Topic 4 Forwards and futures 1. Forward contracts & uses 2. Futures contracts, markets & uses 3. Comparing futures hedge vs forwards hedge 09/11/2010 Pr. Didier Folus 1
1. Forward contracts and uses 1.1. Definition & example Agreement to buy or sell an underlying asset at a fixed price F t and on a fixed date T in the future, for defined grade, quantity & place of delivery. Example of a forward contract on t = March 1, 2011 : Asset Nominal amount Yellow grain corn 50,000 bushels (bu) Negotiated price between 2 counterparts Forward price F t 4.00 USD/bu Buyer United Grain Brokers Corp. Seller Corn Grower ltd. Maturity date May 31, 2011 Place of delivery Saint-Louis City, MO Commitment to pay USD 200 000 Commitment to deliver 50 000 bu 09/11/2010 Pr. Didier Folus 2
Example of cash bids : S t price F t price 09/11/2010 Pr. Didier Folus 3
1.2. Basis evolution Basis on t = F t S t Considering maturity T = May 31, 2011 : Forward price Spot price prime contango Mar. 1 : basis t=0 = 4.00 3.60 = + 0.40 USD Mar. 2 : basis t=1 = 4.11 3.85 = + 0.26 USD Mar. 3 : basis t=2 = 3.82 3.91 = 0.09 USD May 31 : basis t=92 = 0.00 USD discount backwardation 09/11/2010 Pr. Didier Folus 4
1.3. Using forwards for hedging 1.3.1. Commodity consumer case On t, the Kellog s Co. needs 50,000 bushels of corn, deliverable on T = t + 3 months : spot price S t = 3.60 USD/bu 3 month-forward price... F t = 4.00 USD/bu Solution 1 : buying spot on t storage Solution 2 : buying spot on T 09/11/2010 Pr. Didier Folus 5
«loss» «profit» Solution 3 : buying forward on t for delivery on T : deposit 3 % on t. USD 6 000 settling on T USD 200 000 deposit receiving on T 50,000 bu of corn Forward long position at maturity : F t = 4.00 USD/bu Effective hedging price decrease price increase S T Cost of hedging 09/11/2010 Pr. Didier Folus 6
1.3.2. Commodity producer case On t, a farmer expects a 50,000 bushels corn-crop, deliverable on T = t + 3 months : spot price S t = 3.60 USD/bu 3 month-forward price F t = 4.00 USD/bu Solution 1 : selling spot on T Solution 2 : selling forward on t for delivery on T deposit 5 % on t. USD 10 000 delivering on T.. 50,000 bu of corn receiving on T USD 200 000 + deposit 09/11/2010 Pr. Didier Folus 7
1.4. Using forwards for speculation Speculator, owning USD 200 000, expecting a future corn price increase Decision on t : buying forward 50,000 bu of corn at a price of F t = 4.00 USD/bu, settling on T : deposit on t... USD 10 000 settling on T. USD 200 000 deposit receiving + selling corn on T.. USD S T 50,000 result on T (in USD) USD (S T F t ) 50,000 return on T (in %)... (S T F t ) 50,000 /deposit gearing 09/11/2010 Pr. Didier Folus 8
1.5. Using forwards for arbitrage On t, an arbitrageur, having a limit of USD 304 000 : borrows cash USD 300 000 at 5⅓ % for 90 days buys corn spot. 75,000 bu of corn, paying 270 000 USD stores corn... 75,000 bu of corn, paying 20 000 USD sells corn forward 75,000 bu of corn On T, the arbitrageur : delivers corn 75,000 bu receives cash USD 300 000 reimburses USD 300 000 + 4 000 USD interests «Riskfree» profit on T (locked on t) : USD 6 000 Numerous arbitrageurs make disappear the profit quickly 09/11/2010 Pr. Didier Folus 9
1.6. Forwards features About forward contracts : high nominal effective delivery non-tradable on a secundary market counterparty risk customized instruments About forward markets : major underlying assets : currencies, interest rates, commodities... participants : corporations & banks trading the physical asset brokers quotes & market reports 09/11/2010 Pr. Didier Folus 10
Market quotes : Euro in London Source : Financial Times, October 29, 2010. Bid, offer, mid spot rates & forward rates are derivate from Reuters S t F t,1 month F t,3 months F t,1 year 09/11/2010 Pr. Didier Folus 11
