Hedging Equity
Exposures With
Futures
Hedging Equity Portfolios using
Stock Index Futures
A well-diversified portfolio (an index fund)
Stock index futures (S&P 500 index futures)
Stock index futures can be used to hedge a welldiversified equity portfol
Managing
Futures
Hedges
Rolling The Hedge Forward
The expiration date of the hedge is later
than the delivery dates of all the futures
contracts available
The hedger should roll the hedge forward
Close out one contract
Take the same position in the sa
Fixed Income Securities
Prices and Yield-to-Maturity
P
P
=
t
=
C
1
(1 + R)
1
C
+
C
(1 + R)
2
(1 + R)
t
2
+
R = YTM = IRR
t
C
n
(1 + R)
n
Pure Discount Bond
P = Price
FV = Face or Redemption Value
N = Time to maturity
R = Yield or IRR
0
1
2
3
n1
n
-P
FV
P
10/11/2013
Valuing and Pricing Swaps
Pricing vs. Valuing a Swap
Definitions
Valuing a Swap
Determining the NPV of an existing swap given the terms
of the contract and under current market rates.
Pricing a Swap
Determining the price, or fixed rate, on a sw
10/11/2013
Commodity Swaps
and
Equity Swaps
Commodity Swaps
Example of a Basic Commodity Swap
A copper producer wants to fix the price it receives for its
copper output for six years.
1. Monthly production averages 3 million pounds.
2. Commodity swap deal
10/1/2013
Duration
Bond Prices and Yields
Price-Yield Relation
P
P
=
C
1
(1 + R)
1
C
t
=
C
+
( 1 + R )t
2
(1 + R)
t
2
+
C
+
n
(1 + R)
n
R = YTM = IRR
Bond Prices and Yields
Sensitivity of Bond Values to Yield Changes
Changes in market price reflected by
c
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Term Structure
of Interest Rates
Yields, Term Structure, and
Forward Interest Rates
Prices and Yields
Zero-Coupon Bonds
Bond
Price
=
PN
=
PV of Scheduled
Payment
$100
(1 + 0 R N)
N
P N = Bond Price
$100
0
=
Bond Face Value
R N = Yield to maturit
Determinants of
Forward & Futures Prices
Relation between Forward and Cash Prices
Short Selling
Sell securities that you borrow and repay
them later
Yield a profit if the price of a security goes
down
Yield a loss if the price of a security goes up
Sho
Managing Exposures with
Forward and Futures
Contracts
Risk Mangement Applications
Using Forwards and Futures
Speculating: Making Bets on Changes in Price
Hedging: Offsetting Effects of Price Changes
Asset Allocation: Re-engineering Exposures
Accessing
Determinants of
Forward & Futures Prices
Part II
Stock Index Futures
Stock Indices
Track the changes in the value of the underlying
portfolio.
The weight of the stock in the portfolio (value-weighted or
equal-weighted)
The weight changes when the price
Forward and Futures
Contracts
Review: What is a Derivative?
Definition: a contract whose value is derived
from the value of something else.
Derivative Value
Asset Value
S&P 500 Index
S&P 500 Index Futures
Ebay Stock
Ebay Call Options
6-Month LIBOR
Interes
Finance 410
Derivative Markets:
Theory and Applications
Penn State University
Smeal College of Business
Fall Semester, 2013
William A. Kracaw
Pennsylvania State University
Smeal College of Business Administration
University Park, PA 16802
1. Introduction
Interest Rate
Compounding
Simple vs. Continuous Compounding
The effect of increasing the compounding frequency
on the value of the $100 at the end of 1 year when
the interest rate is r=10% per year
r m
100 (1 )
m
m is the compounding frequency
Simple vs.
10/7/2013
Introduction to the
Generic Swap Agreement
The Swap Contract
Definition
A swap is an agreement between counterparties which consists of a
series of forward contracts. Settlement dates are usually spaced at
six-month intervals.
The settlement ter