Chapter 29

THE APPLICATIONS OF FUTURES AND OPTIONS

CONTRACTS

Applications of Futures Contracts

Stock Index Futures

Interest Rate Futures

Stock Index Futures

Speculating on the Movement of the Stock Market

Controlling the Risk of a Stock PortfolioHedging against Adverse Stock Price

MovementsConstructing Indexed Portfolios Index ArbitrageCreating Portfolio InsuranceAsset Allocation

Interest Rate Futures

Speculating on the Movement of Interest Rates

Controlling the Interest Rate Risk of a Portfolio

Hedging against Adverse Interest Rate Movements

Enhancing Returns When Futures are Mispriced

Asset Allocation

Applications of Options Contracts

Stock Options

Stock Index Options

Interest Rate Options

Stock Options and Stock Index Options

Protect current or anticipated positions in individual stocks from adverse price movements.

Protect current or anticipated positions in a diversified portfolio from adverse price movements.

Interest Rate Options

Hedge against adverse interest rate movements.

Speculate on fixed-income security price movements based on expectations of interest rate changes.

General Principles of Hedging With Futures

Major function of futures market transfer price risk from hedgers to

speculatorsPerfect hedge

any loss (profit) on one position is exactly offset by any profit (loss) on the other position

riskfree hedge riskfree rate of return

Risks Associated With Hedging

Basis Risk Basis = Cash price - Futures price

Cross-Hedging Risk Cross hedge Cross-hedging effectiveness

Hedge Positions

Short Hedge protects against a decline in the cash

price of a financial asset or portfolio sell hedge

Long Hedge protects against an increase in the cash

price of a financial asset or portfolio buy hedge