topic04_note - EC372 Bond and Derivatives Markets Topic #4:...

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Unformatted text preview: EC372 Bond and Derivatives Markets Topic #4: Futures Markets III: Applications R. E. Bailey Department of Economics University of Essex Outline Contents 1 Weather futures 1 2 Financial futures contracts 2 3 Short-term interest rate futures 3 3.1 A short-term interest rate hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 4 Long-term interest rate (bond) futures 4 5 Stock index futures 6 5.1 Hedging with stock index futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Reading: Economics of Financial Markets , chapter 16 1 Weather futures Weather futures What does it mean to buy or sell future Weather? For a futures contract, an index of weather must be agreed upon. On the CME the degree day index , DD , measures extreme temperature variations in a named city in a specified month Investors trade contracts specified in terms of the DD index The end of the month is the delivery date cash settlement then closes all remaining open contracts Two indices: HDD (for winter) and CDD (for summer) Example: Today, the HDD index for December delivery in Boston is 800. 1 Suppose that one contract is purchased at 800 and the actual HDD index in December is observed to be 880 The gain equals $1,600 (i.e. 80 points each worth $20). Note: the position could have been offset (sold) before delivery The CME Degree Day Index There are several DD indexes embedded within the CME contracts. First, the DD indexes are location specific: they are quoted for various cities in the US and Europe. Second, contracts cover different time periods: months or seasons (winter or summer) only contracts defined for designated calendar months are described below. Third, separate indexes measure exceptionally high and low temperatures: Cooling Degree Day (CDD) and Heating Degree Day (HDD) indexes, respectively. These are defined as follows: Daily CDD = Maximum { , daily average temperature minus 65 Fahrenheit } Thus, if the average temperature during a day is 80 , the CDD is 15 , while if the average temperature is 58 , the CDD is zero for that day. The daily CDD values are added up to provide an index of high temperatures (relative to 65 Fahrenheit) for each calendar month. The HDD index is defined as follows: Daily HDD = Maximum { , 65 Fahrenheit minus daily average temperature } Thus, the HDD is an index of low temperatures while CDD is an index of high temperatures (both relative to 65 Fahrenheit). The labels CDD and HDD are chosen because high temperatures imply a demand for energy for cooling while low temperatures imply a demand for energy for heating. Note : In Economics of Financial Markets , p. 395, each point of the DD is worth $100 according to the CME contract. The contract has now been changed such that each point is now worth $20 ....
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topic04_note - EC372 Bond and Derivatives Markets Topic #4:...

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