Forwards and Futures: Understanding Forward and Futures Contracts, Study Guides, Projects, Research of Finance

Download Forwards and Futures: Understanding Forward and Futures Contracts and more Study Guides, Projects, Research Finance in PDF only on Docsity! Foundations of Finance: Forwards and Futures Prof. Alex Shapiro 1 Lecture Notes 16 Forwards and Futures I. Readings and Suggested Practice Problems II. Forward Contracts III. Futures Contracts IV. Forward-Spot Parity V. Stock Index Forward-Spot Parity VI. Foreign Exchange Forward-Spot Parity VII. Swaps VIII. Additional Readings Buzz Words: Hedgers, Speculators, Arbitrageurs, Cost of Carry, Convenience Yield, Stock Index Arbitrage, Floating vs. Fixed Rates Foundations of Finance: Forwards and Futures 2 I. Readings and Suggested Practice Problems BKM, Chapter 22, Section 4. BKM, Chapter 23. BKM, Chapter 16, Section 5. Suggested Problems, Chapter 22: 13; Chapter 23: 3, 25. II. Forward Contracts A. Definition A forward contract on an asset is an agreement between the buyer and seller to exchange cash for the asset at a predetermined price (the forward price) at a predetermined date (the settlement date). • The asset underlying a forward contract is often referred to as the $underlying# and its current price is referred to as the $spot# price. • The buyer of the forward contract agrees today to buy the asset on the settlement date at the forward price. The seller agrees today to sell the asset at that price on that date. • No money changes hands until the settlement date. In fact, the forward price is set so that neither party needs to be paid any money today to enter into the agreement. Foundations of Finance: Forwards and Futures 5 3. Transactions from the ¥ perspective Suppose a Japanese firm needs $ in 6 months. They face the opposite problem and can buy $ forward. Such a firm might be the counterparty to the U.S. firm’s forward transaction. (In general, either or both sides might be hedger or speculator). Again, note that: • One does not “buy a forward contract” (no money is exchanged today for a financial asset) One “enters into a forward contract:” “buys yen forward” or “sells dollars forward” • For everyone who has sold the dollar forward (against the yen), there is someone who has bought the dollar forward (against the yen) (like “zero net supply” in options) If one side of the forward contract has a profit (relative to the subsequent spot price), then the other side has a loss (like “zero-sum game” in options). 4. The forward FX market: A few details • Large denomination: $1 Million or more. (The hypothetical yen transaction above would be too small.) • A telephone/computer network of dealers. • Direct participation limited to large money center banks. • Counterparties assume credit risk. (If one defaults, the other has to bear the risk) Foundations of Finance: Forwards and Futures 6 III. Futures Contracts Futures Contracts vs Forward Contracts Forward and futures contracts are essentially the same except for the daily resettlement feature of futures contracts, called marking-to-market. Since this is only a technical difference, in our discussion we will not distinguish between the two, and use futures and forwards interchangeably. (Indeed, for many practical purposes futures and forward prices are very close, and we will take them to be the same). Plenty information is available from: Chicago Mercantile Exchange (http://www.cme.com/) Chicago Board of Trade (http://www.cbot.com/) Foundations of Finance: Forwards and Futures 7 IV. Forward-Spot Parity A. Forward-spot parity is a valuation principle for forward contracts. Often approximately correct for futures contracts as well. F0 forward price P0 spot price F0 = P0 + “cost of carry” The idea: “buying forward” is equivalent to “buying now and storing/carrying the underlying” The cost of carry reflects: + cost of financing the position + storage costs (insurance, spoilage) - income earned by the underlying Example for a Commodity contract Kryptonite is $10 per gram in the spot market. It will cost 2% of its value to store a gram for one year. The annual interest rate is 7%. Therefore: The percentage cost of carry is c = 9% Parity implies F0 = 10(1.09) = 10.90 Foundations of Finance: Forwards and Futures 10 V. Stock Index Forward-Spot Parity • The carrying cost for the index is c = rf - d where rf is the risk-free rate and d is the dividend yield. • Parity: F0 = S0(1 + rf - d)T where F0 is the futures price (today), S0 is the stock price (index level) today, T is the maturity of the contract [This is also sometimes written: F0 = S0(1 + rf ) T - D where D is the total cash dividend on the index.] • Violations of parity imply arbitrage profits. Example of Index Arbitrage S0 = 650, rf = 5%, d = 3% Parity: F0 = 650(1 + 0.05 - 0.03) = 663 Foundations of Finance: Forwards and Futures 11 • If F0=665, then the futures contract is overvalued relative to the spot price. Arbitrage: Borrow $650 +650 Buy index - 650 Short the futures 0 Net cash flow 0 “Unwind” at maturity: Collect divs [3%(650)] 19.5 Sell stock (index) + ST Settle futures -(ST - 665) Repay loan [1.05x650] - 682.5 Total +2 • If F0 = 660, then the futures contract is undervalued relative to the spot. Arbitrage: Long futures 0 Short stock +650 Invest short-sale proceeds - 650 Net cash flow 0 At maturity: Settle futures (ST - 660) Pay dividends [3%(650)] -19.5 Repurchase stock -ST Investment matures 682.5 Total 3 Foundations of Finance: Forwards and Futures 12 VI. Foreign Exchange Forward-Spot Parity In FX markets, forward/spot parity is called “covered interest parity” The cost of carry is the cost of borrowing in one currency (e.g., US dollar $) and investing in the other (e.g., the UK pound £). Example The spot (E0) and forward (F0) rates are dollar per pound $/£. E0 is the number of dollars you can get today for £1 (E0 is the spot $/£ exchange rate). F0 is the number of dollars you can, contracted upon today, to get in the future for £1 (F0 is the forward $/£ exchange rate) (No) Arbitrage enforces the following relation: )"CarryofCost"(E r r EF UK US +=    + += 1 1 1 000