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Questions and Answers
What does "Hedging" refer to?
What does "Hedging" refer to?
Hedging refers to techniques that offset particular sources of risk.
Which of the following are examples of sources of risk that can be hedged in futures markets?
Which of the following are examples of sources of risk that can be hedged in futures markets?
The forward market in foreign exchange is formal and includes a regulated exchange.
The forward market in foreign exchange is formal and includes a regulated exchange.
False
What is the difference between a direct and an indirect exchange rate quote?
What is the difference between a direct and an indirect exchange rate quote?
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What is the primary purpose of the interest rate parity theorem?
What is the primary purpose of the interest rate parity theorem?
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What are the key features of stock-index futures contracts?
What are the key features of stock-index futures contracts?
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Index arbitrage involves taking advantage of discrepancies between the spot and futures prices of individual stocks within a specific index.
Index arbitrage involves taking advantage of discrepancies between the spot and futures prices of individual stocks within a specific index.
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What are the two factors that contribute to the success of program trading?
What are the two factors that contribute to the success of program trading?
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How can stock index futures be used to hedge market risk?
How can stock index futures be used to hedge market risk?
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A market-neutral bet involves buying a stock that is believed to be underpriced and simultaneously shorting the index futures contract to hedge against market movements.
A market-neutral bet involves buying a stock that is believed to be underpriced and simultaneously shorting the index futures contract to hedge against market movements.
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How does the concept of "cross-hedging" apply to interest rate risk?
How does the concept of "cross-hedging" apply to interest rate risk?
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Explain the difference between forward contracts and swaps.
Explain the difference between forward contracts and swaps.
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Credit default swaps (CDS) and interest rate swaps are fundamentally similar in their purpose and structure.
Credit default swaps (CDS) and interest rate swaps are fundamentally similar in their purpose and structure.
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What are the key factors that influence the pricing of commodity futures, particularly when considering storage costs?
What are the key factors that influence the pricing of commodity futures, particularly when considering storage costs?
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What conditions lead to backwardation and contango in commodity futures pricing?
What conditions lead to backwardation and contango in commodity futures pricing?
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Study Notes
Chapter Twenty-Three: Futures, Swaps, and Risk Management
- This chapter covers pricing and risk management in futures markets.
- Hedging is a technique that offsets specific risks.
- Foreign exchange futures, stock index futures, futures on fixed-income securities and interest rates, commodity futures pricing, and swap markets in foreign exchange and fixed-income securities are all covered as part of hedging particular sources of risk.
Overview
- Futures markets, pricing, and risk management are discussed.
- Hedging refers to techniques for offsetting different kinds of risk, such as risks related to foreign exchange, stock indexes, fixed-income securities, interest rates, and commodities.
- Foreign exchange futures, stock index futures, futures on fixed-income securities & interest rates, commodity futures pricing, and swap markets for foreign exchange and fixed income securities are specific examples.
Foreign Exchange Futures: The Markets
- Hedging FX risk can be accomplished using currency futures or forward markets.
- The forward foreign exchange market is informal.
- It's a network of banks and brokers allowing customers to enter forward contracts for future currency purchase/sales at a predetermined exchange rate.
- Current exchange-traded currency futures are traded on the CME or the London International Financial Futures Exchange.
Direct versus Indirect Quotes
- Direct quote: Exchange rate is expressed as dollars per unit of foreign currency.
- Indirect quote: Exchange rate is expressed as the foreign currency per dollar.
Foreign Exchange Futures (2 of 2)
- A table displays data for various currencies (e.g., Japanese Yen, Canadian Dollar, British Pound, Swiss Franc, Australian Dollar, Mexican Peso, Euro) on a specific date. Open, high, low, settlement, change, and open interest are listed for each currency. Data is from January 9, 2019.
Foreign Exchange Futures: (Covered) Interest Rate Parity
- The interest rate parity theorem describes the link between spot and forward exchange rates, and foregin and domestic interest rates.
- This theorem rules out arbitrage opportunities.
- The mathematical formula is F0 = E0 (1 + rus) / (1 + ruk).
- F0 is today's forward rate.
- E0 is today's spot rate.
