Futures Contracts

A futures contract calls for delivery of an asset (or in some cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid

CHAPTER 2 Markets and Instruments

Figure 2.14 Financial futures listings.

FUTURES PRICES

360 161860 156650 7,671

360 164260 132430 1,273

360 1 66660 134230 1,094

360 169060 136130 155

INDEX

DJ INDUSTRIAL AVERAGE (CBOT)-SIO times average Lifetime Open

Open High Low Settle Change High Low Interest Sect 10575 10700 50555 10675 + 10! 12126 9995 13,472 Dec 10745 10822 10745 10B19 + 101 1218Q 8100 2,S10 Est vol 13,000; vol Mon 9,322: open Int 15,590, +147, Idxprl: HI 10626.92; Lo 10516.76; Close 10606.95, +34.97, S&P 500 INDEX (CME]-$250 times Index Sept 143960 145450 143700 144750 + 360 159500 99000 376,523 Dec 146350 147550 146150 146950 +

June 151800 152050 150700 151460 + Sept 154220 154500 153150 153910 + Est vol 59,627; vol Mon 62,516; open Int 386,719, +1,199. Idxprl; HI 1443.54; Lo 1428.96; Close 1438.10, +7,27, MINIS4P 500 (CME)-$50 times index Sept 143950 145450 143700 144750 + B50 156600 137175 40,736 Vol Mon 76,132; open int40,770, +188. S&P Ml DCAP 400 (CME). $500 limes index Sept 494.50 493.00 492.10 497.00 + 2.60 526.00 385.25 12,781 Est vol 616; vol Mon 631; open Int 12,781, + 251. Idxprl; HI492.93; L0 48B.55; Close4?l.S9, +2.92. NIKKEI 225 STOCK AVERAGE (CM£)-$5 times index Sept 16025. 16095. 15900. 15935. + 55 20700. 15575. 15,529 Est vol 721; vol Mon 1,107; open Int 15,559, -108. Idxprl: H1 16099.67; Lo 15773.72; Close 16099.67, +372.18. NASDAQ 100 (CM6)-$100 times index Sept 361700 363500 354200 356950 - 4750 483600 297500 31,637 Est vol 14,093; vol Mon 19,562; wen Int 31,658, -684. Idxorl: HI 3609.35; Lo3518.61; Close3521.15, -88.22. MINI NASDAQ too (CME)-t20 times index Sept 3616.0 3636.5 3542.0 3569.5 - 47.5 4776.0 2963.0 29,302 Vol Mon44,403; open Int 29,317, +154. GSCI (CME)-i250 ti mes nearfcv index Aug 213.60 216.25 213.15 2J4;SS + 1.25 233.00 192.50 35,934 Est vol 420; vol Mon 267; open int 35,989, +86. Idxprl: HI216.40; Lo213.09; Close215.32, +1.99. RUSSELL 2000 (CME)-tSOO times Index Sept 506.00 506.00 499.00 501.50 - 4.50 625.90 423.40 11,658 Est vol 1,120; vol Mon 2,562; open Int 11,658, +614. Idx orl: HI 500.68; Lo 497.71; Close 497.77, -2.87. U.S. DOLLAR INDEX (N YBOTVJ1,000 limes USDX Sept 109.28 110.04 109.10 109.88 + .51112.08 96.17 4,383

Dec 108,87 109.60 109.12 109.53 + .51 111.50 105.55 2,028 Est vol 1,200; vol Mon 476; open int 6,41!, +71. Idxprl: Hi 110.49; Lo 109.35; Close 110.05, +.48. SHARE PRICE INDEX ISFE) A$25 times Index

Lifetime Open

Open High Low Settle Change High Low Interest Sept 3269.0 3282.0 3260.0 3264.0 - 5.0 3379.0 2930.0 144,918 Dec 3290.0 3290.0 3290.0 3283.0 - 5.0 3386.0 3050.0 2,653

Est vol 7,685; vol Mon9,931; open int 148,801, -1,272. Index; Hi3262.4; Lo3245.1; Close3254.1, +3.1. CAC-40 STOCK INDEX (MATIF)-Euro 10.00X index

3.0 6477.0 6392.0 198,346 2.5 6829.5 4060.5 103,172 3.0 6861.5 6117.0 4,681 3.5 6844.0 4489.0 8,445 3.0 5847.0 4304.0 3,000 -253,334.

