Finance Chapter 23: Futures and Risk Management

Chapter Twenty-Three: Futures, Swaps, and Risk Management

• This chapter examines pricing and risk management in futures markets.
• Hedging involves offsetting specific risk sources.
• Examples of particular risk sources include foreign exchange, stock indices, fixed-income securities, and commodities.
• Swap markets are used for foreign exchange and fixed-income securities.

Overview

• The chapter explores pricing and risk management in selected futures markets.
• Hedging involves techniques to counteract specific risks.
• Specific risks include foreign exchange, stock indices, fixed-income securities, and commodities.
• Swap markets are used for foreign exchange and fixed-income securities.

Foreign Exchange Futures: The Markets

• Hedging foreign exchange risk is possible through currency futures or forward markets.
• Forward markets in foreign exchange function informally through a network of banks and brokers.
• Customers can enter forward contracts to buy/sell currencies in the future at an agreed rate.
• Currency futures are traded on exchanges like CME or London International Financial Futures Exchange.

Direct versus Indirect Quotes

• In a direct quote, the exchange rate is expressed as dollars per unit of foreign currency.
• In an indirect quote, the exchange rate is expressed as foreign currency per dollar.

Foreign Exchange Futures (2 of 2)

• Data provided for various currencies (e.g., Japanese Yen, Canadian Dollar, British Pound, Swiss Franc, Australian Dollar, Mexican Peso, Euro) in January 9, 2019.
• The data showed open, high, low, settle prices, and changes in currency futures.

Foreign Exchange Futures: (Covered) Interest Rate Parity

• The interest rate parity theorem defines the relationship between spot and forward exchange rates, along with foreign and domestic interest rates.
• It eliminates arbitrage opportunities.
• The formula relating today's forward rate (F°) to the spot rate (E°) and the corresponding interest rates is provided

Interest Rate Parity Example

• Examples of interest rates for the US and UK are given.
• The formula and a current spot exchange rate between dollars and pounds are shown.
• It demonstrates a scenario where covered interest parity holds when calculating a forward rate for a specific currency.

Using Futures to Manage Exchange Rate Risk

• Hedge ratio is analogous to the number of hedging vehicles (e.g., futures contracts) that offset the risk of an unprotected position.
• Calculated as the ratio of sensitivities to the underlying uncertainty.
• The change in value of an unprotected position due to a change in the exchange rate divided by the profit derived from one futures position for the same exchange rate change is the hedge ratio formula.

Hedge Ratio for Foreign Exchange Risk

• A basic strategy for an exporting firm is to hedge the amount of foreign currency-denominated revenue.
• That approach doesn't account for currency fluctuations affecting the foreign revenue.
• Using profits as a function of the exchange rate would be a better approach.

Profits as a Function of the Exchange Rate

• Data is shown graphically to depict profits based on the exchange rate.
• The data shows a positive correlation between profit and exchange rate.

Stock-Index Futures: The Contracts

• Stock-index contracts settle as the value of the index on the contract maturity date, multiplied by a specific coefficient.
• Cash settlement reduces costs associated with futures trading.
• Broad-based U.S. stock market indexes exhibit a strong correlation.
• The S&P 500 contract dominates the U.S. index futures market.

Sample of Stock-Index Futures

• A table listing various stock index futures contracts, including the underlying market index, contract size, and exchange.

Correlation Coefficients Using Monthly Returns

• Data on correlation coefficients between various indexes using monthly returns.

Creating Synthetic Stock Positions: An Asset Allocation Tool

• Stock-index futures provide a substitute for holdings in underlying stocks.
• Transaction costs in futures trading are significantly lower compared to spot positions.
• Futures are very popular with market timers.

Index Arbitrage

• Index arbitrage exploits divergences between actual futures prices and the theoretically correct parity values of futures contracts to profit.
• If futures prices are too high, short the futures and buy the stocks in the index, and vice versa.

Program Trading

• Program trading involves buying or selling entire stock portfolios.
• This strategy is often used for index arbitrage.
• Significant transaction costs and the need for simultaneous trading in both spot and futures markets are factors influencing program trade success, which depends on relative spot and futures price levels and the synchronization between trading in both markets.

