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Chapter 17 (exam 3) - Chapter 17 Chapter 17 Futures...

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Unformatted text preview: Chapter 17 Chapter 17 Futures Understanding Futures Markets Understanding Futures Markets Spot or cash market » Price refers to item available for immediate delivery Forward market » Price refers to item available for delayed delivery Futures market » Sets features (contract size, delivery date, and conditions) for delivery Understanding Futures Markets Understanding Futures Markets Futures market characteristics » Centralized marketplace allows investors to trade with each other » Performance is guaranteed by clearinghouse Valuable economic functions » Hedgers shift price risk to speculators » Pricing conveys information Sample of Futures Contracts Sample of Futures Contracts Futures Contract Futures Contract An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today »Trading means that a commitment has been made between buyer and seller » Position offset by making an opposite contract in the same commodity (reversing trade) Commodity Futures Trading Commission regulates trading Futures Exchanges Futures Exchanges Where _________________________________ Organized marketplace where _______________ ____________________________________ Members trade for ________________________ The Clearinghouse The Clearinghouse A corporation separate from, but associated with, each exchange Exchange members must be members or pay a member for these services » Buyers and sellers settle with clearinghouse Helps facilitate an orderly market Keeps track of obligations Trading With and Without Trading With and Without a Clearinghouse The clearinghouse eliminates counterparty default risk; allows anonymous trading since no credit evaluation is needed. Without this feature you would not have liquid markets. The Mechanics of Trading The Mechanics of Trading Move to electronic trading; some trading still takes place in trading “pits” through open outcry » Short position (seller) commits a trader to deliver an item at contract maturity » Long position (buyer) commits a trader to purchase an item at contract maturity » Like options, futures trading is a zero sum game The Mechanics of Trading The Mechanics of Trading Contracts can be settled in two ways: » Delivery (less than 2% of transactions) » Reverse the trade Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot Each exchange establishes price fluctuation limits on contracts No restrictions on short selling Futures Margin Futures Margin Earnest money deposit made by both buyer and seller to ensure completion of the contract » Not borrowed from broker Each clearinghouse sets requirements » Brokerage houses can require higher margin Initial margin usually less than 10% of contract value Futures Margin Futures Margin Margin calls occur when price goes against investor » Must deposit more cash or close account » Position marked­to­market daily Each contract has maintenance or variation margin level below which earnest money cannot drop Using Futures Contracts Using Futures Contracts Hedgers » At risk with a spot market asset and exposed to unexpected price changes » Buy or sell futures to offset the risk → Long hedge: protect against rise in price → Short hedge: protect against drop in price Hedging Risks Hedging Risks Basis: difference between cash price and futures price of hedged item » Must be zero at contract maturity Basis risk: the risk of an unexpected change in basis Using Futures Contracts Using Futures Contracts Speculators » Buy or sell futures contracts in an attempt to earn a return ♦ short ­ believe price will fall short ♦ long ­ believe price will rise long » Absorb excess demand or supply generated by hedgers » Assume the risk of price fluctuations that hedgers wish to avoid Futures Pricing Futures Pricing Spot­futures pricing theorem » Describes the theoretically correct relationship between spot and futures prices » Two ways to acquire an asset for some date in the future → Purchase now and store it → Take a long position in futures → Must have the same market determined costs Swaps Swaps Large component of derivatives market » Interest rate swap → Counterparties exchange fixed for floating rate » Currency swap → Counterparties exchange principal and interst in one currency for the same in another country Interest Rate Swap Interest Rate Swap Company A can take out a oneyear loan at a fixed rate of 8% or a floating rate of Libor + 1%. Company A prefers a fixed rate. Company B can take out a oneyear loan at a fixed rate of 6% or a floating rate of Libor + 3%. Company B prefers a floating rate. Swap dealer facilitates the transaction for a fee. 17-18 ...
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