Black-Scholes option pricingmodel is presented in Chapter 11. In Chapter 12, the pricing of non-stock optionsis examined: spot indexes, currency options, futures options, and convertibles. Thepricing of bond and interest rate options is examined using the binomial interest ratemodel in Chapter 13.

Part 4 consists of two chapters on financial swaps. The markets, uses, and pricingof generic interest rate swaps, forward swaps, and swaptions are presented in Chapter14, and the markets, uses, and pricing of credit default swaps and currency swaps arethe focus of Chapter 15.

The text stresses concepts, model construction, numerical examples, and Bloom-berg applications and information sources. The text also includes end-of-the-chapterproblems and Bloomberg exercises. The Bloomberg exercises are designed for prac-titioners who have access to such terminals at their jobs, for professors and studentswho have access to Bloomberg terminals at their universities, and for students who haveaccess to Bloomberg either at their university or possibly through internships they mayhave at financial companies. As I noted previously, it is my hope that the Bloombergexercises will add depth to one’s understanding of derivatives, as well as an apprecia-tion of the breadth of financial information and analytics provided by the Bloombergsystem. Students are invited to visit www.wiley.com for additional materials, suchas Excel spreadsheet programs that can be used to solve a number of the problemsat the end of the chapters and videos that explain how to work some Bloombergexercises. Also located at the Wiley website is an instructor site that includes chapterPowerPoint slides and an instructor’s manual with solutions to end-of-the-chapterproblems.

The book draws some material from some of my earlier texts: Debt Markets andAnalysis, Equity Markets and Analysis, and Introduction to Derivatives. The Bloombergmaterial presented here comes from knowledge gained from using the terminal(or learned from my students who used Bloomberg) when I was the fund professor forthe student equity investment fund and bond investment fund at Xavier University.

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Acknowledgments

Many people have contributed to this text. First, I wish to personally thank StephenSmith, Brandywine Global Investment Management, and the Smith Center for theStudy of Capitalism and Society for their backing and support. I also thank my col-leagues and students at Xavier University for their many years of support and encour-agement. My appreciation is extended to the editors and staff at John Wiley & Sons,Inc., particularly Bill Falloon, executive editor; Jeremy Chia, project editor; SharmilaSrinivasan, production editor; and Cheryl Ferguson, copy editor. My appreciation isalso extended to Stephen Isaacs, Bloomberg Press, for his support, help, and encour-agement on this project.

I also wish to thank my children and their spouses, Wendi, Jamey, Matt, Shayna,and Scott, and my grandchildren, Bryce, Kendall, Malin, Kylee, and Ryan, and MaryFrances Johnson and Marlyn Erhart for their support, encouragement, and under-standing. I also would like to recognize the pioneers in the academic study of deriva-tives: Fischer Black, Myron Scholes, Robert Merton, Stephen Ross, Mark Rubinstein,and others cited in the pages that follow. Without their contributions, this text couldnot have been written. Finally, I extend my gratitude to the many people who makeup the soul of the Bloomberg system—analysts, programmers, systems experts, reps,and journalists. It is truly a remarkable system.

I encourage you to send your comments and suggestions to me: [email protected].

R. Stafford JohnsonXavier University

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mailto:[email protected]

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About the Author

R. Stafford Johnson is Professor of Finance and Director of the Smith Center for theStudy of Capitalism and Society at theWilliams College of Business, Xavier University.He is the author of six books: Options and Futures; Introduction to Derivatives; twoeditions of Bond Evaluation, Selection, and Management; Debt Markets and Analysis;and Equity Markets and Portfolio Analysis. He has also authored or co-authored over50 academic articles. His Equity Markets and Portfolio Analysis and Debt Markets andAnalysis texts are core equity and fixed-income investment books that cover extensivelythe functionality of Bloomberg terminals and its applicability to investments.

