ZeePedia buy college essays online


Investment Analysis and Portfolio Management

<<< Previous Financial Futures: Short Hedges, Long Hedges Next >>>
 
img
Investment Analysis & Portfolio Management (FIN630)
VU
Lesson # 43
FUTURES Contd...
Financial Futures:
Financial futures are futures contracts on equity indexes, fixed-income securities, and
currencies. They give investors greater opportunity to fine tune the risk-return
characteristics of their portfolios. In recent years, this flexibility has become increasingly
important as interest rates have become much more volatile and as investors have sought
new techniques to reduce the risk of equity positions. The drastic changes that have
occurred in the financial markets in the last 15 to 20 years could be said to have generated a
genuine need for new financial instruments that allow market participants to deal with these
changes.
The procedures for trading financial futures are the same as those for any other commodity
with few exceptions. At maturity; stock-index futures settle in cash, because it would be
impossible or impractical to deliver all the stocks in a particular index. Unlike traditional
futures, contracts, stock-index futures typically have no daily price limits (although they can
be imposed).
We will divide the subsequent discussion of financial futures into the two major categories
of contracts, interest rate futures and, stock-index futures. Hedging and speculative
activities within each category are discussed separately.
Interest Rate Futures:
Bond prices are highly volatile, and investors are exposed to adverse price movements,
financial futures, in effect, allow bondholders and others who are affected by volatile
interest rates to transfer the risk. One of the primary reasons for the growth in financial
futures is that portfolio managers and investors are trying to protect themselves against
adverse movements-in interest rates. An investor concerned with protecting the value of,
fixed-income securities must consider the possible impact of interest rates on the value of
these securities.
Today's investors have the opportunity to consider several different interest rate futures
contracts that are traded on various exchanges. The Chicago Mercantile Exchange
trades contracts on Treasury bills and the one-month LIBOR rate as well as euro dollars.
The Chicago Board of Trade (CBT) specializes in longer-maturity instruments, including
Treasury notes (of various maturities, such as two-year and five-year) and Treasury bonds
(of different contract sizes).
Short Hedges:
Since so much common stock is "held by investors, the short hedge is the natural type of
contract for most investors. Investors who hold stock portfolios hedge market risk by selling
stock-index futures, which means they assume a short position.
A short hedge can be implemented by selling a forward maturity of the contract. The
purpose of this hedge is to offset (in total or in part) any losses on the stock portfolio with
gains on the futures-position. To implement this defensive strategy, an investor would sell
one or more index futures contracts. Ideally, the value of these contracts would equal the
242
img
Investment Analysis & Portfolio Management (FIN630)
VU
value of the stock portfolio. If the market falls, leading to a loss on the cash (the stock
portfolio) position, stock-index futures prices wilt also fall, leading to a profit for sellers of
futures.
Long Hedges:
The long hedger, while awaiting funds to invest, generally wishes to reduce the risk of
having to pay more for an -equity position when prices rise. Potential users of a long hedge
include the following:
1. Institutions with a regular cash flow who use long hedges to improve the timing of
their positions.
2. Institutions switching large positions who wish to hedge during the time it takes to
complete the process, (This could also be a short hedge.)
243