FINA3204 02 Futures

Derivative Securities
FINA 3204
Forwards & Futures
Andrew Chiu, PhD

andrew.chiu@ust.hk
The Hong Kong University of

Science and Technology
FINA 3204: Derivative Securities

Andrew Chiu
Course Overview
Forwards &
Futures
Market
Mechanics
Hedging
Strategies
Options
Pricing
Market
Mechanics
Properties
Trading
Strategies
Pricing
Binomial
Tree
Greeks
Black-Scholes
Other Derivatives
Warrants, CBBC

Swaps
Convertible
Bonds
Structured
Products

Andrew Chiu
Forward & Futures

A forward contract is an agreement to buy or
sell a certain quantity of an asset at a future
maturity date for a specified delivery price.
The delivery price is chosen so that the initial

value of the contract is zero
No money is exchanged when contract is written
Potentially infinite return? (Return=Profit/Cost)


Andrew Chiu
Futures Contract Specification

Basic Specifications:
Type of underlying asset

Contract Size
Delivery Price
Delivery Arrangement
Physical delivery to somewhere (or Cash Settlement)
Maturity Date
Actual contracts are more sophisticated and depends on
the underlying asset
www.cmegroup.com
www.hkex.com.hk/eng/prod/drprod/DMProducts.htm

Andrew Chiu
Futures Settlement
Physical Delivery Example
www.shfe.com.cn/docview/docview_211231034.htm
Some brokers do not allow physical delivery, and they may
liquidate your position prior to expiry
www.interactivebrokers.com/en/?f=deliveryexerciseactions
Cash Settlement
More and more futures are cash settled. There are also cashsettled commodities futures.
Settlement Price
Specified on contract
HSI Index Futures Settlement Price
http://www.hkex.com.hk/eng/prod/drprod/hkifo/fut.htm

Andrew Chiu
Margins
A margin is cash or marketable securities deposited
by an investor with his or her broker
The balance in the margin account is adjusted to
reflect daily settlement
Margins minimize the possibility of a loss through a
default on a contract
Example: Hong Kong Exchange Margin Requirements
http://www.hkex.com.hk/eng/market/rm/rm_dcrm/riskda
ta/margin_hkcc/margin.htm
The brokers margin requirement may differ

Andrew Chiu
Clearing House
Reduces default risk by requiring members to
post collaterals and meet daily margin requirements.
Clearing House
Clearing House
Member
Broker
Long Trader

flow of $
when
futures
price
rises
Clearing House
Member
Broker
Short Trader

Andrew Chiu
Regulation
In the US, the regulation of futures markets is
primarily the responsibility of the Commodity
Futures and Trading Commission (CFTC)
Regulators try to protect the public interest and
prevent questionable trading practices
Article:
CFTC Charges High-Speed Trader Under New Powers
Wall Street Journal (July 22, 2013)


Andrew Chiu
Forwards vs Futures
Forwards
Futures
Private contract between 2 parties

(OTC market)
Exchange-traded
Non-standard Contract
Standard Contract
No cash up front
Margin required
Some default risk
No default risk
Settle at maturity
Daily settlement (marking to market)
Usually 1 delivery date
Range of delivery dates
Delivery or final cash settlement usually

occurs
Contract usually closed out prior to

maturity
Little regulation
Regulated


Andrew Chiu
OTC vs. Exchange
Source: Bank for International Settlements.


Andrew Chiu
Futures Exchanges
CME Group
www.cmegroup.com
Hong Kong Exchange

www.hkex.com.hk
China Financial Futures Exchange

www.cffex.com.cn/en_new/
Shanghai Futures Exchange

www.shfe.com.cn/Ehome/index.html
Dalian Commodity Exchange

www.dce.com.cn/portal/cate?cid=1114494099100
Zhengzhou Commodity Exchange

english.czce.com.cn

Andrew Chiu
Futures Trading Hours

Many futures contracts are traded almost 24 hours from
Monday to Friday
Since April 8, 2013, HSI futures trading hours can be
traded between 5:00pm -11:00 pm
http://www.hkex.com.hk/eng/prod/drprod/hkifo/fut.htm


Andrew Chiu
9/11 Terrorist Attack

1120
1100
1080
1060
1040
1020
1000
SPX

ESU01

Andrew Chiu
Subprime Mortgage Crisis

Oct 24, 2008 Bloody Friday
930
920
910
900
890
880
870
860
850
840
SPX

ESZ08

Andrew Chiu
Hedging with Futures

A long futures hedge is appropriate when you
know you will purchase an asset in the future and
want to lock in the price
A short futures hedge is appropriate when you
know you will sell an asset in the future and want
to lock in the price


