A F F

penredheadManagement

Nov 18, 2013 (3 years and 8 months ago)

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A
PPLICATIONS

OF

F
ORWARD

AND

F
UTURES

1

Week 3

Christopher Ting

A R
ECAP

OF

F
ORWARD

AND

F
UTURES

2

Contracts

Forwards

Futures

Custom; OTC traded

Standardized; exchange
traded

Default Risk

Counterparty default
risk

Clearinghouse guarantees
against default.

Margin Requirements

Contract value generally paid at
expiration. Margins and interim
settlements are occasionally
used to mitigate counterparty
default
risk

Margin requirements and
daily mask
-
to
-
market to
settle gains/losses.

Regulatory Requirements

Essentially unregulated.

Regulated in U.S.
at the
federal
level

Transaction Data

Generally unavailable to the
public as transactions are
private

Reported to exchange and
regulatory
agencies

Application/Preferred Risk
Management
Vehicle

Interest rate resets on loans.

Foreign currency
risk

Bond and equity
portfolios

Dealer transactions to
offset Eurodollar
swap/option interest rate
trades

Christopher Ting

M
OTIVATION



Why hedge?


Companies can then focus on their main activities, for
which presumably they do have particular skills and
expertise.


By hedging, they avoid unpleasant surprises such as
sharp rises in the price of a commodity that is being
purchased.



What are the arguments against hedging?


Shareholders are usually well diversified and can make
their own hedging decisions


It may increase risk to hedge when competitors do not


Explaining a situation where there is a loss on the hedge
and a gain on the underlying can be difficult


3

Christopher Ting

Q
UESTIONS

TO

BE

A
NSWERED


When is a short futures position appropriates



When is a long futures position appropriate



Which futures contract should be used



What is the optimal size of the futures position for reducing
risk




Mode of hedging


Hedge
-
and forget


Futures contracts versus forward contracts



4

Christopher Ting

L
ONG

H
EDGE
, S
HORT

H
EDGE
,
AND

B
ASIS


f
1

: Initial Futures Price


f
2

: Final Futures Price


S
2

: Final Asset Price


Hedge the future purchase of an asset by entering into a
long futures contract


Cost of Asset=
S
2



(
f
2



f
1
) =
f
1

+ Basis
2




Hedge the future sale of an asset by entering into a short
futures contract


Price Realized =
S
2

+ (
f
1



f
2
) =
f
1

+ Basis
2



Basis risk arises because of the uncertainty about the basis
when the hedge is closed out.



5

Christopher Ting

M
EASURING

E
QUITY

R
ISK


Equity portfolio risk: beta



What is the beta of an equity index (proxy for market
portfolio) chosen as the performance benchmark?



How is the beta of an equity fund measured?

6

2
)
,
(
m
m
p
p
r
r


C

Measure of the direction and
extent by which the equity
portfolio and the index move
together

Variance of the return on market

Risk level

Christopher Ting

M
ANAGING

P
ORTFOLIO

B
ETA


Dollar beta of the portfolio


market value of the portfolio



p


P



p



To modify the risk level of a portfolio, the target beta

*

should be set in such a way that the sum of the dollar betas
of the existing portfolio and a specified number of futures
contract
N
f
.


Dollar target beta

dollar beta of the portfolio +
N
f



dollar beta of 1 futures contract




Number of contracts required

7




















m
f
P
N
f
p
f



*

* P

=

p

P

+
N
f


f

f

m


multiplier

Futures price

Christopher Ting

H
EDGING

E
XAMPLE


S&P 500 cash value 1,000


S&P 500 futures price is 1,010


Value of Portfolio is $5,050,000


Beta of portfolio is 1.5


Beta of futures is 1.0


Multiplier of S&P 500 is 250


Risk
-
free interest rate = 4%


Dividend yield on index = 1%



What position in futures contracts on the S&P 500 is
necessary to hedge the portfolio (i.e.,

* =
0)

?


8

30
010
,
1
250
000
,
050
,
5
0
.
1
5
.
1






f
N
Christopher Ting

E
XAMPLE
: A
DJUSTING

PORTFOLIO

BETA



A manager of a $5,000,000 portfolio wants to increase the
beta from the current of 0.8 to 1.1. The beta on the futures
contract is 1.05, and the total futures price is $240,000.



What is the required number of futures contracts to achieve
a beta of 1.1?




The appropriate strategy would be to take long position in 6
futures contracts. Taking a long position in index futures
contracts will increase the beta and
leverage up
the position.



