FINS1612 Lecture Notes - Lecture 10: Forward Rate Agreement, Interest Rate Risk, Futures Contract

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cyanalpaca20

11 Nov 2018

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Futures and forward rate agreements (chapt 19) Key things to know: what are they, what are the differences between them, who uses them, how to use them and the risks, able to use futures and fras to hedge interest rate risks. Futures contracts and fras are derivatives because they derive their price from an underlying physical market product. 2 main types of derivative contracts: commodity (e. g gold, wheat, cattle) e. g gold futures, gold options, financial (e. g indices, shares, govt. securities and money market instruments) Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes in interest rates, exchange rates and share prices. They are hedging tools to help manage risk by providing certainty on exposures. A farmer wants to sell wheat in 2 months, but is concerned that the price is going to fall in the meantime. Solution enter into a wheat futures contract to sell.

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Agnes Chin is the chief financial officer of Grains Corp., an established agricultural commodities firm. The headquarters of Grains Corp. is located in Chicago.
It is now January and Agnes is working on two large deals that are coming up in the current year:
-Grains Corp. is going to purchase 100,000 bushels of wheat in 10 monthsâ time so as to meet its orders upstream.

-Grains Corp. is finally going to sell ofits 50,000 bushels of soybeans that has been in storage for the past 6 months. The transaction is to take place in 3
monthsâ time.
Prices in these transactions have not been fixed and hence they are risks that Agnes has to consider hedging. She checks the market data as presented below:

Agnes needs to analyse the nature of commodity price risk and the need for hedging this risk in the transactions. Help Agnes in her analysis by answering the following multiple choice questions:
(a) The 3-month forward price for the soybeans that is implied by the data is best approximated by
(i) 400,000
(ii) 500,000
(iii) 600,000

(b) Agnes notices that the 3-month futures price for soybeans that is traded in the market is significantly higher than the implied 3-month forward price. She may
take advantage of the arbitrage opportunity by
(i) selling 3-month soybeans futures to exactly hedge the price for the current storage of soybeans
(ii) buying more soybeans at spot, storing it for 3 months and buying 3-month soybeans futures
(iii) buying more soybeans at spot, storing it for 3 months and selling 3-month soybeans futures

(c) The futures contracts traded at the exchange expire in the months listed here:
March (H), May (K), July (N), September (U) & December (Z)
Is it possible to build a perfect hedge for the purchase of wheat with wheat futures contracts?
(i) Yes
(ii) No and she should enter into the September contract
(iii) No and she should enter into the December contract

(d) Judging from the data, the current state of the commodity market is likely to be
(i) backwardation
(ii) normal backwardation
(iii) contango

(e) If Agnes were to go long on the wheat futures, she will most likely notice that the market price on her futures contracts will
(i) gradually go down if the market remains generally calm
(ii) stay unchanged if the market remains generally calm
(iii) fluctuate significantly even while the market remain generally clam

copperworm321

T. J. Patrick is a young, successful industrial designer in Portland, Oregon, who enjoys the excitement of commodities speculation. T. J. has been dabbling in commodities since he was a teen-ager-he was introduced to this market by his dad, who is a grain buyer for one of the leading food processors. T. J. recognizes the enormous risks involved in commodities speculating but feels that because he's young, he can afford to take a few chances. As a principal in a thriving industrial design firm, T. J. earns more than $150,000 a year. He follows a well-disciplined investment program and annually adds $15,000 to $20,000 to his portfolio.
Recently, T. J. has started playing with financial futures-interest-rate futures, to be exact. He admits he is no expert in interest rates, but he likes the price action these investments offer. This all started several months ago, when T. J. met Vinnie Banano, a broker who specializes in financial futures, at a party. T. J. liked what Vinnie had to say (mostly how you couldn't go wrong with interest-rate futures) and soon set up a trading account with Vinnie's firm, Banano's of Portland.
The other day, Vinnie called T. J. and suggested he get into 5-year Treasury note futures. He reasoned that with the Fed pushing up interest rates so aggressively, the short to intermediate sectors of the term structure would probably respond the most-with the biggest jump in yields.
Accordingly, Vinnie recommended that T. J. short sell some 5-year T-note contracts. In particular, Vinnie thinks that rates on these T-notes should go up by a full point (moving from about 5.5% to around 6.5%) and that T. J. should short 4 contracts. This would be a $5,400 investment because each contract requires an initial margin deposit of $1,350.
Questions
a. Assume T-note futures ($100,000/contract; 32's of 1%) are now being quoted at 103-16.
1. Determine the current underlying value of this T-note futures contract.
2. What would this futures contract be quoted at if Vinnie is right and the yield does go up by 1 percentage point, to 6.5%, on the date of expiration? (Hint: It'll be quoted at the same price as its underlying security, which in this case is assumed to be a 5-year, 6% semiannual-pay U.S. Treasury note. If necessary, refer to Chapter 11 and review the material on pricing semiannual-pay bonds.)
b. How much profit will T. J. make if he shorts 4 contracts at 103-16 and then covers when 5-year T-note contracts are quoted at 98-00? Also, calculate the return on invested capital from this transaction.
c. What happens if rates go down? For example, how much will T. J. make if the yield on T-note futures goes down by just 3/4 of 1%, in which case these contracts would be trading at 105-8?

d. What risks do you see in the reccommended short sale transaction? What is your assessment of TJ's new interest in financial futures? How do you think it compares to hsi established commodities investment program?

tantiger591

4. If you __________, then you may be forced to buy the underlying stock.

Buy a Call Option
Buy a Put Option
Sell a Call Option
Sell a Put Option

5. Lower risk free rates results in __________ Put Option prices and ______ Call Option Prices.

Higher, Higher
Higher, Lower
Lower, Lower
Lower,Higher

6. Which Statement is correct?

Speculators make money by setting up transactions and are the go betweens in the derivatives market.
A firm should always hedge in order to reduce risk whenever they can
Hedgers do not mind losing money as long as they are reducing their risk
Brokers try to find mispricings in the market where they can buy at a low price and simultaneously sell at a high price without taking on any risk.

7. Which statement regarding executive stock options is correct?

They are short term and usually expire after one year.
They should reduce agency costs by making managers act like shareholders
They are included as compensation expense on the income statement.
Managers can sell the options on an exchange

8. Which of the following statements are correct?

Forward contracts are standardized and trade on an exchange
Profits and Losses on Futures contracts are marked to market on a daily basis.
Delivery of the assets almost never occurs in the forward market
Futures contracts allow you to buy or sell individual stocks for a preset price on the expiration date.

9. You need a barrel of oil next month. You could either buy the oil today and keep it for a month, wait and buy the oil next month when you need it, you could enter into a futures contract to buy oil at the current futures price $81, or you can pay $2 for a call option that gives you the right to buy oil for $80. The current spot price is $79 and the risk free rate is 2%, and carrying costs are $2. If the price ends up being $84 next month, then you should have ______________.

Waited to buy the oil
Entered into a futures contract
Bought a call option
Buy the oil today and store it for a month.

10. Which of these should cause the dollar to appreciate?

A decline in foreign demand for US goods and services
An increase in US demand for foreign goods and services
An increase in foreign demand for US financial assets
An increase in the amount of gold held by the US central bank

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FINS1612 Lecture Notes - Lecture 10: Forward Rate Agreement, Interest Rate Risk, Futures Contract

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