Andrew Chiu
Arguments in Favor of Hedging

Companies should focus on the main business
they are in and take steps to minimize risks
arising from interest rates, exchange rates,
and other market variables


Andrew Chiu
Arguments against Hedging

Shareholders are usually well diversified and can
make their own hedging decisions
Example: Should gold miners hedge?
Dont hedge when the price of the good does not
affect the bottom line.
Example: Gold jewelry manufacturers
Hard to explain a situation when the hedge loses
money and the firm is better off not hedging.
Example: Airlines hedging oil, but oil price falls.

Andrew Chiu
Long Hedge for Purchase of Silver

S0=19
F0=20
F1=S1 in 1 year
Unhedged Cashflow = -S1
Payment for Silver in 1 Year
30
20
10
0
-10
-20
-30
-40
-50
0

10
20
30
Price of Silver in 1 Year (S1)
40

Andrew Chiu
Long Hedge for Purchase of Silver

Hedged Cashflow = - S1 + (F1 - F0) = -F0
Futures Price converges to Spot Price: F1=S1
What if the purchase is made in 6 months?
30
S1
-S1
F1 - F0
Buy
silver
Futures
Payoff
Net CF
-5
-15
-20
10
-10
-10
-20
-10
20
-20
-20
-20
30
-30
+10
-20
Cashflow in 1 Year
20
10
-30
Payment for Silver
-40
Futures Payoff
-50
Total
10
20
30
Price of Silver in 1 Year (S1)

40

Andrew Chiu
Basis Risk
In the previous example, if the purchase is made in 6
months, the futures will need to be closed out before
maturity. Then the hedged cashflow is:
Hedged Cashflow = - S0.5 + (F0.5 - F0)
Basis = S0.5 - F0.5 which is usually not zero
Basis is defined as the spot price minus the futures price
There is no basis risk at maturity because the futures price
converges to the spot price
Futures
Price
Spot Price

Spot Price
Futures
Price

Andrew Chiu
Hedging Using Index Futures

To hedge the risk in a portfolio the number of contracts
that should be shorted is
b
VA
VF
where VA is the value of the portfolio, b is its beta, and

VF is the value of one futures contract
Purpose:
For short-term protection, especially for large equity portfolios.
Remember, youre also capping the upside!
Locking in benefits of stock picking by hedging away market risk
But is beta constant? What happens during market

downturns?

Andrew Chiu
Stack and Roll

We can roll short-term futures contracts forward to hedge
long-term risk.
Example: A firm needs to purchase 5000 troy ounces of silver
(equivalent to 1 futures contract) for each of the next 2
months. It can hedge in 2 ways:
1.
2.
Long 2 silver futures contracts. One contract expires at the end of

the next month, the other expires in 2 months.
Long 2 futures contracts expiring in the next month. At the end of
the next month, let one contract expire. Sell the other contract and
long a new contract that expires in one month. This is stack and roll.
Stack and roll is desirable if long-term contracts are

unavailable or illiquid.


Andrew Chiu
Roll Yield
Holding futures positions will result in profit or loss
even if the underlying is not moving.
For a long (short) futures position,
roll yield is negative (positive) in contango
roll yield is positive (negative) in backwardation
Contango means contracts with longer maturities
have higher prices
Backwardation means contracts with longer
maturities have lower prices
http://www.ipathetn.com/us/product/vxx/#/overview

Andrew Chiu
Forward and Futures Prices

Price is determined using the no-arbitrage
argument
Assumptions:
No transaction costs
Same tax rate on all net trading profits
Same interest rate for saving and borrowing
Arbitrageurs exist to take advantage of arbitrage
opportunities
For derivatives we often use continuously

compounded interest rates

Andrew Chiu
Continuous Compounding
In math, e is just a number:
e 2.71828...
an irrational number
Consider an interest rate problem:

$120 $100 (1 r )
r 20% stated annualized rate
20%
$121.6=$100 1
20%
? =$100 1

interest paid quarterly

interest paid at every instant
Andrew Chiu
Continuous Compounding
It turns out that:
r
r
r
1 e 2.71828...

How much is $100 continuously compounded at 20%?

$122.14 = $100 e0.20
In real life, such a product does not exist. The smallest

compounding period is usually daily.
When the compounding period is infinitesimally small,
were said to be working in continuous time.

