16 16 C h a p t e r Futures ContractsFutures Contracts second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 2 Futures Contracts Our goal in this chapter is to discuss the basics of futures contracts and how their prices are quoted in the financial press. We will also look at how futures contracts are used and the relationship between current cash prices and futures prices. Goal © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 3 Futures Contracts Basics Forward contract Agreement between a buyer and a seller, who both commit to a transaction at a future date at a price set by negotiation today. Futures contract Contract between a seller and a buyer specifying a commodity or financial instrument to be delivered and paid for at contract maturity. The specified price is called the futures price. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 4 Futures Contracts Basics While a forward contract can be struck between any two parties, futures contracts are managed through an organized futures exchange. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 5 Futures Contracts Basics Established in 1848, the Chicago Board of Trade (CBOT) is the oldest organized futures exchange in the United States. It grew with the westward expansion of American ranching and agriculture, and is today, the largest, most active futures exchange in the world. In the 1970s, financial futures were introduced. They are so successful that they now constitute the bulk of all futures trading. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 6 Futures Contracts Basics In general, futures contracts must stipulate at least the following five terms: c The identity of the underlying commodity or financial instrument. d The futures contract size. e The futures maturity date, also called the expiration date. f The delivery or settlement procedure. g The futures price. Futures Contracts Basics 16 - 7 Futures Contracts Basics 16 - 8 © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 9 Work the Web Visit the websites of these futures exchanges: http://www.cbot.com http://www.nymex.com http://www.cme.com http://www.kcbt.com http://www.nybot.com © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 10 Work the Web For futures prices and price charts, visit: http://www.futuresworld.com http://futures.pcquote.com http://www.thefinancials.com [...]... Cash market (or spot market) The market in which commodities or financial instruments are traded for essentially immediate delivery McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 19 Cash Prices 16 - 20 Cash Prices 16 - 21 Cash-Futures Arbitrage Earning risk-free profits from an unusual difference between cash and futures prices is called cash-futures arbitrage... by The McGraw-Hill Companies, Inc All rights reserved 16 - 23 Spot-Futures Parity The relationship between spot prices and futures prices that holds in the absence of arbitrage opportunities is known as the spotfutures parity condition Let F be the futures price, and S be the spot price If r is the risk-free rate per period, and the futures contract matures in T periods, then the spot-futures parity... McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 17 Work the Web For a list of online futures brokers, visit the Commodities & Futures section of Investor Links at: http://www.investorlinks.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 18 Cash Prices Cash price (or spot price) The price of a commodity or financial instrument... 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 25 Stock Index Futures There are a number of futures contracts on stock market indexes The S&P 500 contract is one of the most important ones Because of the difficulty of actual delivery, stock index futures are usually settled in cash McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 26 Index Arbitrage... McGraw Hill / Irwin = = = = duration of the bond portfolio value of the bond portfolio duration of the futures contract value of a single futures contract © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 33 Hedging Interest Rate Risk with Futures As a useful rule of thumb, the duration of an interest rate futures contract is equal to the duration of the underlying instrument plus the... Futures Hedging with Futures Futures Trading Accounts McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 36 Chapter Review Cash Prices versus Futures Prices Cash Prices Cash-Futures Arbitrage Spot-Futures Parity More on Spot-Futures Parity McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved ... future, the purchase of futures to offset potential losses from rising prices is called a long hedge McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 14 Work the Web To learn more about futures, visit: http://www.futurewisetrading.com http://www.usafutures.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 15 Futures Trading... then the spot-futures parity condition is: FT = S (1 + r ) T McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 24 More on Spot-Futures Parity Let D be the dividend (or coupon payment) paid in one period, at or near the end of the futures contract’s life Then, the spot-futures parity condition becomes F = S(1 + r) – D Alternatively, we can write the dividendadjusted... for delivery For example, U.S Treasury note futures allow delivery of any Treasury note with a maturity between 6 1/2 and 10 years Note that the cheapest-to-deliver note may vary over time McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 35 Chapter Review Futures Contracts Basics Modern History of Futures Trading Futures Contract Features Futures Prices Why Futures?... Market Risk with Futures The number of stock index futures contracts needed to hedge a stock portfolio effectively can be determined as follows: β P × VP Number of contracts = VF where βP = beta of the stock portfolio VP = value of the stock portfolio VF = value of a single futures contract McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 16 - 31 Hedging Interest Rate Risk . Contracts Basics 16 - 7 Futures Contracts Basics 16 - 8 © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 9 Work the Web Visit the websites of these futures. Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 16 - 2 Futures Contracts Our goal in this chapter is to discuss the basics of futures. 16 16 C h a p t e r Futures ContractsFutures Contracts second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides