Chapter 0

Introduction

For use with International Financial Management, 3e

Jeff Madura and Roland Fox 9781408079812
Cengage Learning EMEA 2014
 Financial markets

1. Monetary market
2. Debt market

3. Equity market

-------------------------
4. Currency market

5. Derivatives
 DERIVATIVES

-Forwards
-Futures
-Options
 Futures
sXIX
John produces corn.. Large production
Ruth purchases corn in Chicago large quantities..
They do not know each other
But they share on thing they dont sleep much
Reason:

spot market (cash market) located in 54th street Chicago

This is the market where John sells the corn to Ruth
Price of corn has been very volatile = risk
Therefore they cannot sleep if:
Price is tool low, John doesnt cover production costs
Price is too high Ruth will not cover costs
 Futures
Ruth decides to go to see John to negotiate a contract. (after a
horse ride and two days dealing, they agreed on a contract)
Contract:
John compromise is to sell / Ruth to buy
154,500kg of corn
on the 17th Aug
at 1$/kg

Therefore from that day they sleep again.

This is almost a real story.

This is called FORWARD because it is an agreement between

two parties

Note (instead of corn it can be any product including currencies)

 Futures
Problems that might have occurred then:
1.Lack of market
2.Breach of contract
3.They need to agree on 4 basic characteristics
Deadline
Quantity of product
Quality of product
Delivery
4.? a forth problem to be seen
 Futures
To solve the problems

1.We create a market in 42th street Chicago (solves 1)

2.We create a department in the market CLEARING
HOUSE:
Will act as the other part for each part of the contract
Both parties agree, but they sign a contract with the clearing
house not with each other:
John will sell the corn to the clearing house at the agreed price and date
Ruth will buy the corn from the clearing house at the agreed price and date
If John breaks the contract the clearing house complies with
Ruth (sells her corn from somewhere else), and acts against
John
 Futures
A clearing house is an intermediary between buyers and sellers of
financial instruments.
Further, it is an agency or separate corporation of a futures exchange
responsible for settling trading accounts, clearing trades, collecting
and maintaining margin moneys, regulating delivery, and reporting
trading data.
Clearing houses act as third parties to all futures and options
contracts, as buyers to every clearing member seller, and as
sellers to every clearing member buyer.
 Futures
Now the risk of the breach in contract is concentrated in the
clearing house.
Still we need to understand HOW the CH will deal with the
risk (margin see later)

Do not forget:
Every market is a limited corporation, owned by somebody,
and it is also listed in stock markets as any other corporation that
is concerned with profits, reputation, growth.

They mind who enters and how deals are made.

 Futures
sXXI
Ana lives in Manhattan and loves quantitative analysis but she
does not trade corn.
She thinks the price of the corn will raise..

She calls her broker and orders him to buy 10 corn futures
settlement date on June 1.10$

B/10fut/corn , June 1.1$ (Ana CH)

S/10fut/corn , June 1.1$ (Someone CH)

10/June price the price has effectively raised..

Where has raised the price? In the futures market (42th
street) or spot market (54th street)?
 Futures
On the Jun10: (5 days before the settlement date June 15th)
(specific dates):

Ana looks at the futures market

She sees that the price of the futures (settlement date in 5 days)
trade at 1.30$

Then she looks at the spot market..

She sees that the price of the corn today (10th June) is 1.00$

Is this situation possible?

If this is possible then what could anybody do?

Everybody would go crazy buying spot and selling futures
Then price of spot goes up and forward down
 Futures
The spot price and futures price converge, otherwise
ARBITRAGE

Arbitrage:
Arbitrage is the simultaneous purchase and sale of an asset to
profit from a difference in the price. It is a trade that profits by
exploiting the price differences of identical or similar financial
instruments on different markets or in different forms. Arbitrage
exists as a result of market inefficiencies.

