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Options.
Real options.
Main issues
Forwards and Futures
Forward and Futures Prices
Hedging Financial Risks Using Forwards/Futures
Chapter 10
10-1
Forward Contracts
settlement
-
time
The price xed now for future exchange is the forward price.
The buyer obtains a long position in the asset/commodity.
Features of forward contracts:
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c J. Wang
10-2
Chapter 10
Futures Contracts
Standardized contracts:
(1) underlying commodity or asset
(2) quantity
(3) maturity.
Traded on exchanges.
Guaranteed by the clearing house little counter-party risk.
Gains/losses settled dailymarked to market.
Margin account required as collateral to cover losses.
15.401 Lecture Notes
c J. Wang
Fall 2006
Chapter 10
10-3
A Forward Contract
A Futures Contract
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10-4
Chapter 10
Example. Yesterday, you bought 10 December live-cattle contracts at CME, at the closing price of $0.7455/lb.
a loss of $800.
c J. Wang
Fall 2006
Chapter 10
10-5
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10-6
3.1
Chapter 10
Commodities
1. Gold.
c J. Wang
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Chapter 10
10-7
2. Oil.
Costly to store.
Additional benets, convenience yield, for holding physical
commodity (over holding futures).
Not held for long-term investment (unlike gold), but mostly
held for future use.
Let the percentage holding cost be c and convenience yield be
y . We have
F = S0 [1 + rF (y c)]T
= S0(1 + rF y)T
H
where
y = y c
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10-8
Chapter 10
c J. Wang
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Chapter 10
3.2
10-9
Financials
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10-10
Chapter 10
Note:
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Chapter 10
10-11
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10-12
Chapter 10
0
1
2
3
-100.0
3.5 3.5 3.5
100.0 -102.5
0
0
0 - 99.0 3.5 3.5
This strategy allows one to lock in a purchase of the 7% Tbond 6-month later for $99. No arbitrage requires the current
forward price to be $99.
In general, a bonds forward price is
F = S(1 + r y)
where
c J. Wang
Fall 2006
Chapter 10
10-13
4.1
S5
F S5
Net payo
Thus, in this case you know today exactly what you will receive 5
months from now. That is, the hedge is perfect.
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10-14
4.2
Chapter 10
One problem with using forwards to hedge is that they are illiquid.
Thus, if after 1 month you discover that there is no oil, then
you no longer need the forward contract. In fact, holding just
the forward contract you are now exposed to the risk of oil-price
changes.
In this case, you would want to unwind your position by buying
back the contract. Given the illiquidity of forward contracts, this
may be dicult and expensive.
To avoid problems with illiquid forward markets, one may prefer
to use futures contracts.
c J. Wang
Fall 2006
Chapter 10
10-15
Match duration:
(# of contracts)(93, 062.50)(9.68) = (10, 000, 000)(6.80).
Thus:
(# of contracts) =
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c J. Wang
6.80
9.68
= 75.48.
10-16
Chapter 10
Maturity
Contract size
Underlying asset.
Thus, a perfect hedge is available only when
1. the maturity of futures matches that of the cash ow
2. the contract has the same size as the position to be hedged
3. the cash ow being hedged is linearly related to the futures.
In the event of a mismatch between the position to be hedged
and the futures contract, the hedge may not be perfect.
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Fall 2006
Chapter 10
10-17
Homework
Readings:
Assignments:
Problem Set 6
Fall 2006
c J. Wang