Using Index Futures to Hedge Market Risk

• To protect against falling stock prices, sell stock index futures.
• The hedge ratio is the negative of the regression slope.

Predicted Value of the Portfolio as a Function of the Market Index

• Graphically illustrates the predicted value of a portfolio as a function of the market index (e.g., S&P 500 index).
• The graph shows a positive correlation between predicted portfolio value and the market index.

Using Index Futures to Hedge Market Risk

• A market-neutral bet involves buying an underpriced stock and simultaneously shorting the index futures contract to hedge against market risk, while maintaining some alpha.
• The variability in the portfolio comes only from the firm's specific performance.

Example 23.5 Market-Neutral Active Stock Selection

• An example of how to calculate the hedge ratio for a market-neutral active stock selection.

Hedging Interest Rate Risk

• Fixed-income managers may want to hedge market risk, e.g., protecting bond fund gains against rising rates, enabling corporations to issue debt securities while protecting against rising rates and hedging a pension fund against rate declines for future inflows.
• Data illustrating the relationship between interest rate risk and various fixed-income securities

Hedging Interest Rate Risk Example (1 of 3)

• Illustrative example using modified duration to calculate the impact of basis points rising for example by 0.10% on a portfolio value of $10 million.

Hedging Interest Rate Risk Example (2 of 3)

• Details of T-bond futures including current prices, contract multipliers, and values for changes in interest rates are explained.

Hedging Interest Rate Risk Example (3 of 3)

• Further explanation on t-bond contracts, market-neutral strategies and how gains on t-bond futures offset losses in the bond portfolio.
• The implication of imperfect hedging due to changes in the yield spread.
• Includes information about cross-hedging.

Yield Spread

• Shows a graph of the yield spread between 10-year Treasury and Baa-rated corporate bonds.

Swaps

• Swaps are multiperiod extensions of forward contracts.
• Interest rate swaps involve exchanging cash flows based on different interest rates.
• Foreign exchange swaps involve exchanging currencies at future dates.
• Additional types, including inflation swaps, are also mentioned.

Example of Interest Rate Swap

• Example about a bank's swap strategy to deal with interest rate exposure if their assets and liabilities have different rate sensitivities.

Example of FX swap

• Illustrative example of a US exporter engaging in FX swaps to mitigate the risk of exchange-rate fluctuations between the dollar and Pound.

The Swap Dealer

• Swap dealers are financial intermediaries who take the opposing swap position to complete a swap agreement.
• They profit from the bid-ask spread created by these market transactions.

Interest Rate Swap

• Details about interest rate swaps are provided, including fixed and variable rates
• Illustration about an interest rate swap involving a swap dealer, company A and Company B

Eurodollar Futures

• Data on Eurodollar futures, including open, high, low, settle prices and trading volumes, using data from January 9, 2019.

Swap Pricing

• Swaps are comparable to a series of forward contracts.
• Interest rate parity is applicable for pricing swaps.
• Level annuity calculations based on present value match to forward agreement flows.

Forward Contracts versus Swaps

• Illustrations comparing pricing of forward contracts individually versus a two-year swap agreement.

Credit Default Swaps

• Credit default swaps (CDSs) are insurance-like contracts for credit risk.
• They provide coverage against defaults unrelated to ownership of the assets themselves.
• CDS payments are based on the financial health of involved parties.

Commodity Futures Pricing (1 of 3)

• Commodity futures pricing follows similar principles as stock futures.
• Carrying costs, including storage and spoilage, are a key difference.

Commodity Futures Pricing (2 of 3)

• Formula for calculating futures prices adjusted for carrying costs and interest rates.

Commodity Futures Pricing (3 of 3).

• Parity relationship for stored commodities.
• Similar to dividend adjustments for stock pricing.
• Convenience yield (net advantage of owning the physical commodity) is explained.

Commodity Futures Pricing (4 of 3)

• Backwardsation F<S
• When the convenience yield exceeds carrying cost;
• Contango F>S
• When the convenience yield is less than carrying costs.

Typical Agricultural Price Pattern over the Season

• Shows a graph depicting typical agricultural prices over a season.

This quiz explores Chapter 23 of finance, focusing on futures, swaps, and risk management strategies. Discover how hedging techniques are applied to various specific risk sources, including foreign exchange, stock indices, and commodities.