Managing Financial Risk, Smithson & Smith
Chapter 8
Futures and Risk
by: Mark Glitto
A future is an exchange traded contract between a buyer and a seller to exchange a standard quantity of a given instrument, at an agreed price, on a given date. Contracts are highly standardized and the buyer and seller need only agree on the price and the number of contracts traded. So a future can be viewed as an exchange traded forward. After the trade is cleared, the exchange's clearing house is the counter party to the trade. Thus the credit risk of a future is the credit worthiness of the clearing house. Most futures contracts expire on a quarterly bases. Contracts specify either physical delivery of the underlying instrument or cash settlement at expiry.
Futures Contracts Deal with Credit Risk
I. Daily Settlement
With a forward contract the performance is the same as the maturity of the contract. With a futures contract the performance is one trading day. Futures are marked to market and settled at the end of each business day.
II. Margin requirements
Each trading day gains are credited or losses are debited the clients margin account, in cash, as futures positions increase or decrease. Margin varies from .045 to 6% depending on the maximum historical volatility.
III. Clearinghouse
Imposes itself between all parties to every transaction
Futures Prices
At maturity, which is the delivery date for the futures contract, arbitrage between the underlying asset and the futures markets force the price of the futures and the spot market to be the same.
F = P + c
If F > P + c arbiters would short the asset and buy the future.
If F < P + c arbiters would short sell the future and buy the asset.
Cost of Carry Model
The price of a forward is a function of the current asset price plus the cost of carry.
· Financial assets: all we have to deal with are funding costs. We use net cost of carry.
· Commodities: in addition to funding costs the cost of carry includes: cost of storage, transportation and insurance costs.
Thus uncertainty about interest rates is an extra dimension of risk in forwards and futures.
Basis Risk
Basis risk arises when a hedge and the instrument being hedged are imperfectly matched. Since there price does not move in tandem there is the possibility of losses arising. For example, hedging a portfolio of 75 American stocks, some of which are not constituents of the S&P 100 index, with futures on the S&P will incur basis risk because the price movements of the 75 stocks will not be perfectly reflected in the price changes of the S&P 100 future. The larger the mismatch the larger the bases risk. For example an airline using crude oil futures to hedge the price of jet fuel might have a great amount of basis risk. A perfectly matched hedge is selling one year US Treasury futures to hedge 100 million of one year US Treasury notes.
Basis = F - P Think of basis risk this way: bases risk occurs when the exposure being neutralized and the hedge instrument are not identical, so there is a chance that the hedger and the counter party react differently to changing market conditions.
There are four primary sources of basis risk.
1. The Convergence of the Future Price to the Spot Price.
2. Changes in Factors That Affect the Cost of Carry.
3. Mismatches between the Exposure Being Hedged and the Futures Contract Being Used.
-Maturity Mismatch
-Liquidity Differences
-Credit risk Differences
4. Random Deviations from the Cost of Carry Relation.
Expectations Model
States that the current futures price is equal to the market's expected value of the spot price at the future time period.
Backwardation and Contango
Assume the spot price is $18 and the future price 5 years out is $22. Is this a "fair", appropriate, price for the future?
What is the cost to comply risk free with delivery by buying and storing the item (a commodity) for the five year period?
1. Buy the commodity at the spot price (P).
2. Time value of the funds over the five years (r).
3. Cost of storage (s) a percentage of the P price.
so F = P(1 + r + s)T
If F > P Market is in Contango also called carrying charge market. The difference between the forward and the spot is completely explained by the difference between the yield of an asset and the cost of funding that asset.
But what if there is a temporary shortage of the commodity? coffee today or oil during Gulf War
There is a value to having physical possession of the commodity today call this a convenience yield. You don't think we'd store the commodity for five years to sell at $22 if we could get $35 today!
Now F = P(1 + r + s)T - CY
If F < P Market is in Backwardation this occurs in markets were it isn't easy to arbitrage the price difference between forward and the spot.