Andrew Chiu
Natural Logarithm
Recall:
103 1000
log10 1000 3
log10 103 3
But in Finance we only use the natural log (base e):
loge e0.20 ln e0.20 0.20
Beware: on your calculator the function for natural

logarithm is ln, not log
In Finance, wherever you see log without the base,
you can safely assume that it is referring to base e.

Andrew Chiu
e and Natural Logarithm

Some useful properties:
(i )
(iii ) e x e y e x y
(v )
(ii )
(iv)
eln x x
e xy
ln(e x ) x
(vi ) ln(1) 0
Note: ln( negative number ) is illegal
(vii ) ln(e) 1
(viii ) ln( xy ) ln( x) ln( y )
x
(ix) ln ln( x) ln( y )
y

Andrew Chiu
Pricing of Derivatives
Arbitrage is possible when:
1. The same asset does not trade at the same price on all markets.
2. Two assets with the same cash flows do not have the same price.
3. An asset with a known future price does not trade at its future price
discounted by the risk-free rate.
No-arbitrage Argument:
There should be no arbitrage opportunities. Traders called
arbitrageurs will quickly take advantage of the opportunity and in the
process eliminate any mispricing.
To make the parrot into a learned financial economist, he only needs to learn
the single word arbitrage, Ross (1987)


Andrew Chiu
Notation
S0: Spot price today
F0: Futures or forward price today
T: Delivery Time
r: Risk-free interest rate for maturity T


Andrew Chiu
Arbitrage Example
Suppose that:
The spot price of a non-dividend-paying stock is $40
The 3-month forward price (F0) is $43
The 3-month US$ interest rate is 5% per annum
Cashflows
Now
3 months later
Short Forward
Sell stock +43
Borrow money to
buy stock
Borrow +40
Buy stock -40
=0
Repay loan -40

Pay interest -40 x (e0.05x0.25 1)= -0.503
= - 40.503
Arbitrage Profit = 43 40.503 = $2.497
To avoid arbitrage: F0 <= 40.503


Andrew Chiu
Arbitrage Example
Suppose that:
The spot price of a non-dividend-paying stock is $40
The 3-month forward price (F0) is $39
The 3-month US$ interest rate is 5% per annum
Cashflows
Now
3 months later
Long Forward
Buy stock -39
Short stock and

Save money in
bank
Short stock +40

Principle in Savings +40
Invest in Savings -40 Receive interest +40 x (e0.05x0.25 1)=
=0
+0.503
= + 40.503
Arbitrage Profit = 40.503 39 = $1.503
To avoid arbitrage: F0 >= 40.503


Andrew Chiu
Forward Prices
In general, if the spot price of an investment asset is S0 and
the futures price for a contract deliverable in T years is F0,
then:
F0 = S0erT
Initial Action
t=0
Final Action
t=T
Short Forward
Sell one share at F0
F0
Borrow money
S0
Repay money with interest
-S0erT
Buy one share
-S0
(One share is worth ST)
Total

F0 - S0erT = 0

Andrew Chiu
When Underlying Pays a Dividend

Let Dividend = PV(D) at time 0 or FV(D) at maturity date
F0 = [S0 - PV(D)]erT
Initial Action
t=0
Final Action
t=T
Short Forward
Sell one share at F0
F0
Borrow money
S0
-S0erT
Buy one share
-S0
Receive dividends during

FV(D) = PV(D) erT
period and invest in savings
Total

F0 [S0 - PV(D)]erT = 0

Andrew Chiu
When Underlying has a Known Yield

The underlying pays a continuously compounded yield q
(ex: stock index dividend, interest earned on currency)
F0 = S0 e(r-q)T
Assume that the income from the asset is reinvested into the
asset. So 1 share grows to eqT shares.
Initial Action
t=0
Final Action
t=T
Short eqT Forward
Sell eqT share at F0
F0 eqT
Borrow money
S0
-S0erT
Buy one share
-S0
(grows into eqT shares)
Total

F0 eqT S0erT = 0
Andrew Chiu
Summary
The underlying asset provides no income or dividend
F0 = S0erT
The underlying asset provides a known cash income
F0 = [S0 - PV(D)]erT
The underlying pays a continuously compounded yield q
F0 = S0 e(r-q)T
Essentially, we can generalize the formula in terms of cost of carry (c):
F0 = S0 ecT
Cost of carry is the net cost for owning the actual asset.