- rus is US interest rate.
- ruk is UK interest rate.
Interest Rate Parity Example
- rus = 0.04, ruk = 0.01.
- E0 = $1.30 per one pound
Using Futures to Manage Exchange Rate Risk
- The hedge ratio is the number of hedging vehicles (e.g., futures contracts) needed to offset a specific position's risk.
- It's a ratio of sensitivities to a given factor (such as exchange rate changes).
- Change in unprotected position value for a given exchange rate change. The profit from a futures position is also calculated for the same exchange rate change.
Hedge Ratio for Foreign Exchange Risk
- An exporting firm might initially hedge only the amount of their foreign currency revenue.
- This approach is inadequate as foreign revenue depends on the exchange rate.
- A refined strategy estimates profitability as a function of the exchange rate using historical data.
Profits as a Function of the Exchange Rate
- A graph illustrating profits over a range of exchange rates.
- The gradient's numerical value is 2 million.
Stock-Index Futures: The Contracts
- Stock index futures are settled in cash based on an index value at contract maturity.
- This cash amount is multiplied by a predetermined factor for contract size.
- This cash settlement method helps reduce transaction costs in these markets.
- Broadly based US stock index values are highly correlated.
- The S&P 500 futures contract dominates the US stock index futures market.
Sample of Stock-Index Futures
- A table lists various stock index futures contracts (e.g., S&P 500, Mini-Dow, Mini-Russell 2000, NASDAQ 100, Nikkei 225, FTSE 100, DAX-30, CAC-40, Hang Seng). It shows the underlying index, contract size, and exchange for each contract.
Correlation Coefficients Using Monthly Returns
- A table presents correlation coefficients calculated on monthly stock market index returns between 2014 and 2018.
Creating Synthetic Stock Positions: An Asset Allocation Tool
- Stock index futures can replicate stock holdings.
- These futures have lower transaction costs than direct stock trades.
- These are favored by investors who manage portfolios through 'market timing' techniques.
Index Arbitrage
- Index arbitrage capitalizes on disparities between actual futures prices and their theoretical fair value.
- This divergence is exploited to generate profits.
- When a futures price is too high, one could sell the futures contract and buy the underlying stocks.
- Conversely, a low futures price allows one to buy futures and sell the corresponding stocks.
Program Trading
- Program trading involves purchasing/selling multiple stock portfolios.
- It's a commonly used technique in index arbitrage.
- Difficulties include high transaction costs and the need for synchronized trading across markets.
- Success relies on factors such as relative spot and futures prices and synchronized trading across both markets.
Using Index Futures to Hedge Market Risk
- Selling stock index futures helps mitigate potential declines in stock prices.
- Using a regression, one can compute a hedge ratio, which is the negative of the regression slope, for FX risk mitigation.
Predicted Value of the Portfolio as a Function of the Market Index
- This shows a positive correlation between portfolio value and market index—higher index value implies greater predicted portfolio value.
Using Index Futures to Hedge Market Risk
- Market-neutral bet: This strategy involves taking a position on an underpriced stock while mitigating the risk of a decline in market portfolio value.
- The stock is bought, while index futures are sold to counter any market downturn.
- The result is that firm-specific performance is the only remaining source of variability.
Example 23.5 Market-Neutral
Hedging Interest Rate Risk
- Fixed-income managers regularly hedge market risk.
- Bond fund managers may protect profits against rising interest rates.
- Corporations issuing debt securities hedge against rising rates.
- Pension funds with large cash inflows might hedge against a future rate decrease.
Hedging Interest Rate Risk Example
- A portfolio with a value of 10 million dollars and a modified duration of 9 years.
- The portfolio faces the risk of a 10-basis-point increase in yields.
- The related loss in value can be calculated by following the formula loss = 9 % X 0.1% = 0.9 %.
- The potential value loss from a 10 basis-point interest-rate increase for a portfolio is then calculated at $90,000.
Hedging Interest Rate Risk Example (2 of 3)
- Deals with price per 1,000T−Bondfuturespricingat1,000 T-Bond futures pricing at 1,000T−Bondfuturespricingat90/100,acontractmultiplierof100, a contract multiplier of 100,acontractmultiplierof1,000. This shows a $90 value per basis point change.