2. Futures contracts and markets 2.1. Definition and example Futures contract : exchange traded commitment to pay/deliver an asset for a specific time, place, grade and quantity. Futures price appears through trades, for each maturity. Each buyer/seller faces a margin 09/11/2010 Pr. Didier Folus 12
USD 3.81½ Corn futures quotes USD 4.10¾ 09/11/2010 Pr. Didier Folus USD 3.86¼ 13
May 2011 corn futures chart 09/11/2010 Pr. Didier Folus 14
2.3. The operation of margins CME corn futures margin = USD 850 On t = June 7, 2010, an operator buys 10 CME JLY11- corn futures contracts, at the open price : commitment to pay 3.90 5 000 10 = USD 195 000 maturity. # 13 months deposit 850 10 = USD 8 500 The broker/bank opens a margin account The CME Clearing operates margins Margin is a SPAN parameter Standard Portfolio Analysis of Risk performance 09/11/2010 Pr. Didier Folus 15
Margin account running : Date Settle Quote cents/bu Daily result USD Margin account balance USD Margin call USD Cumulative result USD Jun. 7 390.00 8 500 Jun. 8 391.00 + 500 9 000 + 500 Jun. 9 383.00 4 000 5 000 3 500 3 500 Jun. 10 380.00 1 500 7 000 1 500 5 000 Jun. 11 392.00 + 6 000 14 500 + 1 000 Maintenance margin : USD 850 per contract Futures contracts are daily marked to market 09/11/2010 Pr. Didier Folus 16
2.4. The clearing house 2.4.1. Functions of the clearing house Authorizing members Being the counterpart of each transaction Guaranteeing full termination of operations Fixing the deposit Calculating and calling margins, every day Organizing delivery and settlement futures uses CME Clearing Eurex Clearing Ag. LCH.Clearnet Ltd. Depository Trust & Clearing Corporation Nymex Clearing House NY Clearing Corporation 09/11/2010 Pr. Didier Folus 17
2.4.2. Rising demand for OTC clearing Increasing demand for clearing operations outside the Exchange traded universe Ex. : freight derivatives strong increase in the business of shipping goods to China shipping rate volatility : hurricanes, oil prices freight forwards : OTC traded, cash-settled Ex. : IRS, FX, CDS OTC facilities : CME ClearPort Facility (Nymex Clearing House) Euronext.Liffe s Bclear (LCH.Clearnet) Eurex Clearing OTC Facility 09/11/2010 Pr. Didier Folus 18
2.5. Market data from Futures Industry Assoc. 09/11/2010 Pr. Didier Folus 19
Source : FIA, March 2010. 09/11/2010 Pr. Didier Folus 20
Source : FIA, March 2010. 09/11/2010 Pr. Didier Folus 21
Illustrative case : SG Delta One desk crash 2005, 2006 : initially arbitrageur on stock indexes, JK enters into non-authorized directional positions, using futures for «small» amounts March 2007 : JK enters into a massive short position on futures, hedging it using fictive long forwards (fictive counterparties) June 2007 : the real P&L shows a latent loss of EUR 2.2 Bn, but the fictive hedged P&L is close to zero Nov 2007 : Eurex warning on the SG position on futures Dec 2007 : JK closes the position on futures, making a EUR 1.4 bn profit, dissimulating it through the fictive loss on long forwards, the P&L seems to be EUR 55 M. Control Failure Control Failure 09/11/2010 Pr. Didier Folus 22
SG Delta One desk crash (the end) Jan 2008 : JK enters into a EUR 50 Bn notional long position using futures (# 30 on DJ Eurostoxx 50, # 18 on Dax, # 2 on FTSE 100) Jan 16, 2008 :«back office» asks for the counterpart id. on forwards Jan 18, 2008 :JK lies ; the real P&L shows a EUR 2.7 Bn loss Efficient Control... Jan 19, 2008 :SGCIB discovers the fraud Too late! Jan 20, 2008 :SG president decides to close the position immediatly Jan 21, 2008 :SG begins to close, in a very bearish market Jan 22, 2008 :the real loss equals EUR 6.3 Bn Jan 23, 2008 :final net loss equals EUR 4.9 Bn, SG Board is informed 947 fictive trades 115 fictive pairs 9 intra-month reserves Lying emails 09/11/2010 Pr. Didier Folus 23