Andrew Chiu
Forward on Foreign Currency

Treat the foreign currency like an asset that pays a known
yield. The interest rate (rf) from the foreign currency is
similar to the payout from an asset.
The forward price of a contract on a foreign currency is:
F0 S0e

( r rf ) T

Andrew Chiu
Forward on Commodities
Unlike stocks, owning commodities require storage costs (u).
This is adjusted into the forward price as a negative income.
On the other hand, sometimes owning the physical asset is
beneficial because a manufacturer has the option to use it
immediately. Thus holding a commodity provides a benefit
referred to as the convenience yield (y).
The forward price of a contract on a commodity is:

F0 = [S0 +U]e(r-y)T
OR
F0 = S0 e(r+u-y)T
If the commodity cannot be sold (consumption asset):
F0 [S0 +U]e(r-y)T
OR
F0 S0 e(r+u-y)T

Andrew Chiu
Valuing a Forward Contract

A forward contract is worth zero (except for bid-offer spread
effects) when it is first negotiated
Later it may have a positive or negative value
Banks and investors need to value the contract each day
(marking to market)
Suppose that K is the original delivery price and F0 is the
forward price for a contract that would be negotiated today,
the value of a long forward contract is:
f = (F0 K )erT
Similarly, for a short forward contract:
f = (K F0)erT

Andrew Chiu
Example
Lets use a 1-year gold forward contract as an example. Price
of gold is currently 1000, interest rate is 5%, and there is no
convenience yield or storage cost.
When the contract is first established, the delivery price K is
calculated as:
K = F0 = S0 erT = 1000e0.05(1) =1051.271
6 months later, the price of gold rises to 1200 and interest
rate rises to 6%. The value of the long forward contract is:
F0 = S0 erT = 1200e0.06(0.5) =1236.545
f = (F0 K )erT = (1236.545 1051.271 )e0.06(0.5)
f = 179.799

Andrew Chiu
Futures vs Forward Prices

The futures price is the delivery price that makes the futures
contract worth zero.
When short-term interest rate is constant, the futures price
and the forward price are the same. Otherwise they can be
different.
This is due to the daily settlement requirement for futures.
When the underlying correlates with interest rate, futures
price is larger than forward price.
Ex: Underlying rises leading to a positive cash flow at the
end of day. This is saved at a higher than average interest
rate. Conversely, when the underlying falls, the loss is
financed at a lower than average interest rate.

Andrew Chiu
Arbitrage?


Andrew Chiu

FINA3204 02 Futures

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Derivative Securities

Andrew Chiu, PhD

The Hong Kong University of

FINA 3204: Derivative Securities

The Hong Kong University of

FINA 3204: Derivative Securities

Forward & Futures

The delivery price is chosen so that the initial

The Hong Kong University of

FINA 3204: Derivative Securities

Futures Contract Specification

Type of underlying asset

FINA 3204: Derivative Securities

FINA 3204: Derivative Securities

FINA 3204: Derivative Securities

The Hong Kong University of

FINA 3204: Derivative Securities

The Hong Kong University of

FINA 3204: Derivative Securities

Private contract between 2 parties

Some default risk

Daily settlement (marking to market)

Usually 1 delivery date

Range of delivery dates

Delivery or final cash settlement usually

Contract usually closed out prior to

The Hong Kong University of

FINA 3204: Derivative Securities

OTC vs. Exchange

Source: Bank for International Settlements.

The Hong Kong University of

FINA 3204: Derivative Securities

Hong Kong Exchange

China Financial Futures Exchange

Shanghai Futures Exchange

Dalian Commodity Exchange

Zhengzhou Commodity Exchange

FINA 3204: Derivative Securities

Futures Trading Hours

The Hong Kong University of

FINA 3204: Derivative Securities

9/11 Terrorist Attack

The Hong Kong University of

FINA 3204: Derivative Securities

Subprime Mortgage Crisis

The Hong Kong University of

FINA 3204: Derivative Securities

Hedging with Futures

The Hong Kong University of

FINA 3204: Derivative Securities

Arguments in Favor of Hedging

The Hong Kong University of

FINA 3204: Derivative Securities

Arguments against Hedging

FINA 3204: Derivative Securities

Long Hedge for Purchase of Silver

The Hong Kong University of

FINA 3204: Derivative Securities

Long Hedge for Purchase of Silver

Payment for Silver

The Hong Kong University of

FINA 3204: Derivative Securities

The Hong Kong University of