CONTENTS
Preface = xix
Abbreviations of Institutions = xxiii
1 An Introduction to Futures Markets = 1
1.1 Introduction = 1
1.2 What Are Futures Contracts? 4
1.3 Forward Markets as Forerunners of Futures Markets = 5
1.4 Standardization as a Key Characteristic of a Futures Contract = 10
1.4.1 An Example = 10
1.5 Who Trades Futures Contracts and Why = 11
1.5.1 Speculation = 11
1.5.2 Hedging = 12
1.6 Social Benefits of Futures Markets = 13
1.7 Trading Statistics = 13
1.8 Statistics on Hedging and Speculation = 15
1.9 Other Deferred Delivery Contracts = 17
1.9.1 Option Contracts = 17
1.9.2 Forward Contracts = 18
1.10 Growth of Foreign Futures Markets = 20
Conclusion = 23
Questions = 23
Suggested Reading = 23
2 Mechanics of Buying and Seiling Futures = 24
2.1 Futures Commission Merchants = 24
2.2 Exchanges = 25
2.3 Clearinghouses = 26
2.4 Floor Brokers = 26
2.5 The Order Flow : Initiating a Trade = 27
2.6 Liquidating or Settling a Futures Position = 28
2.6.1 Physical Delivery = 29
2.6.2 Offsetting = 30
2.6.3 Exchange of Futures for Physicals = 33
2.6.4 Cash Delivery = 37
2.7 Initial Margins = 38
2.8 Variation Margins = 41
2.9 An Example of Margin Calculations and Payments = 41
2.10 Types of Orders = 45
Conclusion = 51,
Questions = 51
Suggested Reading = 52
3 The Clearinghouse = 53
3.1 Structure = 54
3.2 The Clearinghouse in Operation : An Example = 54
3.3 Some Potential Pitfalls = 59
3.4 A Comparison of the Major Clearinghouses : Structure and Regulatory Framework = 59
3.4.1 Organizational Structure = 64
3.4.2 Margins = 64
3.4.3 Other Solvency Regulations = 65
3.4.4 Self-Insurance Arrangements = 67
3.5 Unresolved Issues = 67
3.5.1 Consolidation of Clearing Associations = 68
3.5.2 Limited versus Unlimited Liability of Clearing Members = 69
3.5.3 Explicit versus Discretionary Rules = 69
3.6 What Is the Role of Government? = 70
Conclusion = 70
Questions = 71
Suggested Reading = 71
Appendix : Exchanges and Clearinghouses = 72
4 Futures Prices = 73
4.1 Reading the Newspape = r73
4.2 Price Characteristics = 77
4.3 Cash Prices versus Futures Prices = 78
4.3.1 The Relationship between Cash and Futures Prices = 78
4.3.2 The Cost-of-Carry Relationship = 80
4.3.3 Cash-Futures Arbitrage = 84
4.3.4 Basis, Contango, and Backwardation = 86
4.3.5 Backwardation Markets = 87
4.3.6 The Convenience Yield = 91
4.4 Spreads = 93
4.4.1 Types of Spreads = 93
4.4.2 Why Trade Spreads = 96
4.4.3 Spread Prices = 97
Conclusion = 100
Questions = 100
Suggested Reading = 100
Appendix : The Cost-of-Carry Pricing Formula = 101
5 Hedging Fundamentals = 102
5.1 Risks That Can and Cannot Be Hedged = 102
5.2 The Basic Long and Short Hedges = 103
5.3 Basis Fundamentals for Hedgers = 104
5.4 Short Hedge with and without Basis Risk = 111
5.4.1 Short Hedge with Zero Basis Risk = 111
5.4.2 Short Hedge with Basis Risk = 114
5.5 Long Hedge with and without Basis Risk = 115
5.5.1 Long Hedge with Zero Basis Risk = 115
5.5.2 Long Hedge with Basis Risk = 117
5.6 Basis Risk versus Price Risk = 118
5.7 Measuring the Anticipated Effectiveness of a Hedge = 120
Conclusion = 125
Questions = 125
Suggested Reading = 126
6 Devising a Hedging Strategy = 127
6.1 Deciding on the Futures Contract = 127
6.1.1 Which Futures Contract = 127
6.1.2 Which Contract Month = 129
6.2 The Hedge Ratio Concept = 130
6.3 Estimating the Hedge Ratio = 132
6.3.1 The Naive Method = 133
6.3.2 Regression Analysis = 135
