Chapter 29 – Applications of Futures and Options

1. Chapter 29 – Applications of Futures and Options BA 543 Financial Markets and Institutions

2. Chapter 29 – Applications of Futures • Two types of Positions • Hedge Position • Buying or Selling Futures when one owns the underlying (long in commodity) or will need the commodity (short in the commodity) • Buys or Sells Futures to offset price volatility • Speculator • No position in underlying commodity (Naked) • Betting on price movement to make money • Zero-Sum Game in Futures (and Options)

3. Chapter 29 – Applications of Futures • The Basic Hedge • From the long commodity position • From the short commodity position • The role of speculation • Price discovery • Risk transfer • Some historical issues with “speculators” • Mechanics of the recording of trades and allocation of buys and sells within a trading company

4. Chapter 29 – Applications of Options • Why hedge with options over futures? • Switch from risk neutral to potential upside • With Futures you avoid the downside by giving up the upside • With Options you pay a premium to avoid the downside but still have the upside potential • Other side of the contract • Speculator (no position with underlying asset) • Taking risk for a premium – insurance company

5. Chapter 29 – Applications of Options • Generic Model of Options Hedging • Long in Stock – protective put on stock • Portfolio of Stocks – buy put on a stock index • Long in Commodity – Need option to “sell” futures contract if prices fall • Buy a put option • Short in Commodity – Need option to “buy” futures contract if prices rise • Buy a call option • Interest Rate Options