Week 6

Futures, swaps, and Risk Management

Chapter Overview

This chapter discusses the various stock index futures, empirical evidence on the pricing of these futures, index arbitrage, foreign exchange futures, interest rate futures, commodity futures pricing, interest rate swaps, and credit default swaps. It presents this material within the context of hedging particular types of risk

Learning Objectives

After studying this chapter, the student should be have a solid understanding of the various futures contracts available, including how these contracts are traded, priced, and used in portfolios. In addition, the student should understand the various types of swaps that are available including interest rate swaps, foreign exchange swaps and fixed-income securities swaps and the potential uses of these tools.

Presentation of Material

23.1 Foreign-Exchange Futures

The chapter opens with a presentation of futures markets for foreign exchange. There is a large and active forward market for foreign exchange. One of the key differences between futures and forwards is their secondary market activity. Futures trade on active secondary markets while forward contracts do not trade in secondary markets. The interest rate parity theorem is a key factor for pricing on foreign exchange contracts. The concept is presented in equation 23.1 along with a pricing example. Forward contracts are not cleared through an exchange and are not marked to market. Please make sure students understand how to read Figures 23.1 and 23.2

23.2 Stock Index Futures

Stock index contracts are available on both domestic and international indexes. The advantages of investing in stock using index contracts include lower transaction costs, better timing and allocation and quicker execution on acquiring or disposing of a position. Table 23.1 presents some samples of stock index futures.

The practice of index arbitrage assures that pricing will follow the spot-futures parity principle. If futures prices are too high, an investor could sell the future and buy the underlying stock. The stock would be delivered against the futures contract at maturity. If the futures price were too low, the investor could go long in the futures contract and short the stocks in the index.

Index arbitrage is difficult to implement in practice. The practice led to the development of program trading, which refers to purchases or sales of entire portfolios of stocks. The success of these grades depends on relative levels of spot and futures prices and synchronized trading the two markets.

Investors can use futures contracts to eliminate exposure to a decline in the general level of stock prices. Motivation for such a hedge could include hedging to protect the value of a portfolio or to profit on a mispriced security. Using index contracts is less costly and quicker that the actual sale of a portfolio.

The hedge that is presented in Example 23.4 is designed to protect against an existing portfolio. The chapter also describes the use of hedging to protect against a general decline in stock prices when an investor believes that a particular security is mispriced. When using this type of hedge, the investor believes that the particular security will adjust in price but does not want exposure to information that will cause a downward adjustment in the prices of all stocks.

23.3 Interest Rate Futures

Interest rate futures contracts are available on a variety of domestic and international instruments. Interest rate futures are used extensively to hedge against unfavorable movements in interest rates. Interest rate hedges have many applications. An obvious possibility for a hedge is for an investor who currently owns a portfolio of fixed-income securities. A rise in rates will cause a loss in value. The investor can avoid this exposure by shorting an interest rate futures contract similar to the systematic risk hedge. The exposure on a fixed-income portfolio is proportional to the portfolio’s modified duration.

23.4 Swaps

Plain swaps are basically a series of forward contracts. Interest rate swaps, first described in Chapter 16, are used by to manage interest rate risk. The market originally developed to allow banks and thrift institutions to obtain longer-term fixed-rate financing that better matched their assets. The market has grown and is now used by many non-financial firms. A foreign exchange swap is a series of forward contracts between two parties. The swap features level exchange rates for the duration of the swap. Credit risk swaps, which have become very popular, allow fixed income investors to protect against default. The Swap dealer effectively creates a neutral position when setting up the swap arrangement. Interest rate contracts are also available to hedge multi-period exposure.

A credit default swap, or CDS, is not the same type of instrument as an interest rate swap. Payment on a CDS is tied to the financial status of one or more reference firms; the CDS therefore allows two counterparties to take positions on the credit risk of those firms. When a particular “credit event” is triggered, say default on an outstanding bond or failure to pay interest, the seller of protection is expected to cover the loss in the market value of the bond. For example, the swap seller may be obligated to pay par value to take delivery of the defaulted bond (in which case the swap is said to entail physical settlement) or may instead pay the swap buyer the difference between the par value and market value of the bond (termed cash settlement). The swap purchaser pays a periodic fee to the seller for this protection against credit events.

23.5 Commodity Futures Pricing

The chapter concludes by pricing commodities. The major difference between commodities and the stock index contract used to develop the pricing concepts is positive storage costs. With commodities both storage costs and spoilage must be considered.

Since some commodities (agricultural) are not storable for long period over several harvests, prices on these commodities will have a seasonal pattern. To measure the present value of a futures price, the authors offer commodity betas. These commodity betas can be used to develop appropriate discount rates.

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