6.4 Ex Ante Hedge Ratios versus Ex Post Hedging Results : An Example = 137
6.5 Hedging Objectives = 141
6.6 Improving Performance through Aggressive Hedging Strategies = 143
6.6.1 Making Use of Basis Relationships = 143
6.6.2 Adjusting for an Unstable Hedge Ratio = 146
6.7 Output Uncertainty = 149
6.8 Margins and Cash Flow Considerations = 150
6.9 Managing the Hedge = 150
6.9.1 Monitoring the Hedge = 150
6.9.2 Adjustments to the Hedge = 151
6.9.3 Hedge Evaluation = 151
6.10 Legal Aspects of Hedging = 151
6.11 Accounting for Futures Transactions and Hedging Positions = 152
6.11.1 Hedge Accounting Principles = 153
6.11.2 Hedges of Existing Assets, Liabilities, and Firm Commitments = 153
6.11.3 Anticipatory Hedges = 154
6.11.4 Required Disclosure = 155
6.12 Federal Income Tax Considerations = 155
6.12.1 Speculative Positions = 155
6.12.2 Hedges = 156
6.12.3 Mixed Straddles = 156
Conclusion = 157
Questions = 157
Suggested Reading = 160
Appendix: Estimated Hedge Ratios = 161
7 Social Benefits of Futures Markets and the Role of Speculation = 162
7.1 Introduction = 162
7.2 Risk Management = 163
7.3 Price Discovery = 164
7.3.1 Current Cash Prices = 164
7.3.2 Expected Cash Prices = 165
7.4 The Concept of a Risk Premium = 166
7.4.1 What Is an Expected Spot Price? = 166
7.4.2 Hedging Imbalances and Risk Premiums = 167
7.5 Speculation and the Magnitude of the Risk Premium = 170
7.6 Critics of Speculation = 173
Conclusion = 175
Questions = 175
Suggested Reading = 176
8 The Economic and Historical Rationales for Regulating Futures Markets = 177
8.1 Allocative Efficiency as a Framework for Understanding Regulation = 177
8.2 The Concept of Market Failure = 178
8.2.1 Monopoly = 178
8.2.2 Public Goods = 179
8.2.3 Externalities = 180
8.2.4 Information Failures = 180
8.2.5 Regulation Is Not Costless = 181
8.3 Evaluating the Performance of Futures Markets = 182
8.3.1 Allocative Efficiency in Futures Markets = 182
8.3.2 Dynamic or Innovational Efficiency = 183
8.3.3 Transactional Efficiency = 183
8.4 Historical Justifications for Regulating Futures Markets = 183
8.4.1 Excessive Speculation = 183
8.4.2 Manipulation = 184
8.4.3 Market Liquidity as a Naturnl Monopoly = 185
8.4.4 Customer Protection = 185
8.4.5 Financial Stability = 186
Conclusion = 186
Questions = 186
Suggested Reading = 187
9 The Regulation of Futures Markets = 188
9.1 The Evolution of Federal Regulation = 188
9.2 Regulation of Commodity and Futures Options = 190
9.3 Legislative Rationale for Government Regulation = 190
9.4 Self-Regulatory Organizations = 191
9.5 Key Elements of Federal Regulation = 192
9.6 Contract Designation = 192
9.7 Manipulation = 193
9.7.1 The Statutory Law = 193
9.7.2 Key Manipulation Cases = 194
9.8 Floor Trading Abuses = 200
9.9 Regulatory Issues = 202
9.9.1 The Jurisdictional Conflict between the CFTC and the SEC = 203
9.9.2 Off-Exchange Instruments = 204
9.9.3 Screen-Based Trading = 205
9.9.4 Globalization of Futures Markets = 205
9.9.5 Dual Trading and the Audit Trail = 206
9.9.6 Institutionalization of Markets and Block Trading = 207
Conclusion = 208
Questions = 208
Suggested Reading = 208
Appendix : Commodity Futures Trading Commission's Guideline 1, Part 5 (Amended) = 209
10 Stock Index Futures = 214
10.1 What Is a Stock Index? = 216
10.2 Stock Index Futures = 227
10.3 Settlement Procedures or Delivery = 228