Example
Telefonica stock price is in Madrid 20 and in London 25
Then you could buy here and sell there that is arbitrage.
If you buy and sell large amounts a small difference is very
profitable
 Futures
Could it be possible to be at 1.30$ in futures market and 1.25$ in
spot. Depend of cost of carry if lower than 0.05$

Pf = Ps + Cc

Note: on Jun15 Cc=0

 Futures
Continuing. It is Jun 10 and price of corn has gone up

Ana decides to close position Sells 10 futures

March Ana Buy/10fut /corn/June 1.1$
March MrX Sells/ 10fut/corn/June 1.1$
-----------------------------------------------------------
Jun/06 Ana Sells/10fut /corn/June 1.3$
Jun/06 MrY Buys/10fut /corn/June 1.3$

Buy/sell futures does not mean that you buy or sell any good,
means that you have a compromise to buy/sell something at
a settlement date.
Ana compromised to buy on the 15th June corn from the CH
Then she compromised (before settlement date) to sell corn on
the 15th to the CH
 Futures
Ana compromised to buy on the 15th June corn from the CH
Then she compromised (before settlement date) to sell corn on
the 15th to the CH

Is there any exchange of corn?

Is there any exchange of money?

Ana bought 10 futures on corn for 1.10$/Kg and sold

before settlement date 10 futures of corn for 1.30$/Kg

Profit = 0.20$ x 10 contracts x 1000 kg each contract=

2000$
 Futures
Now suppose that the price of corn has gone down
we are 5 days to settlement day. 0.98$/Kg
Closes position or waits???
She thinks it might go upand waits

Then next day 0.97$/kg

..
Close and accept the loss

Loss = 0.13 x 10 x 1000 = 1300$

What happen if she stays up to settlement day She

will have to store 10,000kg of corn in her bathroom.
 Futures
95-98% of open contracts will not arrive to settlement
day. Not actual delivery of the underlying asset

What is the underlying asset oil, stocks, corn,

currencies

The 5-3% that arrive MUST comply with the contract

 Three pedagogical tricks
Up to here
1.Only talked about commodities as underlying asset (such as
corn) but futures can be of an non-existing assets (such as
IBEX) --- I cannot deliver IBEX

2.We have discussed the speculative position Ana. However,

this products usually Hedging (reduce risk)

3.We used an example of first buying futures, but you can also
start in a selling position
 Eliminate 3rd trick
Open a Long position = Buy
Open a Short position = Sell

Ana now observes that the price of the corn has broken an
relevant support and she thinks it might go down.. Downward
trend
Then what does she do with corn futures?

So she SELLS futures .

Can we she do that?

Profit = Sell expensive Buy cheap =

Does this formula mind if you do one thing before the other?
 Standardized
Example
Sell in Sep16 a flat to a Swedish that is planning to live in
BCN next year
500,000 100m2 (he checks spot prices an says yes)
I expect to prices to go

Finally closes position at 450,000 meaning?

The Swedish comes and complains.. Too dark, not good

area

What is the problem? Not standardized underlying

asset
 Eliminate 1st Trick
If we think IBEX will go down
What do we do?

Buy futures on IBEX? Sell futures on IBEX?

The dollar might go up.

You will????

Are these standardized underlying assets?

 Eliminate 2 nd trick Hedging
Speculator profile
Downward expectations on price of cattle
David (speculator) sell futures in Chicago mercantile (Futures
market) Standard size of this contract= 40,000ponds

Sell/ 1 Fut/meat June Pf=0.97$/pound ---------- Ps= 0.96$

Buy/ 1 Fut/meat June Pf= 0.87$/pound

Profit = 0.10$/L x 40,000 = 4,000

----------------------------------------------------------------------------------------------------------------------

Hedger profile
Rex is a ranger in Texas, sells cattle
Risk of Rex = price of cattle might go down 0.96$
What can he do?
1.Do nothing (the most common alternative taken worldwide)
2.To hedge the risk
 Hedging two steps
Identify risk risk of Price cattle fall from 0.96
Decide what to do to compensate (offset) possible losses

Hedge = sell futures at a agreed price to block the selling

price and avoid downwards (eg. Pf= 0.97$) , then:

If Price in June =0.87 he will

sell the cattle with a loss
close the short position (to buy futures) with a gain

If Price in June =1.1 he will

sell the cattle with a gain
close the short position (to buy futures) with a loss

Loss and gain offset each other

 Eliminate 2 nd trick Hedging
Rex expects to sell 1,460,320kg of cattle
how many futures will he sell? Size of contract = 40,000kg

1,460,320/40,000= 36.50 contracts

Can we sell 0.5 contracts? No
He sells 36 contracts

Sell/ 36 Fut/cattle Jun 0.97$/Kg

Day before settlement day Pf = 0.87$/Kg and Ps = 0.87$/Kg

Does he close position or delivers the cattle?