Aug 6550.0 6590.0 6526.5 6550.0 -sept 6556.0 6589.0 6531.5 6553.5 ■

MrOl 6727.0 6728.0 6725.0 6711.5 -

Est vol 33,900; vol Mon 105,388; open Inf 313,164, -DAX » GERMAN STOCK INDEX (EUREX) Eure 25 per DAX index pt. Sept 7271.0 7276.0 7135.5 7194.0 - 73.0 B262.0 6505.0 158,808 Dec 7354.0 7356.0 7230.5 7281.5 - 78.5 8192.0 6973.5 2,509

Vol Tue 30,150; open Int 161,501, +9. Index: HI 7244.55; Lo 7094.93; Close 7145,53, -44.84. FT-SE100 INDEX (LIFFEK10 per Index point Sept 4362.0 6423.5 6347.0 6390.0 + 49.0 6862.0 6083.0 268,844 Dec 6481,5 6481.5 6481.5 6471.5 + 49.5 6955.0 4,348 MrOl 6531.5 6542.5 6531.5 6530.0 + 50.0 6710.5 1,645 Est vol 25,761; vol Mon 39,242; open lnl 274,877, +13. DJ EURO STOXX SO INDEX (EUREX)-Euro 10.00 x Index Sept 516B.0 5200.0 5107.0 5133.0 - 35.0 5564.0 4569.0 423,385 Dec 5206.0 5221.0 5183.0 5192.0 - 36.0 5572,0 4944.0 24,337

Vol Tue 42,121; open In! 448,415, +17,706. index: HI 5143.79; Lo 5088.37; Close 5102.74, -20.06. DJ STOXX SO INDEX (EUREX)-Euro 10.00 x index Sept 4883.0 4908.0 4872.0 4875.D - 14.0 5180.0 4713,0 15,443

Index: HI4897.53; Lo4856.61; Close4864.88, -9,30,

Source: The Wall Street Journal, August 2, 2000. Reprinted by permission of The Wall Street Journal, © 2000 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

at contract maturity. The long position is held by the trader who commits to purchasing the asset on the delivery date. The trader who takes the short position commits to delivering the asset at contract maturity.

Figure 2.14 illustrates the listing of several stock index futures contracts as they appear in The Wall Street Journal. The top line in boldface type gives the contract name, the exchange on which the futures contract is traded in parentheses, and the contract size. Thus the second contract listed is for the S&P 500 index, traded on the Chicago Mercantile Exchange (CME). Each contract calls for delivery of $250 times the value of the S&P 500 stock price index.

The next several rows detail price data for contracts expiring on various dates. The September 2000 maturity contract opened during the day at a futures price of 1,439.60 per unit of the index. (Decimal points are left out to save space.) The last line of the entry shows that the S&P 500 index was at 1,438.10 at close of trading on the day of the listing. The highest futures price during the day was 1,454.50, the lowest was 1,437.00, and the settlement price (a representative trading price during the last few minutes of trading) was 1,447.50. The settlement price increased by 8.60 from the previous trading day. The highest and lowest futures prices over the contract's life to date have been 1,595 and 9,900, respectively. Finally, open interest, or the number of outstanding contracts, was 376,523. Corresponding information is given for each maturity date.

The trader holding the long position profits from price increases. Suppose that at expiration the S&P 500 index is at 1450.50. Because each contract calls for delivery of $250 times the index, ignoring brokerage fees, the profit to the long position who entered the contract at a futures price of 1447.50 would equal $250 X (1450.50 - 1447.50) = $750. Conversely, the short position must deliver $250 times the value of the index for the previously agreed-upon futures price. The short position's loss equals the long position's profit.

The right to purchase the asset at an agreed-upon price, as opposed to the obligation, distinguishes call options from long positions in futures contracts. A futures contract obliges the long position to purchase the asset at the futures price; the call option, in contrast, conveys the right to purchase the asset at the exercise price. The purchase will be made only if it yields a profit.