3. Hedging when using futures vs forwards 3.1. Example of a corn grain price risk Corn producer on date t = November 3, 2009 : expected crop on July 2011 20 000 bu production cost. 4.00 USD/bu storage cost per month.. 40 cents/bu CBOT corn futures quotes... see next page Hedging decision on t, using futures (open price)? buy or sell? which maturity? how many contracts? safety & cost? flexibility? risks? 09/11/2010 Pr. Didier Folus 24
Daily settlements for corn futures 09/11/2010 Pr. Didier Folus 25
3.2. Hedging using futures : safety & cost Shorting four 2011-July futures contracts : producer must deliver... bu 20 000 of corn CBOT C.C. will pay... 4 5 000 4.50 = USD 90 000 required deposit.. USD 4 1 100 last trading day Thuesday, July 14, 2011 last delivery day. Thursday, July 16, 2011 CBOT CC will pay on July 31, 2011 Opportunity cost : if S T 450 cents/bu : seller regrets hedging if S T 450 cents/bu : hedging avoids a loss margin calls cost Same as forwards forwards Likely safer as forwards 09/11/2010 Pr. Didier Folus 26
3.3. Hedging using futures : flexibility If S early July = 350 cents/bu, the procucer will : harvest the corn deliver it to the CH on T, receiving USD 90 000 net revenue = 450 cents/bu If S early July = 500 cents/bu, the producer could : sell spot the harvest, receiving USD 100 000 buy 4 futures at F early July = 490.00 cents/bu (market price) pay on T : 4 5 000 (4.50-4.90) = - 8 000 USD net revenue = 460 cents/bu Possibility to exit a futures contract before expiry date forward contracts 09/11/2010 Pr. Didier Folus 27
3.4. Hedging using futures : basis risk 3.4.1. Anticipated delivery If crop is early e.g. June 2011 : solution 1 : storing + delivering to Clearing House solution 2 : selling crop spot + closing futures position Solution 1 : storing harvest during 1 month paying USD 8 000 delivering harvest in July 2011 receiving USD 90 000 net revenue.. 410 cents/bu Same using forward contracts 09/11/2010 Pr. Didier Folus 28
Solution 2 : Early June, producer faces market conditions : spot price S early June = 445.00 cents/bu futures quote F early June = 455.00 cents/bu Delivers harvest, receiving 20 000 4.45 = USD 89 000 Buys futures, agreeing to pay 4 5 000 4.55 = USD 91 000 Result = (F t - (F early June - S early June )) nominal = USD 88 000 basis Net revenue = 440 cents/bu (expected : 450 cents/bu) No basis risk using forward contracts 09/11/2010 Pr. Didier Folus 29
3.4.2. Gap between delivery & futures maturity If the producer had to hedge an August crop? In November 2009, he/she sells 2011-September contracts In August 2011, he/she will : harvest & store 1 month, then deliver in Sep to the Clearing House harvest & deliver on spot market + close futures position implying a basis risk Futures contracts are not tailor-made instruments forward contracts 09/11/2010 Pr. Didier Folus 30
3.4.3. Correlation risk Il the harvest is corn grain, there is no correlation risk. If the harvest is corn silage (forage for livestock), there is a correlation risk, because corn grain price and corn silage fluctuate in different ways. 09/11/2010 Pr. Didier Folus 31
Reconsidering the hedging problem : Statistics from market prices : corn silage volatility.. s CS = 17 % corn grain volatility... s CG = 20 % correlation coefficient r = 0.90 Number of CBOT contracts to sell? Hedge ratio 20 000 cov( rcs, r 5 000 var( r ) CG CG ) 3.06 No correlation risk using forward contracts 09/11/2010 Pr. Didier Folus 32
3.4.4. Roll over risk Futures are short term instruments Hedging for a long time needs to roll over the position The hedger can t know the «forward futures price». Not very different using forward contracts 09/11/2010 Pr. Didier Folus 33