ChapterTwenty-ThreeFutures,Swaps,andRiskManagementThischapterexploresbothpricingandriskmanagementinselectedfuturesmarketsHedgingreferstotechniquesthatoffsetparticularsourcesofriskForeignexchangefuturesStockindexfuturesFuturesonfixed-incomesecuritiesandinterestratesCommodityfuturespricingSwapmarketsinforeignexchangeandfixed-incomesecuritiesOverview?2021McGraw-HillEducation23-2ForeignexchangeriskcanbehedgedthroughcurrencyfuturesorforwardmarketsForwardmarketinforeignexchangeisinformalConsistsofanetworkofbanksandbrokersthatallowscustomerstoenterforwardcontractstopurchaseorsellcurrencyinthefutureatacurrentlyagreed-uponrateofexchangeCurrencyfuturesaretradedontheCMEortheLondonInternationalFinancialFuturesExchangeForeignExchangeFutures:

TheMarkets?2021McGraw-HillEducation23-3ForeignExchangeFutures

(2of2)?2021McGraw-HillEducation23-4InterestrateparitytheoremdescribestherelationshipbetweenspotandforwardexchangeratesandforeignanddomesticinterestratesthatrulesoutarbitrageopportunitiesForeignExchangeFutures:

InterestRateParityWhere: F0

istoday’sforwardrate E0isthecurrentspotrate?2021McGraw-HillEducation23-5DirectexchangeratequoteTheexchangerateisexpressedasdollarsperunitofforeigncurrencyIndirectexchangeratequoteTheexchangerateisexpressedasforeigncurrencyperdollarDirectversusIndirectQuotes?2021McGraw-HillEducation23-6Hedgeratiocanbethoughtofasthenumberofhedgingvehicles(e.g.,futurescontracts)onewouldestablishtooffsettheriskofaparticularunprotectedpositionInterpretedasaratioofsensitivitiestotheunderlyingsourceofuncertaintyUsingFuturestoManageExchangeRateRisk?2021McGraw-HillEducation23-7ProfitsasaFunctionoftheExchangeRate?2021McGraw-HillEducation23-8Stock-indexcontractsaresettledbyacashamountequaltothevalueoftheindexonthecontractmaturitydatetimesamultiplierthatscalesthesizeofthecontractCashsettlementreducescostsBroad-basedU.S.stockmarketindexesareallhighlycorrelatedS&P500contractbyfardominatesthemarketinU.S.stockindexfuturesStock-IndexFutures:

TheContracts?2021McGraw-HillEducation23-9SampleofStock-IndexFutures?2021McGraw-HillEducation23-10CorrelationCoefficientsUsingMonthlyReturns?2021McGraw-HillEducation23-11Onereasonstock-indexfuturesaresopopularisthattheycansubstituteforholdingsintheunderlyingstocksthemselves(i.e.,“synthetic”holdings)TransactioncostsofbuyingandsellingfuturespositionsaremuchlowerthantakingspotpositionsVerypopularamong“markettimers”CreatingSyntheticStockPositions:

AnAssetAllocationTool?2021McGraw-HillEducation23-12IndexarbitrageisaninvestmentstrategythatexploitsdivergencesbetweenactualfuturespricesandtheirtheoreticallycorrectparityvaluestomakeaprofitIfthefuturespriceistoohigh,shortthefuturescontractandbuythestocksintheindexIfthefuturespriceistoolow,buyfuturesandshortthestocksIndexArbitrage?2021McGraw-HillEducation23-13ProgramtradingreferstopurchasesorsalesofentireportfoliosofstocksDifficulttoimplementTransactionscostsNeedforsimultaneoustradingSuccessofprogramtradesdependsontwofactors:RelativelevelsofspotandfuturespricesSynchronizedtradinginthetwomarketsProgramTrading?2021McGraw-HillEducation23-14Toprotectagainstadeclineinstockprices,sellstockindexfuturesHedgeratioisthenegativeoftheregressionslopeMarkel-neutralbetUsingIndexFuturestoHedgeMarketRisk?2021McGraw-HillEducation23-15PredictedValueofthePortfolioasaFunctionoftheMarketIndex?2021McGraw-HillEducation23-16Fixed-incomemanagersalsosometimesdesiretohedgemarketrisk.Considerthefollowing:AbondfundmanagermayseektoprotectgainsagainstariseinratesCorporationsplanningtoissuedebtsecuritieswanttoprotectagainstariseinratesApensionfundwithlargecashinflowsmayhedgeagainstadeclineinratesforaplannedfutureinvestmentHedgingInterestRateRisk?2021McGraw-HillEducation23-17Portfoliovalue=$10millionModifiedduration=9yearsAssumebondportfolio’syieldrisesby10basispoints(0.10%)Resultsinlossof(9)x(.10%)=.90%or$90,000Pricevalueofabasispoint(PVBP)=$90,000/10basispoints=$9,000perbasispointHedgingInterestRateRiskExample

(1of3)?2021McGraw-HillEducation23-18HedgingInterestRateRiskExample

(2of3)

?2021McGraw-HillEducation23-19T-bondcontractdrivestheinterestrateexposureofabondpositiontozeroThisisamarketneutralstrategyGainsontheT-bondfuturesoffsetlossesonthebondportfolioThehedgeisimperfectinpracticebecauseofslippage—theyieldspreaddoesnotremainconstantCross-hedgingHedgingInterestRateRiskExample

(3of3)?2021McGraw-HillEducation23-20YieldSpread?2021McGraw-HillEducation23-21SwapsaremultiperiodextensionsofforwardcontractsAninterestrateswapisacontractbetweentwopartiestotradecashflowscorrespondingtodifferentinterestratesTheforeignexchangeswapisanagreementtoexchangestipulatedamountsofonecurrencyforanotheratoneormorefuturedatesTremendousappealtofixed-incomemanagersbecausetheyallowaquick,cheapandanonymousrestructuringofthebalancesheetSwaps?2021McGraw-HillEducation23-22Dealeristypicallyafinancialintermediary,suchasabankWhyisthedealerwillingtotakeontheoppositesideoftheswapsdesiredbytheparticipants?Bid-askspreadTheSwapDealer?2021McGraw-HillEducation23-23InterestRateSwap?2021McGraw-HillEducation23-24EurodollarFutures?2021McGraw-HillEducation23-25SwapsareessentiallyaseriesofforwardcontractsFindthelevelannuity,F*,withthesamepresentvalueasthestreamofannualcashflowsthatwouldbeincurredinasequenceofforwardagreementsSwapPricing?2021McGraw-HillEducation23-26ForwardContractsversusSwaps?2021McGraw-HillEducation23-27Acreditdefaultswap(CDS)iswhollydifferentfromaninterestrateofcurrencyswapRecall,aCDSislikeaninsurancepolicyonthecreditriskofacorporatebondorloan,butunlikeinsurance,theswapsallowyoutobuy“insurance”onassetsthatyoudon’townDoesnotentailperiodicnettingofonereferencerateagainstanotherPaymentonaCDSistiedtothefinancialstatusofoneormorereferencefirmsCreditDefaultSwaps?2021McGraw-HillEducation23-28GovernedbythesamegeneralconsiderationsasstockfuturesOnedifferenceisthatthecostof“carrying”commodities,especiallythosesubjecttospoilage,isgreaterthanthecostofcarryingfinancialassetsUnderlyin