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

Chapter Twenty- Three Futures, Swaps, and Risk Management INVESTMENTS | BODIE, KANE, ©2021 McGraw-Hill Education. All rights reserved. AuthorizedMARCUSonly for instructor use in the classroom. No reproduction or further distribut...

Chapter Twenty- Three Futures, Swaps, and Risk Management INVESTMENTS | BODIE, KANE, ©2021 McGraw-Hill Education. All rights reserved. AuthorizedMARCUSonly for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.  Overview This chapter explores both pricing and risk management in selected futures markets Hedging refers to techniques that offset particular sources of risk Foreign exchange futures Stock index futures Futures on fixed-income securities and interest rates Commodity futures pricing Swap markets in foreign exchange and fixed- income securities INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-2  Foreign Exchange Futures: The Markets Foreign exchange risk can be hedged through currency futures or forward markets Forward market in foreign exchange is informal Consists of a network of banks and brokers that allows customers to enter forward contracts to purchase or sell currency in the future at a currently agreed-upon rate of exchange Currency futures are traded on the CME or the London International Financial Futures Exchange INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-3  Direct versus Indirect Quotes Direct exchange rate quote The exchange rate is expressed as dollars per unit of foreign currency Indirect exchange rate quote The exchange rate is expressed as foreign currency per dollar INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-4 Foreign Exchange Futures (2 of 2) INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-5  Foreign Exchange Futures: (Covered) Interest Rate Parity Interest rate parity theorem describes the relationship between spot and forward exchange rates and foreign and domestic interest rates that rules out arbitrage Topportunities  1  rUS  F0  E0    1  rUK  Where: F0 is today’s forward rate E0 is the INVESTMENTS current spot | BODIE, KANE, MARCUS rate ©2021 McGraw-Hill Education 23-6  Interest rate parity example Suppose rUS = 0.04, rUK = 0.01 E0 = $1.30 per pound Therefore, if covered interest parity holds: per pound INVESTMENTS | BODIE, KANE, MARCUS  Using Futures to Manage Exchange Rate Risk Hedge ratio can be thought of as the number of hedging vehicles (e.g., futures contracts) one would establish to offset the risk of a particular unprotected position Interpreted as a ratio of sensitivities to the underlying source of uncertainty INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-8  Hedge Ratio for Foreign Exchange Risk For an exporting firm, naïve view might merely hedge the amount of foreign currency-denominated revenue But that approach fails to recognize that the foreign revenue depends on the exchange rate A better approach might be to estimate profits as a function of the exchange rate, using historical| BODIE, INVESTMENTS data KANE, MARCUS Profits as a Function of the Exchange Rate INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-10  Stock-Index Futures: The Contracts Stock-index contracts are settled by a cash amount equal to the value of the index on the contract maturity date times a multiplier that scales the size of the contract Cash settlement reduces costs Broad-based U.S. stock market indexes are all highly correlated S&P 500 contract by far dominates the market in U.S. stock index futures INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-11 Sample of Stock-Index Futures INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-12 Correlation Coefficients Using Monthly Returns INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-13  Creating Synthetic Stock Positions: An Asset Allocation Tool One reason stock-index futures are so popular is that they can substitute for holdings in the underlying stocks themselves (i.e., “synthetic” holdings) Transaction costs of buying and selling futures positions are much lower than taking spot positions Very popular among “market timers” INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-14  Index Arbitrage Index arbitrage is an investment strategy that exploits divergences between actual futures prices and their theoretically correct parity values to make a profit If the futures price is too high, short the futures contract and buy the stocks in the index If the futures price is too low, buy futures and short the stocks INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-15  Program Trading Program trading refers to purchases or sales of entire portfolios of stocks. Often used for index arbitrage. Difficult to implement Transactions costs Need for simultaneous trading Success of program trades depends on two factors: Relative levels of spot and futures prices Synchronized trading in the two markets INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-16 Using Index Futures to Hedge Market Risk To protect against a decline in stock prices, sell stock index futures Can compute the hedge ratio using a regression such as done with FX risk Hedge ratio is the negative of the regression slope INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-17  Predicted Value of the Portfolio as a Function of the Market Index INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-18 Using Index Futures to Hedge Market Risk Market-neutral bet – you think a stock is underpriced (positive alpha), but are concerned the market portfolio will drop Buy the stock, and short the index futures contract The only source of variability will be the firm-specific performance of the stock. You’re hedged against market risk INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-19 Using Index Futures to Hedge Market Risk (2) INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-20  Hedging