O-MSF-FIN-521-Forward-Futures-and-Swaps-Part-2-transcription

Introduction to Forward, Futures, and Swaps Part 2

Lecturer: David Zynda, FIN 521 Investment Analysis, University of Arizona Eller College of Management

Relationship Between Spot and Forward Prices:The forward price of a commodity considers several costs:

• Current Spot Price (S0): Market price today.

• Storage Costs (SC0,T): Costs for storing till delivery.

• Commissions (PC0,T): Fees for storage management.

• Financing Costs (i0,T): Interest incurred until delivery.

• Cash Flows (D0,T): Income from holding the commodity.

Forward Price Formula:FF_{0,T} = S_0 + SC_{0,T} + PC_{0,T} + i_{0,T} - D_{0,T}This shows that all associated costs must be factored into the forward price.

Theoretical Futures Prices:Futures prices can reflect market inefficiencies. For instance:

• Spot Price of Bonds: $102.30

• Futures Price: $112.15

• Expected Income: $2.20

• Financing Cost: $1.10

Theoretical Formula:Theoretical Futures Price = Spot Price + Cost of Carry - Cash Income

Market Structures:

• Contango: Forward price exceeds spot price due to high storage costs.

• Backwardation: Forward price is less than spot price, often associated with low storage costs.

• Convenience Yield: Reflects the value of immediate access to commodities.

Pure Expectations Hypothesis:FF_{0,T} = E(S_T) reflects that future prices represent market expectations on spot prices.

Financial Forwards and Futures:Includes Interest Rate Futures, Equity Index Futures, and Foreign Exchange Futures for various market exposure.

2022 Trading Volume:

• Equity Indexes: 43,843.4 million contracts

• Individual Equities: 13,178.3 million contracts

• Foreign Currency: 7,730.5 million contracts

• Interest Rate: 5,146.3 million contracts

• Agricultural Commodities: 2,394.5 million contracts

• Energy Products: 2,055.7 million contracts

• Non-Precious Metals: 1,630.1 million contracts

• Precious Metals: 564.3 million contracts

• Bitcoin: 24.5 million contracts

T-Bond Futures Deliveries:

• Settlements occur in March, June, September, and December.

• T-Bond contracts require 15-25 year maturity bonds.

Hedging Strategy:Optimal hedge ratio (N^{*}) for interest rate risk shows prudent financing management.

• Funding Costs for bonds currently estimated at 8.25%.

• Modified durations calculated for effective risk management.Approximately 954 futures contracts needed to hedge against rising interest rates due to bond issuance.