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topic03_note - EC372 Bond and Derivatives Markets Topic#3...

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Unformatted text preview: EC372 Bond and Derivatives Markets Topic #3: Futures Markets II: Speculation and Hedging R. E. Bailey Department of Economics University of Essex Outline Contents 1 Speculation 1 2 Hedging strategies 2 2.1 Perfect (risk-free) hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3 Optimal hedging 4 4 Theories of futures prices 6 4.1 Normal backwardation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 5 Manipulation of futures markets 8 Reading: Economics of Financial Markets , chapter 15 1 Speculation Speculation • Motive: to profit from expected changes in futures prices. • Hicks Value and Capital , p. 138: ‘Futures prices are ... nearly always made partly by specu- lators, who seek a profit by buying futures when the futures price is below the spot price they expect to rule on the corresponding date ...’ 1. Speculators partly make prices – hedgers matter too. 2. Implies that contracts will be held to maturity – ‘ corresponding ’ date – when f ( T, T ) = p ( T ) 3. Only buying futures is mentioned but speculators may sell • Investor who expects price to rise : take a long position – buy, planning to sell later at a higher price • Investor who expects price to fall : take a short position – sell, planning to buy later at a lower price 1 Comments on the Hicks’s quotation: 1. Hicks claims only that speculators are partly responsible for futures price determination. Hedging and arbitrage also play a role, though the consequence of arbitrage is for the link between futures and current spot prices, rather than on the general level of prices. The usual presumption is that speculators and hedgers inhabit opposite sides of the market (one group buying contracts from the other). 2. Hicks refers to the expected spot price at the delivery date (what Hicks calls the ‘corresponding date’). Hicks has in mind that the futures contracts will be held to maturity when the speculator will either take delivery (or make delivery) of the underlying asset and simultaneously sell (or purchase) it at the spot price. The speculator’s profit or loss is then the difference in the price at which the futures contract was acquired and the spot price upon delivery. Of course, in active futures markets the contract may well be offset before delivery takes place. But the principle is the same: the profit or loss depends on the change in price between the date at which the contract is acquired and the price when it is offset. 3. Only speculation in the form of buying futures is mentioned. There is no reason, in principle, why speculation by selling futures should be excluded. The direction — purchase or sale — depends on the whether the investor believes that the price will rise or fall. However, Hicks was describing a market in which most hedgers seek to reduce risk by selling futures contracts....
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topic03_note - EC372 Bond and Derivatives Markets Topic#3...

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