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FuturesContracts Suggestedanswers Q.1 A BAB is ashortterm debt instrumentwidely used byAustralianfirmsforshortterm borrowing.ABABisacceptedbyareputablebank,whoundertakestopaytheholderofthebil thefacevalueatmaturity.Byhavingabankacceptingthisresponsibilitytheborroweroral calleddrawersignificantlyreducesthecreditriskhencelowertheinterestrateoryieldon bill.Inreturntheypayasmallfeetotheacceptingbank. ATreasurybondisadebtinstrumentissuedbyAustraliangovernment,formaturitiesof3 yearsand10years,andpayingsemiannualcoupons,setat6%p.a. BAB Treasurybond Term Shortterm Mediumlongterm Interest Discountsecurity Couponpaying Creditrisk Bankrisk So vereignrisk SoinvestorsofaBABearninterestbywayofpayinglessthanthefacevalueatthepurchase andreceivethefacevalueatmaturity.Thedifferenceistheinterestincome Incontrast,Treasurybondinvestorsearninterestbycollectingthestreamofcouponswhich canthenbereinvested. ThekeyriskofholdingaBABisthepricerisk,theriskofhavingtoresellthebillatunf priceduetochangesininterestrates.Ofcoursethisriskisnotrelevantincasethebill tomaturity ThekeyriskofholdingaTreasurybondistwofold(1)thepricerisk,theriskofhavingto thebondatunfavourablepriceduetochangesininterestratesand(2)thereinvestmentrisk ortheriskofhavingtoreinvestcouponsatunfavourableratesduetochangeininterestrat Q.2Convertthefollowing90daybankbillfuturespricestoyield: (i) June09 97.2810097.28=2.72%pa (ii) September09 97.382.62%pa (iii) December09 97.272.73%pa (iv) March10 97.032.97%p.a Q.3OnMarch19,theJune90dayBABfuturesistradingatabidaskof97.2897.29 a. Borrowers(investors)intheBABmarketarethosewhosell(buy)thebill.Therisk borrowersfaceisthattheymayhavetosellthebillatalowpriceduetoanincrease interestrate.Tohedgethisrisktheyshouldsellinadvancethebill,orshortafu BAB.Thepricetheycanshortisthelessfavourablebetweenthebidask,thatis97.28 hedgecoversaninterestperiodof90daysfromthedaythefuturesmatures.Ifthey decidetoholdthecontracttilsettlement,theyhavetodeliveraBAB,whoseacceptori amongstapprovedbanks,withafacevalueof1M,maturingin8590days.Inreturnthey receiveanamountequalto 1000,000 993,337.83 90 1 2.72% 365 Iftheycloseoutthecontractonemonthlaterat96.25(thatis,buythesameJune09BAB futures),implyingadiscountrateof3.75%,orabillsvalueof

1 ----------------------- Page 2----------------------1000,000 990,838.14 90 1 3.75% 365 Thegaintheymakeis 993,337.83 990,838.14 2499.69

Oragainof$2499.69. IfthisisaEurodollarfutures,themovementininterestratesis(96.2597.28)*100=103bas points.Thatistheratehasincreasedby103basispointswhereasthequotedpricehas decreasedby103basispoints.Sinceeachbasispointrepresents$25gain/loss,adecreaseof 103basispointsinthequotedpriceimpliesagainof103*25=$2575ontheshortBABfutures. Notethatitismoreconvenienttousethequotedpriceinsteadofinterestratesbecause quotedpricehasapositiverelationshipwithbillprice:thehigherquotedprice,thehigher billprice.Astheresult,theimpactofchangesinquotedpriceonthegain/lossworksinth samewayasinthecaseofstockfutures:anincreaseinquotedpricesimpliesagain(loss) long(short)position,andviceversa. b. Aspeculatorbelievesinterestratesintheneartermwillfallmorethanmarketpredict Inotherwords,theyexpectthebillpricetorise.Thereforetheyshouldtakealong positionintheBABfuturestoprofitfromthisprediction.Atwhatprice?Ataless favourablepricefromtheirpointofview,thatis97.29.Sincetheyarenotinterested holdingthebilluponsettlementofthefutures,theyshouldsellthecontractpriorto deliverymonth. Q.4Calculatethefollowingamounts. (i) Bankbillfuturescontract YoupurchaseaMarch09contractatapric 97.78. . Calculatethesettlementamount: 1000, 000 90 1 2.51% 365 1000,000 90 1 2.22% 365 706. 80 (ii) SPIfuturescontracts