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PART 1

Futures and ForwardContracts

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CHAPTER 1

Futures Markets

In the mid-1800s, Chicago was the transportation and distribution center foragriculture products. Farmers in the Midwest transported and sold their products towholesalers and merchants in Chicago, who often would store and later transport theproducts by either rail or the Great Lakes to population centers in the East. Because ofthe seasonal nature of grains and other agriculture products and the lack of adequatestorage facilities, farmers and merchants began to use forward contracts as a way ofavoiding storage costs and pricing risk. These contracts were agreements in which twoparties agreed to exchange commodities for cash at a future date, but with the termsand the price agreed upon in the present. An Ohio farmer in June might agree to sellhis expected wheat harvest to a Chicago grain dealer in September at an agreed-uponprice. This forward contract enabled both the farmer and the dealer to lock in theSeptember wheat price in June. In 1848, the Chicago Board of Trade (CBT) wasformed by a group of Chicago merchants to facilitate the trading of grain. Thisorganization subsequently introduced the first standardized forward contract, called a“to-arrive” contract. Later, it established rules for trading the contracts and developeda system in which traders ensured their performance by depositing good-faith moneyto a third party. These actions made it possible for speculators as well as farmersand dealers who were hedging their positions to trade their forward contracts. Bydefinition, futures are marketable forward contracts. Thus, the CBT evolved from aboard offering forward contracts to the United States’ first organized exchange listingfutures contracts—a futures exchange.

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4 Futures and Forward Contracts

Introduction to Futures and Options Markets

Futures and options contracts on stock, debt, and currency, as well as such hybridderivatives as swaps, interest rate options, caps, and floors, are an importantrisk-management tool. Farmers, portfolio managers, multinational businesses, andfinancial institutions often buy and sell derivatives to hedge positions they have inthe derivative’s underlying asset against adverse price changes. Derivatives also areused for speculation. Many investors find buying or selling options or taking futurespositions an attractive alternative to buying or selling the derivative’s underlyingsecurity. Finally, many institutional investors, portfolio managers, and corporationsuse derivatives for financial engineering, combining their debt, equity, or currencypositions with different derivatives to create a structured investment or debt positionwith certain desired risk-return features.

This book is an exposition on derivatives, describing the markets in which deriva-tives are traded, how they are used for speculating, hedging, and financial engineering,and how their prices are determined. Part 1 examines the markets, strategies, and pric-ing of futures and forward contracts, while Parts 2 and 3 focus on options contractsand pricing. Part 4, in turn, examines the swap market.

Overview of Futures Markets

As new exchanges were formed in New York, London, Singapore, and other large citiesthroughout the world, the types of futures contracts grew from grains and agriculturalproducts to commodities and metals and finally to financial futures: futures on foreigncurrency, debt securities, and security indexes. Because of their use as a hedging tool byfinancial managers and investment bankers, the introduction of financial futures in theearly 1970s led to a dramatic growth in futures trading. The financial futures marketformally began in 1972 when the Chicago Mercantile Exchange (CME) created theInternational Monetary Market (IMM) division to trade futures contracts on foreigncurrency. In 1976, the CME extended its listings to include a futures contract on aTreasury bill. The CBT introduced its first futures contract in October 1975 with acontract on the Government National Mortgage Association (GNMA) pass-through,and in 1977, it introduced the Treasury bond futures contract. The Kansas City Boardof Trade was the first exchange to offer trading on a futures contract on an equity index,when it introduced the Value Line Composite Index (VLCI) contract in 1983. Thiswas followed by the introduction of the Standard & Poor’s (S&P) 500 futures contractby the CME and the New York Stock Exchange (NYSE) index futures contract by theNew York Futures Exchange (NYFE).

Whereas the 1970s marked the advent of financial futures, the 1980s saw theglobalization of futures markets with the openings of the London International Finan-cial Futures Exchange (LIFFE) in 1982, Singapore International Monetary Marketin 1986, and the Toronto Futures Exchange in 1984. The increase in the numberof futures exchanges internationally led to a number of trading innovations: elec-tronic trading systems, 24-hour worldwide trading, and alliances between exchanges.Concomitant with the growth in future trading on organized exchanges has been thegrowth in futures contracts offered and traded on the over-the-counter (OTC) market.


