Finance 300 Financial MarketsHousekeepingChapter IX – FuturesPowerPoint PresentationSlide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Finance 300Financial MarketsLecture 24© Professor J. Petry, Fall 2002http://www.cba.uiuc.edu/broker/fin300/fin300pp.htm2Housekeeping•Bond project is due on Thursday. •All groups should run their analysis by the TAs prior to turning it in to make sure you are giving them what you want. They are there to help with this project. Please make use of them.•UISES: Invest wisely.–We are ahead!!!Team Rate of Return (as of 11/18)Petry 3.11%Finnerty 2.86%Oltheten 1.64%Waspi 1.37%Sinow 0.52%3(Similar to) Things To Do: IX-3•George Q. Farmer expects to harvest 50,000 bushels of soybeans in October, but there are no October futures in soybeans. Tofu, Inc wishes to buy 50,000 bushels of soybeans in October, but faces the same problem.•The current spot price for soybeans is $6.20 and the price for November soybeans is 631. Initial margin is $1,125 per contract.A) Construct a hedge strategy for George and for Tofu Inc.B) In October the spot price for soybeans is $6.00 and the November futures price is 611. What is the basis on November soybeans? How do George and Tofu Inc. make out? How would George and Tofu made out had they not hedged?C) In October the spot price for soybeans is $7.00 and the November futures price is 714. Now how do George and Tofu make out? Why is this different than in Part B?Chapter IX – Futures4IX-3 A & B: (Similar question to TTD, different numbers)George Q. Farmer - Hedge Positionhedge is set Sell Nov 98 Futures 10 contracts at 631 (=$315,500) Margin:Oct 1998 Buy Nov 98 Futureshedge is lifted 10 contracts at 611 (=$305,500) Profit:Margin:Sell Soybeans on spot market at 6.00Net Position:George Q. Farmer - No Hedge PositionOct 1998 Sell Soybeans on the spot market at 6.00Net Position:Tofu, Inc - Hedge Positionhedge is set Buy Nov 98 Futures 10 contracts at 631 (=$315,500) Margin:Oct 1998 Sell Nov 98 Futureshedge is lifted 10 contracts at 611 (=$305,500) Profit:Margin:Buy Soybeans on the spot market at 6.00Net Position:Tofu, Inc - No Hedge PositionOct 1998 Buy Soybeans on the spot market at 6.00Net Position:5IX-3 C: (Similar to TTD, but different numbers)George Q. Farmer - Hedge Positionhedge is setMargin:Oct 1998hedge is lifted Profit:Margin:Net Position:George Q. Farmer - No Hedge PositionOct 1998Net Position:Tofu, Inc - Hedge Positionhedge is setMargin:Oct 1998hedge is lifted Profit:Margin:Net Position:Tofu, Inc - No Hedge PositionOct 19986Things To Do: IX-3•Tofu Inc plans to buy 50,000 bushels of soybeans in October. Tofu Inc would like to hedge its price risk exposure on soybeans but there are no October futures in soybeans.•The current spot price for soybeans is $4.20 and the price for November soybeans is 431. Initial margin is $810 and maintenance is $600 per contract.A) Construct a hedge strategy for Tofu Inc.B) In October the spot price for soybeans is $4.00 and the November futures price is 411. What is the basis on November soybeans? What is the net position and effective price per bushel for Tofu, Inc?C) In October the spot price for soybeans is $5.00 and the November futures price is 508. What is the basis? What is the net position and effective price per bushel for Tofu Inc? Why is there a difference between this situation and the one in part B?7TTD: IX-3 (part B)Tofu, Inc - Hedge Positionhedge is setMargin:Oct 1998hedge is lifted Profit:Margin:Net Position:Effective price per bushel:Tofu, Inc - No Hedge PositionOct 1998TTD: IX-3 (part C)Tofu, Inc - Hedge Positionhedge is setMargin:Oct 1998hedge is lifted Profit:Margin:Net Position:Effective price per bushel:Tofu, Inc - No Hedge PositionOct 19988Determination of Futures Prices•Futures prices are based on the following theorem:Spot-futures parity theorem (a.k.a. cost of carry relationship): Describes the theoretically correct spread between spot and futures prices. It states that the futures price reflects the spot price of the underlying asset plus the carrying charges (cost of borrowing, storage, insurance, etc) necessary to carry the underlying asset forward to delivery. Violation of the parity relationship gives rise to arbitrage opportunities •A risk-free profit requiring no initial investment. Arbitrage often involves the simultaneous purchase and sale of essentially the same asset.Chapter IX – Futures9Determination of Futures Prices•Ranges for futures prices can be established by calculating the points at which arbitrage profits become possible. Futures prices will not remain at these levels, as market participants quickly buy up these opportunities until prices adjust them away.•For arbitrage profits to be possible: •Example: Suppose in January 1998 the spot price of gold is $370 and the January 1999 gold futures are trading at $400. The risk free rate of interest is 5%, storage & insurance cost $.10 per ounce, per month. CBT gold futures trade in contracts of 100 ounces, with an initial margin requirement of $1,800.–Abitrage opportunities exist in each of the following slides. –In the first, we use the assumptions from above, and go long in the spot market and short in the futures market. When we sell in the future, the price must be high enough to pay carry costs, and still leave risk-free profit. Pfuture >= Pspot + [cost of carry]–In the second, we change the futures price from 400 to 360, and go short the spot market and long the futures market. Now for arbitrage profits to exist Pfuture+[carry]<=Pspot. The futures price must be low enough to make a profit when we buy the gold.10Arbitrage Profit Opportunities in Futures MarketsJanuary 1998Cash Flow Per OunceBuy 100 troy ounces of gold on the spot market -37,000 -370Storage and insurance -120 -1.2Sell 1 Jan 99 gold futures contract at $400 Initial margin -1800Borrow at 5% for 12 months -38920Initial Investment 0January 1999Deliver gold at futures price of $400 40,000 400Withdraw Margin 1,800Pay off debt principle -38,920 interest -1,946 -19.46Profit934 9.3411Arbitrage Profit Opportunities in Futures MarketsJanuary 1998Cash Flow Per OunceShort 100 troy ounces of gold on the spot market 37,000 370 Borrowing Fee -2,000 -20Buy 1 Jan 99 gold futures contract at $360 Initial margin -1800Invest at 5% for 12 months -33200Initial Investment 0January 1999Take delivery gold at futures price of $360 -36,000