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INVESTMENTS | BODIE, KANE, MARCUS
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Foreign Exchange Futures
• Foreign exchange risk: You may get more or less home currency than you expected from a foreign currency denominated transaction.
• Results: – Cheaper and more flexible – Synthetic position; instead of holding or shorting all of the actual stocks in the index, you are long or short the index futures
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Table 23.2 Correlations among Major U.S. Stock Market Indexes
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Creating Synthetic Positions with Futures
• Index futures let investors participate in broad market movements without actually buying or selling large amounts of stock.
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23-15
Creating Synthetic Positions with Futures
• Speculators on broad market moves are major players in the index futures market. – Strategy: Buy and hold T-bills and vary the position in market-index futures contracts. – If bullish, then long futures – If bearish, then short futures
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23-8
Hedging Foreign Exchange Risk
A US exporter wants to protect against a decline in profit that would result from depreciation of the pound. The current futures price is $2/£1. Suppose FT = $1.90? •The exporter anticipates a profit loss of $200,000 if the pound declines by $.10 •Short or sell pounds for future delivery to avoid the exposure.
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Figure 23.4 Predicted Value of the Portfolio as a Function of the Market Index
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Uses of Interest Rate Hedges
$200,000 / $6,250 = 32 contracts
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Figure 23.3 Profits as a Function of the Exchange Rate
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• This is difficult to implement in practice – Transactions costs are often too large – Trades cannot be done simultaneously
• Development of Program Trading – Used by arbitrageurs to perform index arbitrage – Permits quick acquisition of securities
Portfolio Beta = .8
S&P 500 = 1,000
Decrease = 2.5%
S&P falls to 975
Portfolio Value = $30 million
Projected loss if market declines by 2.5% = (.8) (2.5%) = 2%
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23-5
Pricing on Foreign Exchange Futures
•Interest rate parity theorem
Developed using the US Dollar and British Pound
T
23-2
Futures
• Futures can be used to hedge specific sources of risk.
• Hedging instruments include:
– Foreign exchange futures – Stock index futures – Interest rate futures – Swaps – Commodity futures
• A bond fund manager may seek to protect gains against a rise in rates.
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Stock Index Contracts
• Available on both domestic and international stocks
• Settled in cash • Advantages over direct stock purchase
– lower transaction costs – better for timing or allocation
2% of $30 million = $600,000
Each S&P500 index contract will change $6,250 for a 2.5% change in the index. (The contract multiplier is $250).
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• Futures price too low - long the future and short sell the underlying stocks
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Index Arbitrage and Program Trading
• Less costly and quicker • Use the beta for the portfolio to
determine the hedge ratio.
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23-19
Hedging Systematic Risk
Example
23-7
Direct Versus Indirect Quotes
• Direct exchange rate quote: – The exchange rate is expressed as dollars per unit of foreign currency
• Indirect exchange rate quote: – The exchange rate is expressed as foreign currency units per dollar
• Foreign currency futures are traded on the CME and the London International Futures Exchange.
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23-4
Figure 23.2 Foreign Exchange Futures
F0
E0
1 1
rUS rUK
where
F0 is today’s forward rate
E0 is the current spot rate
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23-6
Text Pricing Example
rus = 4% ruk = 5% E0 = $2.00 per pound
CHAPTER 23
Futures, Swaps, and Risk Management
McGraw-Hill/Irwin
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Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Hedging Systematic Risk
To protect against a decline in stock prices, short the appropriate number of futures index contracts.