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Futures Markets 5

In this market, dealers offer and make markets in more tailor-made forward contractsin currencies, indexes, and various interest rate products. The combined growth in thefutures and forward contracts has also created a need for more governmental oversightto ensure market efficiency and to guard against abuses. In 1974, Congress created theCommodity Futures Trading Commission (CFTC) to monitor and regulate futurestrading. In that legislation, Congress also allowed the creation of self-regulatory orga-nizations, and in 1982, the National Futures Association (NFA), an organization offutures market participants, was established to oversee futures trading. Finally, thegrowth in futures markets led to the consolidation of exchanges. In 2006, the CMEand the CBT approved a deal in which the CME acquired the CBT, forming theCME Group, Inc. With this and other consolidations, the major exchanges todayoffering derivatives include CBT/CME, Eurex, ICE, Hong Kong Futures Exchange,Singapore Exchange, Dubai Mercantile Exchange, Bolsa De Mercadorias & Futuros,and the Australian Stock Exchange. Exhibit 1.1 shows the Bloomberg CTM screenthat lists the major exchanges trading futures and derivatives today.

EXHIBIT 1.1 Major Futures and Derivative Exchanges


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EXHIBIT 1.1 (Continued )

Formally, a forward contract is an agreement between two parties to trade a spe-cific asset at a future date with the terms and price agreed upon today. A futurescontract, in turn, is a “marketable” forward contract, with marketability (the easeor speed in trading a security) provided through futures exchanges that not only listhundreds of contracts that can be traded but provide the mechanisms for facilitatingthe trades. Futures and forward contracts are known as derivative securities. A deriva-tive security is one whose value depends on the values of another asset (e.g., theprice of the underlying commodity or security). Another important derivative is anoption. An option is a security that gives the holder the right, but not the obliga-tion, to buy or sell a particular asset at a specified price on, or possibly before, aspecific date.


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Futures Markets 7

Overview of Options Markets

Like the futures market, the US options market can be traced back to the 1840s whenoptions on agriculture commodities were traded in New York. These option contractsgave the holders the right, but not the obligation, to purchase or to sell a commodity ata specific price on or possibly before a specified date. Like forward contracts, optionsmade it possible for farmers or agriculture dealers to lock in future prices. In contrastto commodity futures trading, however, the early market for commodity options trad-ing was relatively thin. The market did grow marginally when options on stocks begantrading on the over-the-counter (OTC) market in the early 1900s. This market beganwhen a group of investment firms formed the Put and Call Brokers and Dealers Asso-ciation. Through this association, an investor who wanted to buy an option could doso through a member who either would find a seller through other members or wouldsell (write) the option himself.

The OTC option market was functional, but suffered because it failed to providean adequate secondary market. In 1973, the CBT formed the Chicago Board OptionsExchange (CBOE). The CBOE was the first organized option exchange for thetrading of options. Just as the CBT had served to increase the popularity of futures,the CBOE helped to increase the trading of options by making the contracts moremarketable. Since the creation of the CBOE, organized stock exchanges in the UnitedStates, most of the organized futures exchanges, and many security exchanges outsidethe United States also began offering markets for the trading of options. As thenumber of exchanges offering options increased, so did the number of securities andinstruments with options written on them. Today, option contracts exist not only onstocks but also on foreign currencies, indexes, futures contracts, and debt and interestrate-sensitive securities.

In addition to options listed on organized exchanges, there is also a large OTCmarket in currency, debt, and interest-sensitive securities and products in the UnitedStates and a growing OTC market outside the United States. OTC debt derivativesare primarily used by financial institutions and nonfinancial corporations to managetheir interest rate positions. The derivative contracts offered in the OTC marketinclude spot options and forward contracts on Treasury securities, London InterbankOffered Rate–related (LIBOR-related) securities, and special types of interest rateproducts, such as interest rate calls and puts, caps, floors, and collars. OTC interestrate derivatives products are typically private, customized contracts between twofinancial institutions or between a financial institution and one of its clients.

The Nature of Futures Trading and the Role of the Clearinghouse

Futures Positions

A speculator or hedger can take one of two positions on a futures (or forward) contract:a long position (or futures purchase) or a short position (futures sale). In a long futuresposition, one agrees to buy the contract’s underlying asset at a specified price, with thepayment and delivery to occur on the expiration date (also referred to as the delivery


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date). In a short position, one agrees to sell an asset at a specific price, with deliveryand payment occurring at expiration.