Onmaturitydatetheinterestrateis2.51

YoushortaMarch09contractatapriceo

OnmaturitytheSPIis3415. Calculatethesettlementamount: 3150 3415 25 6625 (iii) 3yearTreasuryfutures

YoushortaMarch09contractatapriceo Thepriceonmaturityis95.13 Calculatethesettlementamount:

Atafutures priceof96.94,theyieldis %pa, implyingabondpriceof 2 ----------------------- Page 3----------------------3000 1 .0153 6.32 s4.87% pa,implyingabondpriceof 3000 1 0.02435 0.02435 1 00,000 103,118.87 1.0 2435 Profitonthisshortpositionis 108366.32 103118.87 5 ,247.45 Q.5 a.TheEurodollarfuturespriceis93.23,implyinga3monthLIBORof6.77%p.a. 1 1 100,000 0.0153 1.0153 108,36 1 0 1

Atasettlementpriceof95.13,theyiel

b.Sincewewanttoprotectourselvesagainstaninterestraterise,wewillshort$10millio

worthoffuturecontracts(i.e.,10contracts).WetakeashortpositionastheEurodollarfu pricemovesoppositetheinterestrate. c.Wewillhavetorepayprincipalplusinterestontheloanthatwearetakingfromthe followingJunetoSeptember.BecauseweshortedaEurodollarfutures,weareguaranteedthe borrowingratecalculatedin(a)thatis6.77%p.aor6.77%*91/360=1.7113%over91days. Therefore,wehaveanetrepaymentof: $10,000,000 (1 +r ,130 91 Asanexample,ifthe3monthLIBORrateinJunewas7.6%p.a,wewouldneedtorepay $10,000,000x(1+7.6%*91/360)=10,192,111 ) $10,000,000 =1.017113 $10,171

Ontheother,a3monthLIBORrateof7.6%inJuneimpliesafinalsettlementpriceof92.4, whichmeansthepayofffromtheshortpositionin10futurescontractswouldbe10100 (93.2392.4)=20,750 Thereforethenetrepaymentontheloanis 10,192,11120,750=10,171,361

Theslightdifferencebetweenthisnumberand10,171,130iscausedbythesimplificationof thewayEurodollarfuturesspayoffiscomputed,plusthefactthatthepayoffoccursatthe beginningoftheloanwhereasloanrepaymentoccursattheend

Q.6 1.Bysellinggastocustomersatafixedprice(inadvanceoftheheatingseason),thenatur gascompanyisworriedaboutthecasewhennaturalgaspricesareabnormallyhigh.Inthis case,theyarenotabletoraisetheirpricetotheircustomersandmighthavetobuynatural atthehigherpriceinordertodeliveryenoughquantity.Anaturalgasfuturescontract (specifically,alongposition)canhelpprotectagainstpricerisk,butisunabletohelpth companyonquantityrisk.Sincefixedpricecustomersarenolongerpricesensitive,theyare 3 ----------------------- Page 4-----------------------

likelytoconsumearelativelylargequantitywhenthereiscoldweather,whichalsohappens bewhengaspricesarelikelytobehigh. Whenenteringinalongfuturescontract,thecompanyhastosetthenumberofcontractsto golong.Iftheypurchasealargeamountoffuturescontractstocoverthecaseofverycold weather,theywillsufferwhentheweatherisrelativelywarm.Inthiscase(lowgas prices/warmweather),theywilllosealargeamountofmoneyontheirfutureshedge;hence theirhedgehasaddedadifferentrisk.Iftheypurchaseasmallamountofnaturalgasfuture thentheyruntheriskofhavingtosellalargequantityofexpensivenaturalgastoitsfix pricecustomers.

b.Heatingdegreeday(HDD)futurescouldbetheidealhedginginstrument.Bygoinglongwith aheatingdegreedayfuturescontract(eitherbyitselforincombinationwithanaturalgas futurescontract),thecompanycanhedgequantityrisk.WhenHDDishigh,theirfixedprice customerswillbedemandingalargequantityofexpensivegas.Byreceivingpayofffromthe longHDDcontracts,thecompanycanmanagetotalrisk(notjustpricerisk).OfcourseifHDD low,thatisthemonthwasonlymildlycold,theywillhavetopayundertheHDDcontract,bu theirconsumersdonotusethatmuchofnaturalgaswhilsthavingpaidafixedprice.