PRICING OF FUTURES, CROSS HEDGE, LEVERAGE, HEDGE FUNDS

FCA Kapil Agrawal

Basis

Basis is the difference between the cash / spot price and the future price of the underlying at a particular location. At expiry, this BASIS becomes Zero.

Graphically, if X Axis is the Time period and we take price at the Y Axis, the graph of Basis or (Futures and spot) shall be like the tip of an arrow >.

BASIS encourages ARBITRATION.

Pricing Of Currency FuturesCost of Carry approach: According to some

economists, futures price is essentially the cost of carrying the underlying.

Thus future price = Spot price + Storage cost + Insurance Cost + Transportation cost + Interest Cost.

The Expectation Approach: It is argued that future price depends on the expected price of the underlying in future. Therefore, a speculative element also creeps in the pricing.

The Perfect Hedge Vs Cross HedgingHedging, as we know, is the act of protecting oneself against risk due to adverse price movement.

In other words, the hedge is a future position that is taken as a temporary substitute to protect the value of an existing position. The futures positions, which completely eliminates price risk as well as quantity risk in business is called the PERFECT HEDGE.

Perfect Hedge arises when 1.The time horizon or maturity exactly matches the expiry date.2.The quantity to be hedged matches exactly with the quantity of the futures contact.3.The quality of the underlying asset is available in the future contract.

In practice, however, it is rare that all factors match so well. There is still possibility to hedge against risks in RELATED ASSETS (in case of asset or quality mismatch) or in future contacts which mature at different time. Such hedge is called a CROSS HEDGE.

Contd.Cross hedge cannot be expected to effectively reduce complete risk as compared to direct hedge but, if used properly, they do considerably hedge the risks.Example:-A firm receives export payments in Canadian dollars, wishes to hedge future downward risk. Canadian dollar is not traded in Indian currency markets. Past statistics reveal that fluctuation in Canadian dollar is in parallel to that of US$. We can consider cross hedging the value of Canadian dollar with a position in US $ although such hedge is not trustworthy. Additionally we can create a position in US Forex markets and hedge the US $ with Canadian dollar.-The availability of Euro future contacts is 31st Jan & 29th Feb and an exporter’s schedule of payment from Great Britain is due on 15th Feb. The trader wishes to hedge to safeguard against the forex fluctuations. He can cross hedge 29thFeb contract and square off trade of 29th Feb on 15 Feb- A trader has to hedge $ 22500 dollars while contract size is 1000 $.He has to cross hedge 22 contracts only, which is the nearest quantity available.The objective of hedging is to reduce the exposure to risk. With the help of cross hedging, majority of the risk can be avoided.

Leverage In Currency FuturesSHORTRADER COMPANY takes SHORT POSITION in 200 contracts of US $ @ Rs 60/- at 5% margin. US $ declines to Rs 59/- in one months’ time.

What is the amount of exposure taken by SHORTRADE COMPANY?What is the investment of the company ? (Margin)What is the amount of profit/ loss earned by the company ?What is the percentage profit earned by the company ?

Answer

1. Rs 60 x 200 x 1000 = Rs 120 lacs2. 120 lacs x 5% = Rs 6 lacs3. 200 x 1000 x 1 = Rs 2 lacs4. 33 %

MACRO HEDGE FUNDSMACRO “HEDGE” FUNDS

MACRO HEDGE FUNDS make their profits from speculation, and their portfolios are often highly risky. Most macro hedge funds are also highly leveraged—that is, the amounts invested in their portfolios, the firms’ assets, are much greater than their share capital, with investments in excess of capital being financed by borrowing.

Leverage increases the potential profits of shareholders, but it also increases their risks:

The greater the leverage, the bigger the profit to shareholders if investments are successful and the bigger the loss to shareholders if they are not.

ARBITRAGE “HEDGE” FUNDSARBITRAGE “HEDGE” FUNDS

ARBITRAGE HEDGE FUNDS use sophisticated models to detect arbitrage opportunities—differences in the prices of nearly equivalent securities or portfolios—in financial & currency markets. Having detected such opportunities, those funds construct arbitrage trading strategies to profit: they buy securities that are underpriced and sell those that are overpriced, while simultaneously taking offsetting positions to hedge against any risks involved and lock in their arbitrage profits. Arbitrage is a relatively low-risk activity.

The Story of LTCM

LTCMLong-Term Capital Management was founded in March 1994 by John Meriwether,a former Salomon Brothers trading star, along with a small group of associates, mostnotably economists Robert Merton and Myron Scholes, who received the Nobel Prizein Economics in 1997. The fund initially specialized in high-volume arbitrage trades in bond and bond-derivatives markets but gradually became more active in other markets and more willing to speculate. The fund thus started as an arbitrage fund but gradually became more like a macro fund.LTCM was very successful: by the end of 1997 it had achieved annual rates of return of around 40 percent and had nearly tripled its investors’ money. That track record and the prestige of its associates made LTCM very popular with investors and was a darling of WALL STREETShare capital of LTCM was $ 7.3 billion and assets had grown to about $120 billion.However, despite that high leverage—an assets-to-equity ratio of over 16 to 1—the management of LTCM concluded that the capital base was too high to earn the rate of return on capital for which they were aiming. They therefore returned $2.7 billion of capital to shareholders, thus cutting the fund’s capital to $4.8 billion and increasing its leverage ratio to around 25 to 1. In effect, the management of LTCM had taken a major gamble: they made the firm much riskier, in the hope of bolstering the returns to shareholders

LTCM Gets into DifficultiesUnfortunately, LTCM’s luck ran out not long afterwards. Most markets were edgy during the first part of 1998, but market conditions deteriorated sharply in the summer and led to major losses for LTCM in July. Disaster then struck the next month, when the Russian government devalued the ruble and declared a moratorium on future debt repayments. Those events led to a major deterioration in the creditworthiness of many emerging-market bonds.This was very bad for LTCM because the fund had bet massive exposure in such bonds. When LTCM wanted to sell these contracts when they started taking losses, they could not get out of their positions at a reasonable price since there were few buyers. And the buyers knew they were in distress. The huge size of LTCM's leveraged capital base forced them into markets with less liquidity.To make matters worse, the fund sustained major losses on other speculative positions as well. As a result, by the end of August LTCM’s capital was down to $2.3 billion and the fund had lost over half of the equity capital it had at the start of the year

Contd.As its losses mounted, the fund had increasing difficulty meeting margin calls and needed more collateral to ensure that it could meet its obligations to counterparties.

The fund was running short of high-quality assets for collateral to maintain its positions, and it also had great difficulty liquidating its positions: many of its positions were relatively illiquid (i.e., difficult to sell) even in normal times and hence still more difficult to sell—especially in a hurry—in nervous and declining markets.

The fund was now in very serious difficulties. Not surprisingly, that information soon leaked out and the fund’s problems became common knowledge.

The Federal Reserve Intervenes

Cont..There was concern at the US Federal Reserve that if LTCM defaulted on their contracts it would cause chaos and a market crash. This in turn could place the US economy in danger. So the Fed organized a bail-out. A consortium of banks and trading houses put four billion dollars into LTCM. In return the consortium took possession of LTCM's market positions. The investors that had money in LTCM got ten cents on their invested dollar. The partners were largely wiped out. Once LTCM's market positions were unwound the rescue consortium made money on their investment.

LTCM's mistakes were made fatal by massive leverage and lack of liquidity. If not for their huge leverage, LTCM could have survived these mistakes, or at least survived without such breathtaking losses.

THANK YOU

FCA KAPIL AGRAWAL