BUS307 Topic 8 - Topic 8 Futures and Forwards BUS307 Commercial Banking SPOT FORWARD AND FUTURES CONTRACTS The cash fow timing For the spot Forward and

BUS307 Topic 8 - Topic 8 Futures and Forwards BUS307...

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Topic 8 Futures and Forwards BUS307 Commercial Banking
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SPOT, FORWARD, AND FUTURES CONTRACTS The cash flow timing for the spot, forward and futures contracts needs to be clearly understood. A spot contract is an agreement between a buyer and seller at time 0, when the seller agrees to deliver the asset immediately and the buyer agrees to pay for that asset immediately. A forward contract is an agreement between a buyer and a seller at time 0, when there is a contractual agreement that an asset will be exchanged for cash at some later date.
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SPOT, FORWARD, AND FUTURES CONTRACTS A futures contract is similar to a forward contract but normally organised through an exchange. The significant difference is the marking – to – market that occurs each day to reflect the changing futures price. For the main features of a futures transaction and marking-to- market refer to McGrath and Viney (1997:424-430). See an example at Lange et al. 2015., Endnote 10, p266.
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MICRO, MACRO, SELECTIVE AND COMPLETE HEDGING Hedging strategies need to note the following: Internal hedges may be present in the balance sheet; Monitoring and information costs to maintain hedged position; and Complete elimination of interest rate risk exposure will reduce the FO’s income potential.
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HEDGING PROCEDURES Step 1: Determine whether a Micro (specific asset or liability) or Macro (entire duration gap of an FI) Hedge Strategy will be employed. Step 2: Determine the Duration and Interest rate Exposure of the On-Balance-Sheet Items. Step 3: Determine the Duration and Interest Rate Exposure of the Off-Balance-Sheet Items selected for Hedging. Step 4: Determine the Number of Contracts to Immunise the Portfolio
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HEDGING INTEREST RATE RISK WITH FORWARD CONTRACTS The procedures for forward and futures contracts are similar. Hence the focus will be on hedging strategies based on futures contracts. See Lange et al., (2015: 220-222).
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HEDGING INTEREST RATE RISK WITH FUTURES CONTRACTS In order to be able to calculate the duration of futures instruments, it is imperative that the contract specifications are known. Students should note the following futures pricing formulae: 90-DAY BANK BILL FUTURES P = $1,000,000 / [ 1 + ( i * 90 / 365)] i = yield percent per annum. This is based on a contract unit of $1 million face value with 90 days to maturity.
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HEDGING INTEREST RATE RISK WITH FUTURES CONTRACTS 3-YEAR GOVERNMENT BOND FUTURES P = $6,000*A 6, i/2 + $100,000 / (1 + i/2) 6 i = yield percent per annum. This is based on a Commonwealth Treasury bond with a face value of $100,000 and a coupon rate of 12% per annum paid half yearly and 3 years to maturity.
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