Interest Rate Risk Fixed-income managers also sometimes desire to hedge market risk. Consider the following: A bond fund manager may seek to protect gains against a rise in rates Corporations planning to issue debt securities want to protect against a rise in rates A pension fund with large cash inflows may hedge against a decline in rates for a planned future investment INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-21  Hedging Interest Rate Risk Example (1 of 3) Portfolio value = $10 million Modified duration = 9 years {D* = Modified duration D* = D / (1+y)} Assume bond portfolio’s yield rises by 10 basis points (0.10%) Loss = D* x (1 + y) = ( 9 ) x (.10%) =.90% $10 million x 0.90% = $90,000 Price value of a basis point (PVBP) = $90,000/10 basis points = $9,000 per basis point INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-22  Hedging Interest Rate Risk Example PVBP for $100,000 T-Bond futures. Current (2 of 3) price is $90/$100 face value. Contract multiplier is $1,000. $90 per one basis point change. INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-23  Hedging Interest Rate Risk Example (3 of 3) T-bond contract drives the interest rate exposure of a bond position to zero This is another market neutral strategy Gains on the T-bond futures offset losses on the bond portfolio The hedge is imperfect in practice because of slippage — the yield spread does not remain constant INVESTMENTS | BODIE, KANE, This is Cross-hedging MARCUS ©2021 McGraw-Hill Education 23-24 Yield Spread INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-25  Swaps Swaps are multiperiod extensions of forward contracts An interest rate swap is a contract between two parties to trade cash flows corresponding to different interest rates The foreign exchange swap is an agreement to exchange stipulated amounts of one currency for another at one or more future dates Many other types, including inflation swaps Tremendous appeal to fixed-income managers because they allow a quick, cheap and anonymous restructuring of the balance sheet INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-26  Example of Interest Rate Swap Suppose a bank has mostly fixed-rate assets (e.g. mortgages, long-term bonds) but variable-rate liabilities (money market deposits, commercial paper) – highly exposed to interest rate increases. Enters into a swap agreement to exchange $X fixed rate interest payments for some variable rate INVESTMENTS | BODIE, KANE, MARCUS  Example of FX swap US exporter sells $10 million worth of products per year to British customers. Allows them to pay in pounds. Currently $1.20 per pound. Is concerned that the pound will depreciate against the dollar, decreasing his profits. Enters into swaps to buy dollars and sell pounds for multiple years, locking in the FX rate INVESTMENTS | BODIE, KANE, MARCUS  The Swap Dealer Dealer is typically a financial intermediary, such as a bank Why is the dealer willing to take on the opposite side of the swaps desired by the participants? Bid-ask spread INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-29 Interest Rate Swap INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-30  Eurodollar Futures These will work for one-period swaps for the LIBOR rate. INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-31  Swap Pricing Swaps are essentially a series of forward contracts. Should be priced according to the interest rate parity equation. Find the level annuity, F *, with the same present value as the stream of annual cash flows that would be incurred F1 in a Fsequence 2 F * of forward F * agreements  2   (1  y1 ) (1  y 2 ) (1  y1 ) (1  y 2 ) 2 INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-32 Forward Contracts versus Swaps INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-33  Credit Default Swaps A credit default swap (CDS) is wholly different from an interest rate of currency swap Recall, a CDS is like an insurance policy on the credit risk of a corporate bond or loan, but unlike insurance, the swaps allow you to buy “insurance” on assets that you don’t own Does not entail periodic netting of one reference rate against another Payment on a CDS is tied to the financial status of one or more reference firms INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-34  Commodity Futures Pricing (1 of 3) Governed by the same general considerations as stock futures One difference is that the cost of “carrying” commodities, especially those subject to spoilage, is greater than the cost of carrying financial assets Underlying asset for some contracts, like electricity futures, simply cannot be “carried” Spot prices for some commodities demonstrate markedINVESTMENTS seasonal patterns | BODIE, KANE, that can affect pricingMARCUS ©2021 McGraw-Hill Education 23-35  Commodity Futures Pricing (2 of 3) Let F0 = futures price, P0 = cash price of the asset, and C = carrying cost F0  P0 (1  r f )  C Now define c C then : P0 F0  P0 (1  r f  c ) INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-36  Commodity Futures Pricing (3 of 3) F0 = P0(1 + rf + c) is a parity relationship for commodities that are stored Similar to parity relation for stocks. Think of c as a “negative dividend”. Net of benefits from possession of the commodity, known as “convenience yield”. The formula works great for an asset like gold, but not for electricity or agricultural goods, which are impractical to stockpile INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-37 Commodity Futures Pricing (4 of 3)! When the convenience yield exceeds the carrying costs (interest plus storage charges), you have backwardation F < S. Quite common for energy futures. When the convenience yield is less than carrying costs, you have contango F > S. INVESTMENTS | BODIE, KANE, MARCUS Typical Agricultural Price Pattern over the Season INVESTMENTS | BODIE, KANE, MARCUS ©2021 McGraw-Hill Education 23-39