RSM435H1 Study Guide - Fall 2018, Comprehensive Midterm Notes - Futures Contract, Variance, Risk-Free Interest Rate
RSM435H1
MIDTERM EXAM
STUDY GUIDE
Fall 2018
Derivative: instrument whose value depends on value of more basic underlying variables
•
Trade standardized contracts that have been defined by the exchange
○
Traditionally traded through open-outcry system
○
Exchange traded markets
•
Collateral acts like margin account in central counterparty
□
Bilateral trades usually includes Credit Support Annex (CSA) requiring one or both
parties to provide collateral
▪
Trades either cleared through central counterparty or bilaterally
○
Major players are institutional
○
Transactional are larger in size but less volume
○
Standardized OTC products must be traded on swap execution facilities
▪
CCP must be used as intermediary for standard products
▪
Trades must be reported to central registry
▪
New regulations since financial crisis have made OTC markets more similar to exchange
○
OTC markets
•
Types of markets
Trade OTC
•
Payoffs represent total loss or gain
○
It costs nothing to enter forward contract
•
Most popular in currencies and interest rates
•
Forward price: delivery price that would be applicable to a contract that is negotiated today
•
Contract has zero value to both sides at inception
•
Forwards are settled at end of life of contract
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Forwards
Long position: ST- K
•
Short position: K - ST
•
Where K=delivery price, ST- spot price at maturity
•
Payoffs
Like forwards, but traded on exchange
•
Can close futures contract by entering into offsetting position
▪
Closed out prior to delivery
○
Most futures contracts do not lead to delivery
•
Short seller specifies delivery by filing notice of intention to delivery with exchange
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Price converges to price of underlying asset as delivery period approaches
○
Price determined by supply and demand
•
○
Close out futures just before maturity and replace them with new contracts to reflect new
exposure
If expiration of hedge later than delivery dates of futures available, can stack and roll futures
•
Futures
Daily price movement limits are specified by the exchange for most contracts
•
Trading ceases for the day if contract is limit up or limit down
•
However, limits are also a barrier to trading when the underlying asset price is changing
rapidly
○
Limits present large price movement due to speculation
•
Price limits
Limits number of contracts a speculator may hold
•
Prevent speculators from exercising influence on markets
•
Position limit
If futures price has gone up, money transferred from short to long
□
If futures price has gone down, money transferred from long to short
□
Daily settlement
▪
Margin account balance adjusted at end of each trading day
○
Margin accounts protect against one party backing out or not having means to honor agreement
•
Trader entitled to withdraw any balance in margin account in excess of initial margin
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If margin account falls below maintenance margin, trader must top-up funds through variation
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Margin account
Lecture 1: Intro to Derivatives
September 12, 2018
RSM435 Page 1
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Broker can close out margin if trader does not provide variation margin
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If margin account falls below maintenance margin, trader must top-up funds through variation
margin
•
Most brokers pay interest on balance in margin account
•
T-bills and stocks generally accepted in lieu of cash at 90% and 50% of face value respectively
•
Trading on behalf of clients
○
Futures commission merchants
1.
Trading on behalf of own account
○
Locals
2.
Types of futures traders
Short position in futures contracts
○
Appropriate if investor already owns asset and expects to sell in future
○
Short hedge
•
By hedging, you keep your costs are constant
▪
▪
If price of input increases, market price will rise to reflect higher costs, leading to a
higher profit margin for you
▪
If price of input decreases, market price will decrease to reflect lower costs, leading
to a lower profit margin for you
If industry prices fluctuate to reflect changing costs, hedging will put you at disadvantage
○
May be appropriate not to hedge if hedging is not the industry norm
•
Hedging strategies using futures
Known as cross-hedging
▪
Asset to hedge is not identical to asset underlying futures contract
a.
Uncertainty as to exact date asset will be bought/sold
b.
Hedge requires futures to be closed before delivery
c.
Occurs if:
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Basis should be zero at expiration if asset hedged and underlying asset are the same
○
Basis = spot price of asset to be hedged - futures price of contract used
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Basis risk
Size of position taken in futures contract relative to size of exposure
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Choose ratio that minimizes variance of value of hedged position
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Where h* is optimal hedge ratio, ρ is correlation between change in spot price and futures
price, σSis standard variation of the spot price, and σFis the standard variation of the
futures price
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h*=ρ*σs/σF
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Where N*is optimal number of contracts, QAis size of position being hedged, and QFis
size of one futures contract
○
N*=h**QA/QF
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Daily settlement means hedges are actually a series of one day hedges
○
Where
is given by standard deviation of percentage one day changes in the spot
and futures prices, VAis the value of the position (asset prices times QA) and VFis
futures prices times QF
▪
N*=
*VA/VF
○
Impact of daily settlement
•
Results in portfolio growing at risk free rate
▪
N*=β*VA/VF
○
Hedging an equity portfolio
•
Hedge ratio
Traded on exchange and OTC
•
Options expire 3rd Friday of the month
•
Options
Uses of derivatives
Forwards neutralize risk by providing fixed price
•
Options act as insurance against adverse price movements
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Hedging
Only have to provide the margin instead of paying upfront
○
Speculating using futures rather than spot prices means smaller initial outlay
•
Speculating using options caps the loss at the price paid for the option
•
Speculating
Arbitrage
Change nature of liability
RSM435 Page 2
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Document Summary
Derivative: instrument whose value depends on value of more basic underlying variables. Trade standardized contracts that have been defined by the exchange. Trades either cleared through central counterparty or bilaterally. Bilateral trades usually includes credit support annex (csa) requiring one or both parties to provide collateral. Collateral acts like margin account in central counterparty. Transactional are larger in size but less volume. New regulations since financial crisis have made otc markets more similar to exchange. Standardized otc products must be traded on swap execution facilities. Ccp must be used as intermediary for standard products. Forward price: delivery price that would be applicable to a contract that is negotiated today. Contract has zero value to both sides at inception. Forwards are settled at end of life of contract. Where k=delivery price, st- spot price at maturity. Most futures contracts do not lead to delivery. Can close futures contract by entering into offsetting position.