Clearly, a holder of a call has a better position than does the holder of a long position on a futures contract with a futures price equal to the option's exercise price. This advantage, of course, comes only at a price. Call options must be purchased; futures contracts may be entered into without cost. The purchase price of an option is called the premium. It represents the compensation the holder of the call must pay for the ability to exercise the option only when it is profitable to do so. Similarly, the difference between a put option and a short futures position is the right, as opposed to the obligation, to sell an asset at an agreed-upon price.

SUMMARY

1. Money market securities are very short-term debt obligations. They are usually highly marketable and have relatively low credit risk. Their low maturities and low credit risk ensure minimal capital gains or losses. These securities trade in large denominations, but they may be purchased indirectly through money market funds.

2. Much of U.S. government borrowing is in the form of Treasury bonds and notes. These are coupon-paying bonds usually issued at or near par value. Treasury bonds are similar in design to coupon-paying corporate bonds.

3. Municipal bonds are distinguished largely by their tax-exempt status. Interest payments (but not capital gains) on these securities are exempt from federal income taxes. The equivalent taxable yield offered by a municipal bond equals rm/(1 - t), where rm is the municipal yield and t is the investor's tax bracket.

4. Mortgage pass-through securities are pools of mortgages sold in one package. Owners of pass-throughs receive the principal and interest payments made by the borrowers. The originator that issued the mortgage merely services the mortgage, simply "passing through" the payments to the purchasers of the mortgage. A federal agency may guarantee the payment of interest and principal on mortgages pooled into these pass-through securities.

5. Common stock is an ownership share in a corporation. Each share entitles its owner to one vote on matters of corporate governance and to a prorated share of the dividends paid to shareholders. Stock, or equity, owners are the residual claimants on the income earned by the firm.

6. Preferred stock usually pays fixed dividends for the life of the firm; it is a perpetuity. A firm's failure to pay the dividend due on preferred stock, however, does not precipitate corporate bankruptcy. Instead, unpaid dividends simply cumulate. Newer varieties of preferred stock include convertible and adjustable rate issues.

7. Many stock market indexes measure the performance of the overall market. The Dow Jones Averages, the oldest and best-known indicators, are price-weighted indexes. Today,

CHAPTER 2 Markets and Instruments many broad-based, market-value-weighted indexes are computed daily. These include the Standard & Poor's 500 Stock Index, the NYSE index, the Nasdaq index, the Wilshire 5000 Index, and indexes of many non-U.S. stock markets.

8. A call option is a right to purchase an asset at a stipulated exercise price on or before a maturity date. A put option is the right to sell an asset at some exercise price. Calls increase in value while puts decrease in value as the price of the underlying asset increases.

9. A futures contract is an obligation to buy or sell an asset at a stipulated futures price on a maturity date. The long position, which commits to purchasing, gains if the asset value increases while the short position, which commits to purchasing, loses.

KEY TERMS

money market capital markets bank discount yield effective annual rate bank discount method bond equivalent yield certificate of deposit commercial paper banker's acceptance Eurodollars repurchase agreements federal funds

London Interbank Offered

Rate Treasury notes Treasury bonds yield to maturity municipal bonds equivalent taxable yield current yield equities residual claim limited liability capital gains price-earnings ratio preferred stock price-weighted average market-value-weighted index index funds derivative assets contingent claims call option exercise (strike) price put option futures contract

http://www.finpipe.com

This is an excellent general site that is dedicated to education. Has information on debt securities, equities, and derivative instruments.

http://www.nasdaq.com

http://www.nyse.com

http://www.bloomberg.com

The above sites contain information on equity securities.

http://www.investinginbonds.com

This site has extensive information on bonds and on market rates.

http://www.bondsonline.com/docs/bondprofessor-glossary.html http://www.investorwords.com

The above sites contain extensive glossaries on financial terms.

http://www.cboe.com/education http://www.commoditytrader.net

The above sites contain information on derivative securities.

