Wetrewqrt PDF
Wetrewqrt PDF
Wetrewqrt PDF
401
Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School
20072008 by Andrew W. Lo
Critical Concepts 15.401
Motivation
Forward Contracts
Futures Contract
Valuation of Forwards and Futures
Applications
Extensions and Qualifications
Readings:
Brealey, Myers, and Allen Chapters 27
You have the opportunity to buy a mine with 1 million kgs of copper for
$400,000. Copper has a price of $2.2 / kg, mining costs are $2 / kg,
and you can delay extraction one year. How valuable is the option to
delay? Is the mine a good deal?
1.4 3.5
1.2 3.0
1.0 2.5
0.8 2.0
0.6 1.5
0.4 1.0
Euro / $ (left scale)
0.2 Real / $ (right scale) 0.5
0.0 0.0
Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03
12.0 140
Sales US $
11.0 130
10.0 120
9.0 110
8.0 100
7.0 90
6.0 80
5.0 70
4.0 60
3.0 50
2.0 40
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
Hedging or Speculation?
Alternative Tools?
Futures, forwards, options, and swaps
Insurance
Diversification
Match duration of assets and liabilities
Match sales and expenses across countries (currency risk)
Evidence*
Random sample of 413 large firms
Average cashflow from operations = $735 million
Average PP&E = $454 million
Average net income = $318 million
The price fixed now for future exchange is the forward price
The buyer of the underlying is said to be long the forward
Example:
Current price of soybeans is $160/ton
Tofu manufacturer needs 1,000 tons in 3 months
Wants to make sure that 1,000 tons will be available
3-month forward contract for 1,000 tons of soybeans at $165/ton
Long side will buy 1,000 tons from short side at $165/ton in 3 months
Example:
NYMEX crude oil (light) futures with delivery in Dec. 2007 at a price of
$75.06 / bbl. on July 27, 2007 with 51,475 contracts traded
Each contract is for 1,000 barrels
Tick size: $0.01 per barrel, $10 per contract
Initial margin: $4,050
Maintenance margin: $3,000
No cash changes hands today (contract price is $0)
Buyer has a long position (wins if prices go up)
Seller has a short position (wins if prices go down)
Payoff Diagram
$6
Long position (buy) Short position (sell)
4
-4
-6
Today, the futures price closes at $0.7435/lb, 0.20 cents lower. The value
of your position is
(0.7435)(10)(40,000) = $297,400
which yields a loss of $800.
Futures
Hedgers Clearing Speculators
Corp
Gold
Easy to store (negligible costs of storage)
No dividends or benefits
Two ways to buy gold for T
Buy now for St and hold until T
Buy forward at t, pay Ft,T at T and take delivery at T
No-arbitrage requires that
Gasoline
Costly to store (let c be percentage cost per period)
Convenience yield does exist (let y be percentage yield per period)
Not for long-term investment (like gold), but for future use
Two ways to buy gasoline for T
Buy now for St and hold until T
Buy forward at t, pay Ft,T at T and take delivery at T
No-arbitrage requires that
Financials
Let underlying be a financial asset
No cost to store (the underlying asset)
Dividend or interest on the underlying
Example: Stock index futures
Underlying are bundles of stocks, e.g., S&P, Nikkei, etc.
Futures settled in cash (no delivery)
Let the annualized dividend yield be d; then:
Example:
Gold quotes on 2001.08.02 are
Spot price (London fixing) $267.00/oz
October futures (CMX) $269.00/oz
What is the implied interest rate?
F = S0(1 + rf )2/12
rf = (F/S0)6 1 = 4.58%
Example:
Gasoline quotes on 2001.08.02:
Spot price is 0.7760
Feb 02 futures price is 0.7330
6-month interest rate is 3.40%
What is the annualized net convenience yield (net of storage costs)?
Example:
The S&P 500 closed at 1,220.75 on 2001.08.02
The S&P futures maturing in December closed at 1,233.50
Suppose the T-bill rate is 3.50%
What is the implied annual dividend yield?
Example:
You have $1 million to invest in the stock market and you have decided to
invest in the S&P 500. How should you do this?
One way is to buy the S&P 500 in the cash market:
Buy the 500 stocks, weights proportional to their market caps
Another way is to buy S&P futures:
Put the money in your margin account
Assuming the S&P 500 is at 1,000 now, number of contract to buy:
(value of a futures contract is $250 times the S&P 500 index)
Example (cont):
As the S&P index fluctuates, the future value of your portfolio (in $MM)
is given by the following table (ignoring interest payments and
dividends):
Example (cont):
Compare hedged and unhedged portfolio (in $MM):
Brealey, R., Myers, S., and F. Allen, 2006, Principles of Corporate Finance. New York: McGraw-Hill
Irwin.
Guay, W. and S. Kothari, 2003, How Much Do Firms Hedge with Derivatives?, Journal of Financial
Economics 70, 423461.
Siegel, D. and D. Siegel, 1990, The Futures Market: Arbitrage, Risk Management, and Portfolio
Strategies. Hinsdale, IL: Dryden Press.
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