10.4 Stock Index Futures Price Quotations = 229
10.5 Theoretical Futures Prices = 231
10.6 The Equivalent Portfolio Rationale = 232
10.7 Stock Index Arbitrage = 233
10.8 The Observed Relationship between Actual and Theoretical Futures Prices = 236
10.9 Stock Index Futures as a Portfolio Management Tool = 239
10.10 Hedging with Stock Index Futures = 241
10.10.1 Who Hedges? = 241
10.10.2 Market and Non-Market Risk = 243
10.11 Measuring Market Risk = 244
10.12 The Minimum-Variance Hedge Ratio = 248
10.13 A Hedging Example = 250
10.14 Portfolio Insumnce = 254
Conclusion = 256
Questions = 256
Suggested Reading = 256
11 The 1987 Stock Market Crash and the Controversy over Stock Index Futures = 258
11.1 The Stock Market Crash = 259
11.2 The Alleged Role of Stock Index Futures Trading = 259
11.3 Market Developments Pilor to the Crash = 260
11.4 The Evidence = 263
11.5 The Aftermath of the Crash : Proposed Remedies = 265
11.5.1 Curbs on Portfolio Insurance and Program Trading = 265
11.5.2 Higher Futures Margins = 266
11.5.3 Trading Halts = 269
11.6 Effects on Stock Market Volatility = 271
11.7 Evidence from Foreign Markets = 272
Conclusion = 273
Questions = 274
Suggested Reading = 274
12 Short-Term Interest Rate Futures = 275
12.1 Interest Rate Obligations in General = 275
12.2 Interest Rate Futures in General = 276
12.3 The Term Structure of Interest Rates = 278
12.3.1 Spot versus Forward Yields = 279
12.3.2 Theories of the Term Structure = 279
12.3.3 Forward Rates versus Futures Rates = 281
12.4 Treasury Bill Futures = 282
12.4.1 Cash Price Quotations = 282
12.4.2 Futures Quotations and Futures Prices = 283
12.4.3 Delivery Requirements = 287
12.4.4 Determination of the Delivery Price = 287
12.4.5 The Pricing of T-Bill Futures = 287
12.4.6 The Implied Repo Rate 289
12.5 Eurodollar Futures = 292
12.5.1 Eurodollar Time Deposits = 293
12.5.2 Futures Quotations and Futures Prices = 294
12.5.3 Delivery and the Determination of Final Settlement Prices = 295
12.5.4 The Pricing of Eurodollar Futures = 296
12.6 The Ted Spread = 298
12.7 Applications Using Short-Term Futures Contracts = 299
12.7.1 Short Hedge : Locking in a Borrowing Rate = 300
12.7.2 Long Hedge : Locking in an Investment Yield = 301
12.7.3 Synthetic Interest Rate Securities = 302
12.7.4 Strip versus Stack Hedging Strategies = 303
Conclusion = 307
Questions = 307
Suggested Reading = 308
13 Long-Term Interest Rate Futures = 310
13.1 The Cash T-Bond Market = 313
13.1.1 Quoted Bond Prices = 314
13.1.2 Bond Yields = 316
13.1.3 Calculating the Bond's Transaction Price = 317
13.1.4 The Inverse Relationship between Bond Prices and Market Yields = 317
13.2 Duration = 318
13.2.1 Macaulay's Duration = 318
13.2.2 Modified Duration = 320
13.2.3 The Duration of a Portfolio = 320
13.2.4 Summary = 321
13.3 The U.S. T-Bond Futures Contract = 321
13.3.1 The Delivery Process and Deliverable Bonds = 321
13.3.2 Futures Price Quotations = 324
13.3.3 Invoice Prices = 325
13.3.4 Conversion Factors = 326
13.4 Pricing T-Bond Futures = 326
13.5 Identifying the Cheapest-to-Deliver Bond = 333
13.5.1 Using Theoretical Ftitures Prices = 334
13.5.2 Using Implied Repo Rates = 336
13.6 Hedging with T-Bond Futures = 337
13.6.1 Using Durations Lo Determine Hedge Ratios = 338
13.6.2 Using Regression Analysis to Determine Hedge Ratios = 340
13.6.3 Duration versus Regression = 345
13.7 Portfolio Duration Adjustments = 348