WEBSITES

Bodie-Kane-Marcus: Investments, Fifth Edition

I. Introduction

2. Markets and Instruments

© The McGraw-Hill Companies, 2001

PART I Introduction

PROBLEMS

1. The following multiple-choice problems are based on questions that appeared in past CFA examinations.

a. A firm's preferred stock often sells at yields below its bonds because:

i. Preferred stock generally carries a higher agency rating.

ii. Owners of preferred stock have a prior claim on the firm's earnings.

iii. Owners of preferred stock have a prior claim on a firm's assets in the event of liquidation.

iv. Corporations owning stock may exclude from income taxes most of the dividend income they receive.

b. A municipal bond carries a coupon of 6 3/4% and is trading at par; to a taxpayer in a 34% tax bracket, this bond would provide a taxable equivalent yield of:

c. Which is the most risky transaction to undertake in the stock index option markets if the stock market is expected to increase substantially after the transaction is completed?

i. Write a call option.

ii. Write a put option iii. Buy a call option.

iv. Buy a put option.

2. A U.S. Treasury bill has 180 days to maturity and a price of $9,600 per $10,000 face value. The bank discount yield of the bill is 8%.

a. Calculate the bond equivalent yield for the Treasury bill. Show calculations.

b. Briefly explain why a Treasury bill's bond equivalent yield differs from the discount yield.

3. A bill has a bank discount yield of 6.81% based on the asked price, and 6.90% based on the bid price. The maturity of the bill is 60 days. Find the bid and asked prices of the bill.

4. Reconsider the T-bill of Problem 3. Calculate its bond equivalent yield and effective annual yield based on the ask price. Confirm that these yields exceed the discount yield.

5. Which security offers a higher effective annual yield?

a. i. A three-month bill selling at $9,764. ii. A six-month bill selling at $9,539.

b. Calculate the bank discount yield on each bill.

6. A Treasury bill with 90-day maturity sells at a bank discount yield of 3%.

a. What is the price of the bill?

b. What is the 90-day holding period return of the bill?

c. What is the bond equivalent yield of the bill?

d. What is the effective annual yield of the bill?

7. Find the price of a six-month (182-day) U.S. Treasury bill with a par value of $100,000 and a bank discount yield of 9.18%.

8. Find the after-tax return to a corporation that buys a share of preferred stock at $40, sells it at year-end at $40, and receives a $4 year-end dividend. The firm is in the 30% tax bracket.

Bodie-Kane-Marcus: Investments, Fifth Edition

I. Introduction

2. Markets and Instruments

© The McGraw-Hill Companies, 2001

CHAPTER 2 Markets and Instruments

9. Turn to Figure 2.10 and look at the listing for Honeywell.

a. What was the firm's closing price yesterday?

b. How many shares could you buy for $5,000?

c. What would be your annual dividend income from those shares?

d. What must be its earnings per share?

10. Consider the three stocks in the following table. P, represents price at time t, and Qt represents shares outstanding at time t. Stock C splits two for one in the last period.

Po

Qo

Pi

Qi

P2

Q2

A

9o

100

95

100

95

100

B

5o

2oo

45

200

45

200

C

1 oo

200

110

200

55

400

a. Calculate the rate of return on a price-weighted index of the three stocks for the first period (t = 0 to t = 1).

b. What must happen to the divisor for the price-weighted index in year 2?

c. Calculate the rate of return for the second period (t = 1 to t = 2). Using the data in Problem 10, calculate the first-period rates of return on the following indexes of the three stocks:

a. A market-value-weighted index.

b. An equally weighted index.

12. An investor is in a 28% tax bracket. If corporate bonds offer 9% yields, what must municipals offer for the investor to prefer them to corporate bonds?

13. Short-term municipal bonds currently offer yields of 4%, while comparable taxable bonds pay 5%. Which gives you the higher after-tax yield if your tax bracket is:

Find the equivalent taxable yield of the municipal bond in the previous problem for tax brackets of zero, 10%, 20%, and 30%.

The coupon rate on a tax-exempt bond is 5.6%, and the rate on a taxable bond is 8%. Both bonds sell at par. The tax bracket (marginal tax rate) at which an investor would be indifferent between the two bonds is:

16. Which security should sell at a greater price?

a. A 10-year Treasury bond with a 9% coupon rate versus a 10-year T-bond with a 10% coupon.

b. A three-month maturity call option with an exercise price of $40 versus a three-month call on the same stock with an exercise price of $35.

c. A put option on a stock selling at $50, or a put option on another stock selling at $60 (all other relevant features of the stocks and options may be assumed to be identical).

d. A three-month T-bill with a discount yield of 6.1% versus a three-month bill with a discount yield of 6.2%.

