L example l the price of corn s t 1040 f 1020 l net

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l Example: l The price of corn: S T =$1,040 ; F 0 =$1,020 l Net payment of $20 from the short position to the long. 15
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Settlement procedures: Offsetting trades l The majority of futures contracts are closed out before maturity by an offsetting trade . l The offsetting contract should have the same maturity, size, underlying. l The payoffs at time t : l A long position is closed out by a short position: - F 0 + F t l A short position is closed out by a long position: F 0 – F t l Example: In August, an investor enters a long position in 30 December S&P 100 contracts. In September she decides to close her position before the contract expires. To do so, she must sell 30 December S&P 100 contracts. 16
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Overview 1. Forward/Futures: definition and payoffs 2. Settlement procedures 3. Convergence of Forward/Futures prices to spot prices. 4. Hedging strategies using Forward/Futures 5. Basis risk 17
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Arbitrage Opportunities l An arbitrage strategy is a position that requires no cash outlay and generates a riskless profit. l An arbitrage opportunity exists in one of two ways: 1. By creating a zero-cost position, in which the future payoff is always strictly positive (“money tomorrow”). 2. By creating a position with a positive payoff today and no cash flows in the future (“money today”). l The no-arbitrage condition allows us to determine the price of forward/futures contracts. Fin330 18
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“Convergence” of Futures to Spot Price Fin330 19 Time Time (a) (b) Futures Price Futures Price Spot Price Spot Price
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“Convergence” of Futures to Spot Price l Assume that the spot price is higher than the future price during the delivery period ( t=T ): S T >F T . l Then there exits an arbitrage opportunity : l long a futures contract; l get delivery; l immediately sell the asset. l There is a riskless profit at maturity: S T - F T >0. l Same logic if S T <F T . l Therefore, we must have: S T =F T . Fin330 20
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Overview 1. Forward/Futures: definition and payoffs 2. Settlement procedures 3. Convergence of Forward/Futures prices to spot prices 4. Hedging strategies using Forward/Futures 5. Basis risk 21
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Why entering this contract? l Different players in the market buy/sell future contracts for different reasons. l Hedgers : insuring against a change in price. l Speculators : betting on a change in price. l Arbitrageurs : Get riskless profits by simultaneously entering into transactions that offset each other and gaining from the price difference 22
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Hedging l Hedging allows to reduce the risk or fully eliminate the risk ( perfect hedging ) associated with future price changes. l A short hedge involves a short position in a futures contract. l The short hedge is used when a financial asset or commodity is expected to be sold in the future. l It allows a producer to lock in a price for its output. Fin330 23
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Hedging l A long hedge involves a long position in a futures contract.
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