The previous chapter provided a basic introduction to the operation of futures markets and the principles of futures pricing. This chapter explores both pricing and risk management in selected futures markets in more depth. Most of the growth has been in financial futures, which now dominate trading, so we emphasize these contracts. | Chapter 23 Futures and Swaps: A Closer Look Futures markets Chicago Mercantile (International Monetary Market) London International Financial Futures Exchange MidAmerica Commodity Exchange Active forward market Differences between futures and forward markets Foreign Exchange Futures Interest rate parity theorem Developed using the US Dollar and British Pound where F0 is the forward price E0 is the current exchange rate Pricing on Foreign Exchange Futures Text Pricing Example rus = 5% ruk = 6% E0 = $ per pound T = 1 yr If the futures price varies from $ per pound arbitrage opportunities will be present. Hedging Foreign Exchange Risk A US firm wants to protect against a decline in profit that would result from a decline in the pound: Estimated profit loss of $200,000 if the pound declines by $.10. Short or sell pounds for future delivery to avoid the exposure. Hedge Ratio for Foreign Exchange Example Hedge Ratio in pounds $200,000 per $.10 change in the pound/dollar exchange . | Chapter 23 Futures and Swaps: A Closer Look Futures markets Chicago Mercantile (International Monetary Market) London International Financial Futures Exchange MidAmerica Commodity Exchange Active forward market Differences between futures and forward markets Foreign Exchange Futures Interest rate parity theorem Developed using the US Dollar and British Pound where F0 is the forward price E0 is the current exchange rate Pricing on Foreign Exchange Futures Text Pricing Example rus = 5% ruk = 6% E0 = $ per pound T = 1 yr If the futures price varies from $ per pound arbitrage opportunities will be present. Hedging Foreign Exchange Risk A US firm wants to protect against a decline in profit that would result from a decline in the pound: Estimated profit loss of $200,000 if the pound declines by $.10. Short or sell pounds for future delivery to avoid the exposure. Hedge Ratio for Foreign Exchange Example Hedge Ratio in pounds $200,000 per $.10 change in the pound/dollar exchange rate $.10 profit per pound delivered per $.10 in exchange rate = 2,000,000 pounds to be delivered Hedge Ratio in contacts Each contract is for 62,500 pounds or $6,250 per a $.10 change $200,000 / $6,250 = 32 contracts Available on both domestic and international stocks. Advantages over direct stock purchase: lower transaction costs better for timing or allocation strategies takes less time to acquire the portfolio Stock Index Contracts Creating Synthetic Positions with Futures Synthetic stock purchase: Purchase of the stock index instead of actual shares of stock. Creation of a synthetic T-bill plus index futures that duplicates the payoff of the stock index contract. Pricing on Stock Index Contracts The spot-futures price parity that was developed in Chapter 22 is given as; Empirical investigations have shown that the actual pricing relationship on index contracts follows the spot-futures relationship. Exploiting mispricing between underlying stocks and the futures index contract. .