To illustrate how positions are taken, suppose in December, Speculator X believesthat summer will be unusually dry in the Midwest, resulting in increases in theprice of corn. With hopes of profiting from this expectation, suppose on 12/14/15Speculator X decides to take a long position in a July corn futures contract andinstructs her broker to buy one July corn futures contract listed on the CBT (onecontract is for 5,000 bushels, see Exhibit 1.2). To fulfill this order, suppose X’s brokerfinds a broker representing Speculator Y, who believes that the summer corn harvestwill be above normal and therefore hopes to profit by taking a short position in theJuly corn contract. After negotiating with each other, suppose the brokers agree to aprice of $3.89/bu. on the July contract for their clients. In terms of futures positions,Speculator X would have a long position in which she agrees to buy 5,000 bushelsof corn at $3.89/bu. from Speculator Y at the delivery date in July, and SpeculatorY would have a short position in which he agrees to sell 5,000 bushels of corn at$3.89/bu. at the delivery date in September.

If both parties hold their contracts to delivery, their profits or losses would bedetermined by the price of corn on the spot market (also called cash, physical, oractual market). For example, suppose the summer turns out to be mild, causing thespot price of corn to trade at $3.32/bu. at the grain elevators in the Midwest at or nearthe delivery date on the July corn futures contract. Accordingly, Speculator Y with hisshort position would buy the corn on the spot market for $3.32/bu, and then sell it onthe futures contract to Speculator X for $3.89/bu., resulting in a $2,850 profit minuscommission and transportation costs. Speculator X with her long position, in turn,would have to buy 5,000 bushels of corn on her corn futures contract at $3.89/bu.from Speculator Y, and then sell the corn for $3.32/bu. on the spot market, losing$2,850 plus commission and transportation costs.

Clearinghouse

To provide contracts with marketability, futures exchanges use clearinghouses.The clearinghouses associated with futures exchanges guarantee each contract and actas intermediaries by breaking up each contract after the trade has taken place. Thus,in the previous example, the clearinghouse (CH) would come in after Speculators Xand Y have reached an agreement on the price of the July corn, becoming the effectiveseller on X’s long position and the effective buyer on Y’s short position. Once theclearinghouse has broken up the contracts, then X’s and Y’s contracts would be withthe clearinghouse. The clearinghouse, in turn, would record the following entries inits computers:

Clearinghouse Record:

1.

2.

Speculator X agrees to buy July corn at $3.89/bu. from the clearinghouse.

Speculator Y agrees to sell July corn at $3.89/bu. to the clearinghouse.


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Futures Markets 9

This intermediary role of the clearinghouse makes it easier for futures traders toclose their positions before expiration. Returning to our example, suppose that earlysummer is dry in theMidwest, leading a third speculator, Speculator Z, to want to takea long position in the listed July corn futures contract. Seeing a profit opportunity fromthe greater demand for long positions in the July contract, suppose in June SpeculatorX agrees to sell a July corn futures contract to Speculator Z for $4.14/bu. Upon doingthis, Speculator X now would be short in the new July contract, with Speculator Zhaving a long position, and there now would be two contracts on July corn. After thenew contract between X and Z has been established, the clearinghouse would step inand break it up. For Speculator X, the clearinghouse’s record would now show thefollowing:

Clearinghouse Record for X:

1.

2.

Close

Speculator X agrees to buy July corn at $3.89/bu. from the clearinghouse.

Speculator X agrees to sell July corn at $4.14/bu. to the clearinghouse.

Thus, to close, the Clearinghouse owes X $0.25 per contract to be paid at expiration:($0.25/bu.)(5,000 bu.) = $1,250.

The clearinghouse accordingly would close Speculator X’s positions by payingher $0.25/bu. ($4.14/bu. − $3.89/bu.), a total of $1,250 on the contract [(5,000bu.)($0.25/bu.)]. Since Speculator X’s short position effectively closes her long posi-tion, it is variously referred to as a closing, reversing out, or offsetting position or simplyas an offset. Thus, the clearinghouse makes it easier for futures contracts to be closedprior to expiration.