Conclusion = 348
Questions = 348
Suggested Reading = 349
Appendix : The Conversion Factor and the Cheapest-to-Deliver Concept = 351
14 Foreign Currency Futures = 352
14.1 The Foreign Currency Market = 355
14.1.1 1Why Does It Exist? = 355
14.1.2 The Cash Market = 355
14.2 Foreign Exchange Quotations = 356
14.3 Cross Exchange Rates = 358
14.4 Determinants of Exchange Rate Levels = 360
14.5 Currency Futures = 362
14.5.1 Futures Price Quotations = 364
14.5.2 Pricing of Currency Futures = 365
14.5.3 Covered Interest Rate Parity = 367
14.5.4 Identifying a Foreign Currency Arbitrage = 369
14.6 Forward versus Futures Currency Contracts = 369
14.7 Applications of Foreign Currency Futures = 372
14.7.1 Hedging with Currency Futures = 372
14.7.2 Synthetic Foreign Currency Futures Contracts = 374
14.7.3 Hedging with Synthetic Cross Rate Futures Contracts = 375
14.8 Euro Rate Differential Futures Contracts = 376
Conclusion = 376
Questions = 377
Suggested Reading = 378
15 Commodity Futures = 379
15.1 Pricing Fundamentals = 379
15.2 Agricultural Futures = 380
15.2.1 Trading and Growth = 380
15.2.2 Contract Specifications and Delivery = 382
15.2.3 Invoice Prices and Delivery Differentials = 385
15.2.4 Cash and Futures Price Quotations = 387
15.2.5 The Determination of Agricultural Futures Prices : The Case of Soybean Futures Prices = 387
15.2.6 The Crush Spread = 390
15.3 Energy Futures = 391
15.3.1 Recent Developments in Energy Markets = 391
15.3.2 Trading and Growth = 393
15.3.3 Contract Specifications and Delivery = 394
15.3.4 The Crack Spread = 398
15.4 Precious Metals Futures = 402
15.4.1 Trading and Growth = 402
15.4.2 Contract Specifications and Delivery = 403
15.4.3 Cash and Futures Prices = 406
15.4.4 The Gold and Silver Ratio = 407
15.5 Industrial Metal Futures = 408
15.5.1 Trading and Growth = 408
15.5.2 The London Metal Exchange = 409
15.5.3 Determinants of Industrial Metal Prices = 419
15.6 Hedging = 422
Conclusion = 422
Questions = 422
Suggested Reading = 423
16 Trading Methods and Strategies = 424
16.1 Fundamental Analysis = 425
16.1.1 Analyzing a Commodity = 425
16.1.2 Sources of Information = 425
16.1.3 Case Study : Silver = 429
16.2 Technical Analysis = 429
16.3 Chart Analysis = 432
16.3.1 Price-Pattern Recognition Charts = 432
16.3.2 Common Technical Price Patterns = 434
16.3.3 Market Trend Analysis = 439
16.3.4 Structural Analysis = 444
16.4 Trading Systems = 447
16.5 Risk Management and the Allocation of Portfolio Equity = 450
16.6 Measuring Volatility = 451
16.7 Keeping a Trading Diary = 453
Conclusion = 456
Questions = 457
Suggested Reading = 457
Appendix: Example of Fundamental Analysis : The Soybean Complex, February 5, 1991 = 457
17 Speculators : Who Are They and Who Wins and Loses? = 463
17.1 The Role and Volume of Speculation = 463
17.2 A Profile of the Small Speculator = 467
17.3 Large Speculators : Commodity Funds = 470
17.4 The Performance of Traders in General = 472
17.4.1 Early Studies = 472
17.4.2 Recent Studies = 472
17.4.3 Implications = 476
17.5 The Performance of Commodity Funds = 476
17.5.1 Aggregate Net Returns = 476
17.5.2 The Distribution of Fund Returns = 478
17.5.3 Implications : Commodity Funds as an Investment = 483
17.5.4 Aggregate Gross Returns Are Positive = 483
Conclusion = 484
Questions = 484
Suggested Reading = 485
Appendix : Estimating Average Operational and Management Fees = 486
