VII: Futures 22: Hedges, Speculation, and Arbitrage.
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Transcript of VII: Futures 22: Hedges, Speculation, and Arbitrage.
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VII: Futures
22: Hedges, Speculation, and Arbitrage
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Futures
Hedge use futures to reduce risk on an existing
position Speculate
use futures to take on risk in the hope of making a profit
Arbitrage Use the difference between spot and futures
prices to generate risk-free profit
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
CUSE
Arbitrage
Shares of Discovery Café trade in the primary market (NYSE) and in the Champaign-Urbana Stock Exchange (CUSE).
DVC$100
CUSE$1.50
brokerage$1.50
brokerage
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Arbitrage
Price range on the CUSE
$100NYSE
Arbitrage-free price range
Buy CUSE & sell NYSE
Buy NYSE & sell CUSE
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Arbitrage
Price range on gold futures
Spot goldLow price
High price
Arbitrage-free price range
Buy futures & sell spot
Buy spot & sell futures
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Arbitrage
Gold Futures 1 year contract 1 c is 100 troy ounces Margin is $1,800 and $1000 per contract
Spot Gold is trading at $370/ounce
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Arbitrage
Price range on gold futures
Spot gold$370
$340 $400
Arbitrage-free price range
Buy futures & sell spot
Buy spot & sell futures
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Arbitrage:
Buy spot; sell futures Buy spot at $370/ounce Sell futures at $400/ ounce Profit: $30/ounce (minus a few costs of carry)
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Chapter 22: Hedges, Speculation, and Arbitrage
Arbitrage
October 2011
Buy 100 ounces gold @$370/oz
storage & insurance
Sell 1 October 08 gold contract @ $400/oz Initial Margin
Borrow at 5% for 12 months
Initial Investment
October 2012
Deliver gold @ $400 contracted priceMargin returned
Repay loan Principal
interest
Arbitrage Profit
© Oltheten & Waspi 2012
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Chapter 22: Hedges, Speculation, and Arbitrage
Arbitrage
October 2011
Buy 100 ounces gold @$370/oz
storage & insurance
Sell 1 October 07 gold contract @ $X/oz Initial Margin
Borrow at 5% for 12 months
Initial Investment
October 2012
Deliver gold at contracted price $XMargin returned
Repay loan Principal
interest
Arbitrage Profit
© Oltheten & Waspi 2012
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Arbitrage
Spot gold$370
$340
Arbitrage-free price range
Buy futures & sell spot
Buy spot & sell futures
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Chapter 22: Hedges, Speculation, and Arbitrage
Arbitrage
October 2011
Short Sell 100 ounces gold @$370/oz
borrowing fee
Buy 1 October 08 gold contract @ $340/oz Initial Margin
Invest at 5% for 12 months
Initial Investment
October 2012
Take delivery of the gold @ $340 contracted price Margin returned
Cash in investment Principal
interest
Arbitrage Profit
© Oltheten & Waspi 2012
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Chapter 22: Hedges, Speculation, and Arbitrage
Arbitrage
October 2011
Short Sell 100 ounces gold @$370/oz
borrowing fee
Buy 1 October 07 gold contract @ $X/oz Initial Margin
Invest at 5% for 12 months
Initial Investment
October 2012
Take delivery of the gold @ $X contracted price Margin returned
Cash in investment Principal
interest
Arbitrage Profit
© Oltheten & Waspi 2012
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Arbitrage
Spot gold$370
Arbitrage-free price range
Buy futures & sell spot
Buy spot & sell futures
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Futures
Hedge use futures to reduce risk on an existing
position Speculate
use futures to take on risk in the hope of making a profit
Arbitrage Use the difference between spot and futures
prices to generate risk-free profit
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Speculation Susan
50,000 bushels of soybeans costs $210,000.
The price of soybeans is going up
$
$$$50,000 bushels in soybeans
futures costs $8100.
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Speculation
420
431
-$40,000
-$30,000
-$20,000
-$10,000
$0
$10,000
$20,000
$30,000
$40,000
360 380 400 420 440 460 480
Price (Soybeans Spot)
Profi
t
Soybean Futures
Soybeans
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
179.01%
9.52%431
-500%
-400%
-300%
-200%
-100%
0%
100%
200%
300%
400 410 420 430 440 450 460
Price (Soybeans Spot)
Retu
rn
Soybean Futures
Soybeans
9.52%1$210,000$230,000
179.01%$8,100
$14,500
Speculation
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Speculation & Leverage
Susan Speculates Futures contracts
Pays $8,100 for the contract Earns profit on $215,500 worth of soybeans
Soybeans Earns profit on $210,000 worth of soybeans Pays $210,000
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Speculation
Let’s really speculate.Let’s use derivatives
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Derivative Securities
A derivative is a financial instrument whose underlying security is another financial instrument. Soybean Futures
The underlying security is soybeans. Soybeans are real so soybean futures are NOT Derivatives
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Derivatives
Shares of Exxon Mobil The underlying security is Exxon Mobil. Exxon Mobile
is real so Exxon Mobile shares are NOT Derivatives.
Exxon Mobil100
Shares
Exxon Mobil
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Derivatives
Exxon Mobile Stock Options The security underlying the option is a share of Exxon
Mobile. Shares are financial instruments; the options on the shares are derivatives.
Exxon Mobil100
Shares
Exxon Mobil
OPTION
100Shares
Exxon Mobil
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Derivatives
Mutual Funds The security underlying the mutual fund unit is shares
of Exxon Mobile, etc. The Mutual Fund is a derivative security.
100Shares
Exxon Mobil
EquityMutualFund
1 Unit
100Shares
General Motors100
Shares
JP Morgan
100Shares
Illinois Water
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Speculating with Interest Rate Futures
Speculation on interest rates is easier in the futures market than in the spot market. It is as easy to sell as to buy Investments are leveraged
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Speculating with Interest Rate Futures
Example: Interest rates are 6% You expect them to decline to 5% within 6
months You have $1,000,000 with which to speculate
Strategy A – buy bonds Strategy B – buy interest rate futures
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Buy $1m 20 year 6% T-bonds @100-00 -$1,000,000
Strategy A: Buy T-Bonds
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Buy $1m 20 year 8% T-bonds @100-00 -$1,000,000
Six months later I am right7%
I am wrong9%
Coupon [$1,000,000 * .06 * ½] +$30,000. +$30,000.
Sell 19½ year 6% T-Bonds at 5% [112:12] +$1,123,750.
Sell 19½ year 6% T-Bonds at 7% [89:14] +$894,375.
Final Market Value $1,153,750. $924,375.
Rate of Return (over six months) +15.375% -7.5625%
LJ
Strategy A: Buy T-Bonds
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
T-Bond Futures
The T-Bond future is defined as a contract to deliver the equivalent of a $100,000 20 year 6% T-Bond
Initial margin is $2,500 per contract
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Buy 400 6 month T-Bond Futures @ 100-00[-$40,000,000] margin:
-$1,000,000
Strategy B: T-Bond Futures
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Chapter 22: Hedges, Speculation, and Arbitrage © Oltheten & Waspi 2012
Buy 400 6 month T-Bond Futures @ 100-00[-$40,000,000]
margin: -$1,000,000
Six months later I am right5%
I am wrong7%
Sell 400 T-Bond futures @ 5% [112:12]Profit:
Margin:
Sell 400 T-Bond futures @ 9% [89:31]Profit:
Margin:
Rate of Return (over six months)
LJ
Strategy B: T-Bond Futures
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Futures III