Hedging Interest Rate Risk Example (3 of 3)
- Using T-bond contracts to remove interest rate exposure risk from bond positions.
- This approach is an example of a market-neutral strategy where the gains related to the T-bond futures offset losses in the bond portfolio.
- Issues of market imperfections and yield spreads not remaining constant create challenges and an imperfect hedge.
- This approach is a form of cross-hedging.
Yield Spread
- A graph displays variations in yield spreads between 10-year Treasury and Baa-rated corporate bonds from 1970 to 2018.
Swaps
- Swaps are advanced forward contracts.
- An interest rate swap trades different interest rate cash flows between two parties.
- A foreign exchange swap exchanges stipulated future amounts of one type of currency for another.
- There are various other swap types, including inflation swaps.
- Fixed income managers look at swaps for the ease, low cost, and anonymity when restructuring balance sheets.
Example of Interest Rate Swap
- Banks with mostly fixed-rate assets and variable-rate liabilities would look at an interest rate swap exchange.
- This exchange can involve swapping fixed-rate interest payments for a variable interest rate.
Example of FX Swap
- A US exporter selling to British customers is exposed to currency risks.
- They could hedge or lock in the FX rate via swaps to buy dollars and sell pounds in multiple future years.
The Swap Dealer
- Dealership is a financial intermediary like a bank;
- Explains the reason for the dealership willingness to take on the opposite side of swap contracts;
- Bid-ask spread.
Interest Rate Swap
- An example of a swap involving two parties (Company A and Company B).
- Company B pays a fixed rate to the swap dealer.
- Company A receives a rate that's linked to LIBOR (London Interbank Offered Rate).
- The swap dealer profits in this exchange.
Eurodollar Futures
- A contract covering Eurodollars, with open, high, low, settlement, change, and open interest information for various dates. Data is from January 9, 2019.
Swap Pricing
- Swaps are sequences of forward contracts, prices calculated with interest rate parity.
- Determining the annuity level that matches cash flow value stream in a sequence of forward agreements. This involves finding a level annuity with the same present value.
Forward Contracts versus Swaps
- Charts compare forward contracts and swap agreements.
Credit Default Swaps
- A credit default swap (CDS) is essentially an insurance contract for credit risk, not on the assets of the buyer, but on the assets of another party.
- CDS payments are related to the creditworthiness of the reference firms.
Commodity Futures Pricing (1 of 3)
- Commodity futures pricing is like stock futures pricing in most aspects, but commodities introduce carrying costs, mainly with physical storage needs that affect the price value.
- The cost of "carrying" commodities differs substantially from financial assets; primarily because of spoilage and storage complications. Commodities' underlying assets (e.g. electricity) also create unique pricing challenges.
- Spot prices for various commodities can vary considerably.
Commodity Futures Pricing (2 of 3)
- Formula for calculating futures price in relation to cash price and carrying costs. Futures price (F°) equals the asset's cash price (P°) times (1 + risk-free rate) plus the carrying cost (C).
Commodity Futures Pricing (3 of 3)
- Futures price parity relationship for commodities involving storage consideration.
- The concept of "negative dividend" (represented by c) or convenience yield reflecting commodity benefits.
- The formula works best for assets (like gold) that are easily storable, but less effective for goods that are inefficient to stockpile (e.g. electricity, agricultural goods).
Commodity Futures Pricing (4 of 3)
- When convenience yield outweighs carrying costs (interest plus storage).
- This results in backwardation where the futures price is below the spot price. This is common in energy futures.
- Conversely, contango happens when carrying costs outweigh convenience yield: futures price above spot price.
Typical Agricultural Price Pattern over the Season
- A graph depicting the typical fluctuation in agricultural prices over a seasonal cycle (adjusted for inflation).
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Description
This quiz covers key concepts from Chapter 23, focusing on futures markets, pricing, and risk management strategies. It highlights important aspects such as hedging techniques for various risks, including foreign exchange and fixed-income securities. Prepare to test your understanding of futures and swaps in financial contexts.