Commission costs and the costs of transporting commodities cause most futurestraders to close their positions instead of taking delivery. As the delivery dateapproaches the number of outstanding contracts, known as open interest, declines,with only a relatively few contracts still outstanding at delivery. Moreover, at expira-tion, the contract prices on futures contracts established on that date (fT) should beequal (or approximately equal) to the prevailing spot price on the underlying asset(ST). That is, at expiration: fT = ST. If fT does not equal ST at expiration, an arbitrageopportunity would exist. Arbitrageurs could take a position in the futures contractand an opposite position in the spot market. For example, if the July corn futurescontract were available at $3.25 on the delivery date in July and the spot price forcorn were $3.32 at a grain elevator near the delivery place specified on the contract(resulting in no hauling cost), then arbitrageurs could go long in the July contract,take delivery by buying the corn at $3.25 on the futures contract, and then sell thecorn on the spot at $3.32 to earn a riskless profit of $0.07/bu. Arbitrageurs’ effortsto take long positions, however, would drive the contract price up to $3.32. On theother hand, if fT exceeds $3.32, then arbitrageurs would reverse their strategy, pushingfT to $3.32/bu. Thus, at delivery, arbitrageurs will ensure that the prices on expiring


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contracts are equal to the spot price or the spot prices plus the hauling cost. As aresult, closing a futures contract with an offsetting position at expiration will yield thesame profits or losses as closing futures positions on the spot by purchasing (selling)the asset on the spot and selling (buying) it on the futures contract.

Returning to our example, suppose that near the delivery date on the July con-tract, the spot price of corn and the price on the expiring corn futures contractsare $3.63/bu. To close his existing short contract, Speculator Y would need to takea long position in the July contract, while to offset her long contract, Speculator Zwould need to take a short position. Suppose Speculators Y and Z take their offset-ting positions with each other on the expiring July corn contract priced at fT = ST =$3.63/bu. After the clearinghouse breaks up the new contract, Speculator Y wouldreceive $0.26/bu. from the clearinghouse and Speculator Z would pay $0.51/bu. to theclearinghouse:

Clearinghouse Records for Speculator Y:

1.

2.

Close

Speculator Y agrees to sell July corn to CH for $3.89/bu.

Speculator Y agrees to buy September wheat from CH at $3.63/bu.

Thus, to close Speculator Y owes the Clearinghouse $0.26/bu.

($0.26/bu.)(5,000 bu.) = $1,300.

Clearinghouse Records or Speculator Z:

1.

2.

Close

Speculator Z agrees to buy September wheat at $4.14/bu.

Speculator Z agrees to sell September wheat for $3.63/bu.

Thus, to close the Speculator Z owes Clearinghouse $0.51/bu.

(–$0.51/bu.)(5,000 bu.) = –$2,550.

To recapitulate, in this example, the contract prices on July corn contracts wentfrom $3.89/bu. on the X and Y contract, to $4.14/bu. on the X and Z contract, to$3.32/bu. on the Y and Z contract at expiration. Speculator X received $0.25 and Spec-ulator Y received $0.26/bu. from clearinghouse, while Speculator Z paid $0.51/bu. tothe clearinghouse. The clearinghouse with a perfect hedge on each contract receivednothing (other than clearinghouse fees attached to the commission charges), and nocorn was purchased or delivered.

Note: This example is based on a July 2016 corn futures prices and spot prices.As shown in the Bloomberg Description screen in Exhibit 1.2, the July contract callsfor purchase or delivery of 5,000 bushels of No. 2 yellow corn. The futures and spotprice graphs (GP) in Exhibit 1.3 show the futures price was ¢389 (cents per bushel)on 12/14/15, ¢414 on 6/1/16, and ¢363 1/2 on 7/15/16 (expiration date) when thespot corn price was $3.32 1/2 and the implied hauling cost was $0.31/bu.


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Futures Markets 11

EXHIBIT 1.2 Bloomberg Spot and Futures Corn Prices

July 2016 CBT Corn Futures Contract on 7/15/16 (C N6 <Comdty>

Yellow Corn Spot Prices, 7/15/16 (CORNILNC <Index>)

Types of Futures Contracts

Various types of futures contracts are traded on the CBT, CME, Eurex, Singapore, andother exchanges. There are also a number of competing contracts offered by dealers onthe OTC market. Futures and forward contracts can be classified either as a physicalcommodity, energy, equity index, foreign currency, bond, and interest rate.

