If spot-futures parity is not observed, then arbitrage is possible.
If the futures price is too high, short the futures and acquire the
stock by borrowing the money at the risk free rate.
If the futures price is too low, go long futures, short the stock
and invest the proceeds at the risk free rate.
Futures Pricing (Cont.)
17 BUFN 740: Capital Markets Topic 6
Futures Pricing (Cont.)
18 BUFN 740: Capital Markets Topic 6
Strategy Initial Cash Flow Cash Flow at Time T
Buy the future 0
Borrow and buy the
share
To get one share of the stock, we have two ways:
(1) borrow to buy one share of the stock now and keep it to T
(2) buy one future contract
Lets compare the cash flow of these two strategies:
Futures Market Arbitrage
Suppose the risk-free rate is 0.5% , the futures price should be
$10001.005=$1005.
The actual futures prices is $1010. The spot-futures parity is
violated. An arbitrage opportunity exists!
Buy low sell high-- sell overpriced futures and buy the stock using
borrowed money.
The Cash Flow of Cash and Carry
19 BUFN 740: Capital Markets Topic 6
Strategy Initial Cash Flow Cash Flow in 1 year
Borrow $1000 +1,000 -1,0001.005=-$1,005
Buy stock for $1000 -1,000 S
T
Sell the futures 0 $1,010- S
T
Total 0 $5
Futures Market Arbitrage (Contd)
What if the actual futures price is $980. The spot-futures parity is
violated. An arbitrage opportunity exists!
Buy low sell high-- buy underpriced futures
--sell the stock and lend the proceed
The Cash Flow of Reverse Cash and Carry
20 BUFN 740: Capital Markets Topic 6
Strategy Initial Cash Flow Cash Flow in 1 year
Buy the futures 0 -980+ S
T
Short sale stock 1,000 -S
T
Lend -1,000 $1,005
Total 0 $25
Relationship between Forward and Futures Prices
In the previous example, we assume for convenience that the
entire profit to the futures contract accrues on the delivery date.
The parity theorems apply strictly to forward pricing because
contract proceeds are realized only on delivery.
When interest rate is uncorrelated with the price of the
underlying asset, forward and futures prices are the same.
Even if interest rate IS correlated with the price of the
underlying asset, forward and futures prices are still very close.
In real data, generally, the difference between forward price and
futures price is indeed insignificant and thus will be ignored
throughout this course.
BUFN 740: Capital Markets Topic 6 21
Swaps
22 BUFN 740: Capital Markets Topic 6
A swap is an exchange of periodic cash flows between two
parties. The cash flows may vary in terms of currency
denomination, interest rate basis and/or other financial features.
Examples:
1. Interest Rate Swap - exchange of fixed-rate interest
payments for floating-rate interest payments
2. Currency Swap - exchange of one stream of cash flows
denominated in one currency for another stream of cash flows
denominated in another currency.
Plain Vanilla Interest Rate Swap
BUFN 740: Capital Markets Topic 6 23
A plain vanilla interest rate swap is a widely used interest rate swap.
Party B agrees to pay party A cash flows equal to interest at a fixed interest
rate on a notional principal for a number of years. At the same time, party A
agrees to pay party B cash flows equal to interest at a floating interest rate on
the same notional principal for the same number of years.
The notional principal does not change hand. The cash flows are in the same
currencies.
It involves two companies that have different comparative advantages in the
debt market: one company may be relatively more competitive in the fixed-
rate market, while the other may be relatively more competitive in the
floating-rate markets.
Example
Suppose BUD wants to borrow $100 million at a floating rate for 5 years
and IBM wants to borrow $100 million at a fixed rate for 5 years. Costs of
funds are as the following
The central question in the analysis of a swap is: can both companies be
better off by contracting a swap agreement?
Even though the rates IBM can borrow at in both markets are higher than
those for BUD, IBM's disadvantage (the difference in rates) is smaller in the
floating rate market.
So we say that IBM has a comparative advantage in borrowing at floating
rates and BUD has a comparative advantage in borrowing at fixed rates.
24 BUFN 740: Capital Markets Topic 6
Total Gains From Swap
Assume interest is paid semiannually.
If a swap market does not exist, then BUD has to borrow at
LIBOR and IBM has to borrow at 12%. The total amount of
each interest payment BUD and IBM have to pay is 100(LIBOR
+12%)/2 m.
Now if BUD and IBM enter into a swap contract and let BUD
borrow at fixed rate of 10% and IBM borrow at LIBOR + 0.5%,
The total amount of each interest payment BUD and IBM have
to pay is only 100(LIBOR +10.5%)/2 m.
The difference for each payment is 100(LIBOR +12%)/2 -
100(LIBOR +10.5%)/2=$0.75million.
BUFN 740: Capital Markets Topic 6 25
Mechanics of Swap
Step 1: BUD and IBM sign a swap contract which specifies that
every 6 months, BUD pays IBM 100 LIBOR/2 million and
IBM pays BUD 100 11%/2=$5.5 million. Only the net
payment change hands.
Step 2: BUD borrows $100m for 5 years, paying 10% annually.
IBM borrows $100m for 5 years, paying LIBOR+0.5%
annually.
The net cost of fund for BUD is LIBOR-1% each year (1%
better). The net cost of fund for IBM is 11.5% each year (0.5%
better).
BUFN 740: Capital Markets Topic 6 26