18 The Fundamentals of Options = 487
18.1 The Evolution of Option Trading in the United States = 487
18.1.1 Options on Securities = 487
18.1.2 Options on Commodities and Futures = 488
18.1.3 Current Regulatory Structure = 489
18.2 Terminology and Definitions = 490
18.2.1 What Is an Option Contract? = 490
18.2.2 Exchange-Traded versus Over-the-Counter Options = 491
18.2.3 Options on Physicals versus Options on Futures = 494
18.3 Options on Physicals = 494
18.3.1 Individual Stock Options and the Basics of Option Pricing = 495
18.3.2 Stock Index Options = 500
18.3.3 Currency Options and Interest Rate Options = 501
18.4 Options on Futures = 503
18.4.1 Margins = 506
18.5 Futures versus Options on Futures = 512
18.5.1 Long and Short Futures Positions = 512
18.5.2 Basic Option Positions : Calls and Puts = 517
18.5.3 Covered Option Positions = 521
18.5.4 Synthetic Futures and Options = 522
Conclusion = 524
Questions = 524
Suggested Reading = 524
19 Option Pricing = 525
19.1 The Put-Call Parity Pricing Relationship : Common Stock = 526
19.2 Option Pricing in General : Fundamental Determinants = 528
19.2.1 Call Options = 529
19.2.2 Put Options = 533
19.3 The Black-Scholes Model = 533
19.3.1 An Example : Computing the Value of a Call Option Using Black-Scholes = 537
19.3.2 Modifications of the Black-Scholes Model = 538
19.4 The Black Model for Futures Options = 541
19.4.1 An Example: Using the Black Model to Value Futures Options = 542
19.4.2 The Put-Call Parity Relationship for Futures Options = 543
19.5 Estimation of Price Volatility = 545
19.5.1 Historical Price Volatility = 547
19.5.2 Implied Price Volatility = 548
19.5.3 Summary = 551
19.6 Sensitivity of Option Premiums = 551
19.6.1 Delta : Changes in Option Prices Relative to the Underlying Futures Price = 553,
19.6.2 Gamma : The Rate of Change of Delta = 555
19.6.3 Lambda: Changes in Option Prices Relative to Changes in Volatility = 556
19.6.4 Theta : Changes in Option ― Prices Relative to Time to Expiration = 557
19.6.5 Rho : Changes in Option Prices Relative to Interest Rates = 558
19.7 Applicaticris of Option Pricing = 558
19.7.1 Interest Rate Options = 559
19.7.2 Corporate Securities = 560
Conclusion = 562
Questions = 562
Suggested Reading = 563
Appendix 1 : The Normal and Standardized Normal Probability Distributions = 564
Appendix 2 : The Binomial Option Pricing Model = 567
Appendix 3 : A Generalized Black-Scholes Option Pricing Model = 571
20 Speculating and Hedging with Options = 572
20.1 Speculating on Price Changes = 573
20. 1.1 Simple Call and Put Strategies = 573
20.2 Combining Simple Call and Put Strategies with Existing Speculative Positions = 574
20.2.1 Covered Option Strategies = 574
20.2.2 Synthetic Options = 576
20.2.3 Summary = 577
20.3 Option Spreads = 578
20.3.1 Bullish Option Spreads = 579
20.3.2 Bearish Option Spreads = 581
20.3.3 Horizontal or Time Spreads = 583
20.4 Call and Put Combinations = 584
20.4.1 Synthetic Futures = 584
20.4.2 Straddles = 585
20.4.3 Strangles = 586
20.4.4 Summary = 588
20.5 Risk Management with Options = 588
20.5.1 Hedging against a Price Increase = 588
20.5.2 Hedging against a Price Decline = 605
20.6 Delta Hedging = 614
20.6.1 Variations in Delta : An Example = 614
20.6.2 Applying Delta Hedging = 617
Conclusion = 620
Questions = 620
Suggested Reading = 621
References = 622
Glossary = 627
Source Acknowledgments = 633
Index = 637