17. Look at the futures listings for the Russell 2000 index in Figure 2.14.

a. Suppose you buy one contract for September delivery. If the contract closes in September at a price of $510, what will your profit be?

b. How many September maturity contracts are outstanding?

18. Turn back to Figure 2.13 and look at the Hewlett Packard options. Suppose you buy a March maturity call option with exercise price 35.

a. Suppose the stock price in March is 40. Will you exercise your call? What are the profit and rate of return on your position?

b. What if you had bought the call with exercise price 40?

c. What if you had bought a March put with exercise price 35? Why do call options with exercise prices greater than the price of the underlying stock sell for positive prices?

Both a call and a put currently are traded on stock XYZ; both have strike prices of $50 and maturities of six months. What will be the profit to an investor who buys the call for $4 in the following scenarios for stock prices in six months? What will be the profit in each scenario to an investor who buys the put for $6?

21. Explain the difference between a put option and a short position in a futures contract.

22. Explain the difference between a call option and a long position in a futures contract.

23. What would you expect to happen to the spread between yields on commercial paper and Treasury bills if the economy were to enter a steep recession?

24. Examine the first 25 stocks listed in the stock market listings for NYSE stocks in your local newspaper. For how many of these stocks is the 52-week high price at least 50% greater than the 52-week low price? What do you conclude about the volatility of prices on individual stocks?

SOLUTIONS TO CONCEPT CHECKS

1. The discount yield at bid is 6.03%. Therefore

2. If the bond is selling below par, it is unlikely that the government will find it optimal to call the bond at par, when it can instead buy the bond in the secondary market for less than par. Therefore, it makes sense to assume that the bond will remain alive until its maturity date. In contrast, premium bonds are vulnerable to call because the government can acquire them by paying only par value. Hence it is more likely that the bonds will repay principal at the first call date, and the yield to first call is the statistic of interest.

3. A 6% taxable return is equivalent to an after-tax return of 6(1 - .28) = 4.32%. Therefore, you would be better off in the taxable bond. The equivalent taxable yield of the tax-free bond is 4/(l - .28) = 5.55%. So a taxable bond would have to pay a 5.55% yield to provide the same after-tax return as a tax-free bond offering a 4% yield.

CHAPTER 2 Markets and Instruments

SOLUTIONS TO CONCEPT CHECKS

4. a. You are entitled to a prorated share of IBM's dividend payments and to vote in any of IBM's stockholder meetings.

b. Your potential gain is unlimited because IBM's stock price has no upper bound.

c. Your outlay was $50 X 100 = $5,000. Because of limited liability, this is the most you can lose.

5. The price-weighted index increases from 62.5 [i.e., (100 + 25)/2] to 65 [i.e., (110 + 20)/2], a gain of 4%. An investment of one share in each company requires an outlay of $125 that would increase in value to $130, for a return of 4% (i.e., 5/125), which equals the return to the price-weighted index.

6. The market-value-weighted index return is calculated by computing the increase in the value of the stock portfolio. The portfolio of the two stocks starts with an initial value of $100 million + $500 million = $600 million and falls in value to $110 million + $400 million = $510 million, a loss of 90/600 = .15 or 15%. The index portfolio return is a weighted average of the returns on each stock with weights of V6 on XYZ and % on ABC (weights proportional to relative investments). Because the return on XYZ is 10%, while that on ABC is -20%, the index portfolio return is V6 X 10% + % X (-20%) = -15%, equal to the return on the market-value-weighted index.

7. The payoff to the call option is $4 per share at maturity. The option cost is $3.50 per share. The dollar profit is therefore $.50. The put option expires worthless. Therefore, the investor's loss is the cost of the put, or $3.40.

E-INVESTMENTS:

Go to http://www.bloomberg.com/markets/index.html. In the markets section under

INTEREST RATES

RATES & Bonds, find the rates in the Key Rates and Municipal Bond Rates sections.

Describe the trend over the last six months in

Municipal Bonds Yields

AAA Rated Industrial Bonds

30-year Mortgage Rates

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