 Eliminate 2 nd trick Hedging
Rex closes position
Buys 36 contracts Pf= 0.87$/kg

(0.97 - 0.87) * 36 * 40,000= 144,000$ gain cost of carry

Sells the cattle in Texas

(0.87 0.96) * 1,460,320 = 131,428$ loss

Hedging is not to profit from speculation .. Hedging is to be able

to sleep at night because you agree on a specific selling or
buying price avoiding uncertainty.
 Hedging
Should we hedge all the cattle or just a part of it?

Example
Repsols CFO and price of oil --- Risk?
Price can go down..
Expected production of oil 2,000mill barrels
Options:
1 Do nothing
2 Hedge the possible downward trend (standard size of contract = 1000
barrels)

Hedge = 2,000,000/1000= 2,000 contracts

What happens if price goes up?

 Hedging
Should we hedge all the cattle or just a part of it?

Example -- Repsols CFO and price of oil

Sell/ 2,000 futures/oil 140$/barrel June

June= price 150$/barrel

Gain= (150-140)*2000*1000=20,000,000

Sell 2000 futures at 140$:

Loss= (150-140)*2000*1000= 20,000,000

UPS!! You lost 100% of gain normally 20%-30% or 40%

 Hedging
A) Purchase manager in Carrefour
Buys the meat for all the Carrefour supermarkets
You expect downward trend of price

Would you hedge? How much?

B) An Equity fund manager, Risk?

Value of portfolio going down

How would you hedge your portfolio?

 Daily Settlements
Daily settlements of gains and losses
Example
Buy Telefonica 18 and sell 20 -- Gain = 2
Not this simple Settlement day is not relevant

Telefonica Gain Total Action

18
17.7 -0.3 -0.3 payment
17 -0.7 -1 payment
17.5 0.5 -0.5 payment
17.6 0.1 -0.4 payment
18.6 1 0.6 collection
Future is a promise to buy/sell (an open position)
CH operates in your name and needs a provision to meet this
payments -- MARGIN (initial and variation margins)
 Example
COMEX (NY) (Commodity Exchange) Size contract = 100 oz.
Day 1 Margin = 5,000$
Day 2 Buy/ 1 future /gold Aug 853.40$. Closes 853.10$
Day 3 Gold closes 852.40$. No operative
Day 4 Sell 1 future Aug 855.00$

DAY Debit Credit Tot

1Variation margin 5,000 5,000
2Initial margin 1,000 4,000
2Variation (-0.3 * 100) 30 3,970
3variation (-0.7 * 100) 70 3,900
4Close (+2.6*100) 260 4,160
4Initial margin 1,000 5,160
 Example
COMEX (NY) (Commodity Exchange) Size contract = 100 oz.
Day 1 Margin = 5,000$
Day 2 Buy/ 1 future /gold Aug 853.40$. Closes 850.10$
Day 3 Gold closes 843.10$. No operative
Day 4 Sell 1 future Aug 810.10$

DAY Debit Credit Tot

1Variation margin 5,000 5,000
2Initial margin 1,000 4,000
2Variation (-3 * 100) 300 3,700
3variation (-7 * 100) 700 3,000
4Close (-33*100) 3300 -300
4Initial margin 1,000 700

If you go negative (-300) Your position will be automatically closed

and you would receive 1,000- 300 =700
 Leverage
When we bought the future contract..
The value of the contract = 100*853.40=85,340$
You are committed to buy in August that amount in $
They ask you a margin (payment) of 1,000 and a provision of
5,000

If we do the same on spot market (Zurich gold market)

You buy and pay 85,340$ and sell + collect 85,500
Gain 160$ with a treasury requirement of 85,340$

Futures market amplify returns in gains but also in losses

(High risk)