Physical Commodities

Physical commodities include both agriculture and metallurgical. Agriculture com-modities consist of grains (e.g., wheat, corn, and oats), oil and meal (e.g., soybeansand sunflower), livestock (e.g., cattle, pork bellies, and live hogs), forest products


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EXHIBIT 1.3 Prices on July 2016 CBT Corn Futures Contracts and Yellow Corn Spot Prices, 7/1/15to 7/15/16

(e.g., plywood), foodstuffs (e.g., orange juice, coffee, and sugar) and textile (e.g., cot-ton).Many of the agricultural commodities have different contracts for different gradesand expiration months, with the expiration months on crops typically set up to con-form to their harvest patterns. Metallurgical contracts include metal (e.g., gold, silver,platinum, and copper) and petroleum products (e.g., heating oil, crude oil, gasoline,and propane).

The New York Mercantile Exchange (NYMEX), ICE, Dubai Exchange, and otherexchanges offer a number of futures contracts on crude oil, gasoline, and heating oil.Some of these contracts require a cash settlement, while others require physical deliv-ery. Exhibit 1.4 shows the Bloomberg Description screen for the NYMEX’s July 2016crude oil futures contract and a spot contract on West Texas crude. The NYMEX alsooffers contracts on natural gas. One of the NYMEX contracts calls for the physicaldelivery of 10,000 million British thermal units (Btu) of natural gas to be made duringthe deliverymonth at a uniform rate. Finally, theNYMEXoffer contracts on electricity.A typical contract calls for receiving (delivering) a specified number of megawatt-hoursfor a specified price at a specified location during a particular month. The contractscan vary from a 5 × 8 contract in which power is received five days a week during the


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Futures Markets 13

EXHIBIT 1.4 NYMEX August 2016 Crude Oil Futures Contract and Spot Index, 7/15/16Bloomberg Description Screen (CLQ6 <Comdty>, USCRWTIC <Index>)

August Crude Oil Contract

Bloomberg West Texas Intermediate (WTI) Crushing Crude Oil Spot Price Index

off-peak hours for a specified month to a 7 × 24 contract that calls for receiving powerevery day and hour during the month.

A somewhat-related contract is a weather derivative. In 1999, the CME offeredcontracts on cumulative heating degree days (HDD) and cooling degree days (CDD).A day’s HDD is a measure of the volume of energy needed for heating during a day,and a CDD is measure of the volume of energy required for cooling during a day. Eachcan be measure as

HDD = Max [65∘ − A, 0]

CDD = Max [A − 65∘, 0]

where:

A = average high and low temperature during a day.


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The CME contracts are measured in terms of cumulative HDD or CDD for aspecified month at a specified weather station (e.g., Atlanta, New York, or Cincin-nati). These contracts call for a cash settlement. Exhibit 1.5 shows the BloombergDescription screen for the CME’s October 2016 Cincinnati HDD futures contract.

In addition to exchange-traded energy and weather futures contracts, theexchanges also offer spot options and futures option contracts on energy and weatherproducts. There is also an extensive OTC market for energy derivatives, as well asother commodity contract. For example, OTC dealers have offered for a numberof years a long-term swap arrangement on crude oil in which one party agrees toexchange a fixed price on oil to another party who agrees to exchange a floating price.Weather derivatives have been offered since the 1970s by OTC dealers.

Currency Futures and Forward Contracts

As noted in the introduction, foreign currency futures contracts were introducedin May of 1972 by the CME. Today, currency futures are listed on various futuresexchanges (see Exhibit 2.1 in Chapter 2). The CME is the largest currency futuresexchange. The contracts on the CME call for the delivery (or purchase) of a specifiedamount of foreign currency at the delivery date. The contract prices are quoted interms of dollars per unit of foreign currency.

Forward contracts on foreign currencies are provided in the Interbank ForeignExchange Market. This OTC market is larger than the currency futures market,

EXHIBIT 1.5 CME October 2016 Cincinnati HDD Oil Futures Contract, 7/15/16 BloombergDescription Screen (CJV6 <Index>)

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