9

95
.
5
000
,
240
$
000
,
000
,
5
$
05
.
1
8
.
0
1
.
1















f
N
Christopher Ting

T
HE

H
EDGE

ISN

T

P
ERFECT

(1)


Rounding to the nearest whole contract gives rise to imperfect hedge.


If the reference index (used to calculate the betas) increased in value by
2%; the value of the equity position increased by
1.6%
; and the value of
the futures price increased by
2.1
%
.
These values correspond exactly to
what we would expect with the provided betas of 0.8 and 1
.
05.


Had the leveraged position worked as desired (i.e., achieved an effective
beta of 1
.
1), the value of the portfolio would have increased 1.1(0.02) =
2.2% to $5,110,000 = $5,000,000(1 + 0.022)


In our example, where we leveraged up the beta with 6 contracts, the
profit from the futures contract position is
$30,240 = 6($240,000)(
1.021
)
-

6($240,000)


The profit from the equity position itself is
$80,000 = $5,000,000(
1.016
)
-

$5,000,000


Therefore, the final value of the equity portfolio plus futures position is:

$5,110,240 = $30,240 + $80,000 + $5,000,000



10

Christopher Ting

T
HE

H
EDGE

ISN

T

P
ERFECT

(2)


The return on the position is

0.022048 = ($30,240 + $80,000)
/
$5,000,000



The effective beta on the portfolio proved to be





In this case, the discrepancy was due to rounding in the
futures position.



There is often other error from the fact that the portfolio and
futures contracts are not perfectly correlated with the index.



11

1024
.
1
020
.
0
022048
.
0
value

index

of

change

%
value

portfolio

of

change

%
beta
effective



Christopher Ting

C
LASS

E
XERCISE


A fund has $400 million invested in a diversified portfolio of
common stocks with a beta of 1.1 relative to S&P 500, which
is at the level of 968.00. The six
-
month S&P 500 futures is
trading at 998.00 and has a beta of 0.95. The dollar multiplier
for the futures contract is 250.


1.
To reduce the beta of the portfolio to 0.90, how many
contracts should the fund manager trade (buy or sell)?


2.
The S&P 500 index is down 3% at the futures expiration
date. The portfolio is down 3.4%; the futures are trading at
969.56. What is the value of the overall position (stock
portfolio + futures) and the
effective
beta?

12

Christopher Ting

A
DVANTAGES

OF

F
UTURES


Lower Transaction Costs



The use of futures contracts is
preferable to liquidation/purchase of portfolio securities,
especially over short time horizon.



Asset Allocation Revisions



Futures allow managers to
make asset allocation changes without disturbing the
underlying portfolio.



Transaction Time



Risk management strategies can be
quickly initiated in response to a particular forecast, and
quickly closed out should the outlook change.



Contract Liquidity



Futures contracts are generally more
liquid than a portfolio’s individual securities.


13

Christopher Ting

D
ISADVANTAGES


Potentially Divergent Risk Management Outcomes



Betas can be unstable
and are hard to measure. If a portfolio’s beta value does not capture the
portfolio’s actual sensitivity to underlying sources of risk, then the hedging
process will be inexact. As a result, the actual outcome may diverge from the
desired outcome.


Contract Liquidity



Futures are
not

exempt from liquidity problems. The
liquidity of long
-
term futures is significantly lower than that of short
-
term
futures.


Entity Liquidity Needs



Although they require less capital to trade, futures
cannot solve an investor’s immediate liquidity needs. For example, to meet
an impending cash requirement, underlying securities still have to be
liquidated.


Leverage


Futures positions are leveraged; losses (or foregone gains) on
purchases or sales of futures are potentially large in percentages. For this
reason, some firms prohibit the use of these instruments.


14

Christopher Ting

M
ANAGED

F
UTURES


“Managed futures” is a diverse collection of active hedge fund
trading strategies that specialize in liquid, transparent, exchange
-
traded futures markets and deep foreign exchange markets



Managed futures traders are commonly referred to as
“Commodity Trading Advisors” or “CTAs,” a designation which
refers to a manager’s registration status with the Commodity
Futures Trading Commission and National Futures Association.



Most CTAs trade equity index, fixed income, and foreign
exchange futures. They don’t simply take on systematic exposure
to an asset class, or beta, but are attempting to add alpha through
active management and the freedom to enter short or spread
positions, which can result in totally different return profiles than
the long
-
only passive indices.

15

Christopher Ting

M
ANAGED

F
UTURES

G
ROWTH

IN

A
SSETS

U
NDER

M
ANAGEMENT

1980
-
2008

AUM ($billions)

16

Source:
AlphaMetrix

Alternative Investment Advisors,
BarclayHedge

Alternative Investment Database

B
ARCLAY
H
EDGE

S

BTOP50 I
NDEX

17

0
50
100
150
200
250
300
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
Dec 1987

Feb 1991

Apr 1995

Jun 1999

Aug 2003

Oct 2007

Dec 2011

Source:
BarclayHedge

Alternative Investment Database

Christopher Ting

P
ERFORMANCE

OF

M
ANAGED

F
UTURES


Maximum, Minimum, and Mean Rolling Return of Barclays
Capital BTOP 50 Index Over Different Holding Periods (Jan
1987 through Dec 2008)

18

Rolling Rate of Return

Months

Source:
AlphaMetrix

Alternative Investment Advisors, Bloomberg

C
ASE

S
TUDY

19

Christopher Ting

O
PTIMAL

H
EDGING

WITH

I
NDEX

F
UTURES

(1)


An institutional investor holds a portfolio of Japanese stocks
that has returns following closely that of the Nikkei 225
stock index returns

S
t
+1
/
S
t
,

where

S
t
+1
=
S
t
+1


S
t .



The value of the portfolio in yens is
N
S



S
t
, i.e.,
N
S


shares of
a “stock” called Nikkei 225.



Multiplier of Nikkei 225 futures traded on SGX is
¥
500.



Value of the hedged portfolio with
N
f

futures contracts is


V
t

=
N
S



S
t


N
f



500



f
t



P


F




20

Christopher Ting

O
PTIMAL

H
EDGING

WITH

I
NDEX

F
UTURES

(2)


The change in portfolio value is


V
t+
1

=
N
S




S
t+
1



N
f



500





f
t+
1




P



F



The investor
minimizes the risk
or variance of

V
t
+1

by
finding an optimal number
N
f

such that the risk is minimum.





Solving the first order condition with respect to
N
f

leads to


21









1
1
1
2
2
1
2
1
,
500
2
500

















t
t
f
S
t
f
t
S
t
f
S
N
N
f
N
S
N
V
C
V
V
V




1
1
1
*
500
,







t
t
t
S
f
f
f
S
N
N
V
C
Christopher Ting

O
PTIMAL

H
EDGE

R
ATIO

o

S

: standard deviation of

S
, the change in the spot
price during the hedging period

o

f

: standard deviation of

f
, the change in the
futures price during the hedging period

o
r

: the coefficient of correlation between

S

and

f




o
h
*: hedge ratio that minimizes the variance of the
hedger’s total position in the underlying and the
futures.


22

f
S
S
f
N
N
h


r


*
*
500




f
S
S
f
f
S
S
t
t
t
S
f
N
N
f
f
S
N
N


r


r
500
500
500
,
2
1
1
1
*









V
C
Christopher Ting

M
INIMUM

V
ARIANCE

H
EDGE


To hedge the risk of an index portfolio, the number of
contracts that should be shorted is









Beta of the index futures can be estimated with the following
linear specification





23

m
f
P
N
f


*
1
1
1








t
t
t
t
t
e
f
f
S
S






t
t
t
t
t
t
t
t
t
S
t
t
t
t
t
t
t
t
t
S
t
t
t
S
f
f
P
f
f
f
f
f
S
S
S
N
f
f
f
f
f
S
S
f
S
N
f
f
S
N
N
500
500
,
500
,
500
,
1
1
1
1
2
1
1
1
1
1
*























































V
C
V
C
V
C























t
t
t
t
t
t
f
f
f
f
S
S
1
1
1
,
V
C

Christopher Ting

C
ASE

S
TUDY

(1)


An asset management company has a long position of 500
lots in STI ETF. The volume
-
weighted average price per
share is S$3.4567 when the STI ETF shares were purchased.


Using a proprietary quant strategy, the fund holds the view
that over the next 2 weeks, STI is expected to decline.


To protect the fund’s value, the fund decides to use a futures
contract to hedge.


Naturally, the fund looks into STI futures traded on SGX.



Question: What is the book value of the long position in STI
ETF?



Question: Should the fund perform a long hedge or a short
hedge?



24

Christopher Ting

C
ASE

S
TUDY

(2)


Unfortunately, the liquidity of STI futures is almost zero.

25

Christopher Ting

C
ASE

S
TUDY

(3)


By contrast, futures on MSCI Singapore index are more
liquid.

26

Christopher Ting

C
ASE

S
TUDY

(4)


Suppose the said 2 weeks start from November 9, 2010.



Question: Which maturity month of
SiMSCI

should the fund
use?



Question: How many contracts should the fund cross
-
hedge
with
SiMSCI

futures to achieve an optimal result?



27