Principles of Behavior Modification Note Set 2 Gary L. Cates, Ph.D., N.C.S.P.
Set 2 Principles
Transcript of Set 2 Principles
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Principles
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Definition and Types
Physical delivery vs Cash Settlement
Principles of hedging and speculation
Types and Positions
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DEFINITION OF FUTURES CONTRACTS
standardised legal agreement to buy or sell a
commodity or financial instrument at a specifiedprice, at a specified time in the future
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REQUIREMENTS FOR A VIABLE
FUTURES MARKETS
A deep market
Commodity must be in abundant
supplyCommodity must be easily graded
Prices must be free to fluctuate
Prices must be reported publicly
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THE FUTURES CONTRACT
Standard Features: Physical delivery or cash settlement
Expiry date
Contract months
Contract size
Price Quotations
Grade
Underlying instruments
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HEDGING
CASH MARKET FUTURES MARKET
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HEDGING
Taking a position in the futures market
to offset the loss in the cash
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TYPES OF HEDGEANTICIPATORY
- Taking the same position in the futures market
now that you intend to take in the cash marketlater
HEDGING CURRENT MARKETPOSITION/PORTFOLIO HEDGE
- Taking an opposite position in the futures marketthat you have already taken in the cash market
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WHY HEDGE?
To preserve and promote wealth by reducing exposureto financial and commodity price movements,catastrophes, variable operating costs and income
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ADVANTAGES
Liquid and central market
- high volume and turnover lead to the ease of entering andgetting out of the market
Leverage- pay a small capital outlay to have a sizable value of contracts
Positions may be close out- contracts can be close out at any time when required
Convergence of futures and cash prices- at maturity futures price should be equal to cash price
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DISADVANTAGES
Standardized contracts
- since it is standardized, therefore mayunderhedged or overhedged.- e.g. RM1.8million portfolio
Initial and variation margins- traders may not feel comfortable with thepayments of margins
Forgo benefits of favourable movements- would not be okay if what the trader anticipatesdid not materialize
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STEPS IN IMPLEMENTING A HEDGE
DETERMINE THE TYPE OF HEDGING
DETERMINE THE NUMBER OF CONTRACTSNEEDED TO HEDGE
DETERMINE THE CONTRACT MONTHS
DETERMINE THE EFFECTIVE BUYING OR SELLINGPRICE
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HEDGE IMPERFECTIONS
BASIS RISK risk that futures and cash instrument pricesare not equal at expiry or are not perfectly correlated
- delivery basis difference between the cost of deliveryof futures and cash instrument
- grade basis difference between the grade of futures andcash instrument
- location basis difference between prices in differentmarkets or areas
AMOUNT HEDGED hedge may not cover exactly the
amount of the cash instrument TIMING differences in timing of futures and cash
instrument
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SPECULATING WITH FUTURES
Speculators provide liquidity to a market and
continuous trading Speculators are attracted to the market because of:
high leverage
low transaction costs and commission as
opposed to stock or property market
large and small traders have equal access to the
market
minimal administrative works
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TYPES OF SPECULATORS
OUTRIGHT POSITIONS: buy low sell high
Scalpers goes for minimum price fluctuations on heavyvolumes, taking small profits or losses, rarely holdovernight positions
Day traders
does intraday trading and differs fromscalpers in that his volumes are smaller
Position traders looks are long term price trends, mayhold a position for days, weeks or months and only close
out when prices are favourable
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SPREAD TRADING:
simultaneous buy and sale of related contracts inorder to profit from a change in the differencebetween the two futures prices
Intracommodity spread
Same futures contracts but different delivery months Intercommodity spread
Different futures contracts, same delivery months Different futures contracts, different delivery months
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INTRACOMMODITY SPREAD
In a normal market, the nearby month sells at adiscount to the distant delivery
Therefore, trader buys the nearby maturity andsells the distant maturity in anticipation of a
narrowing in the spread difference
EXAMPLE
Buy 5 Mar CPO at 1100, sell Jul CPO at 1130
Later sell 5 Mar CPO at 1109, buy Jul CPO at 1134
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INTERCOMMODITY SPREAD
Involves the simultaneous purchase and sale of
different, but related, commodities in the same ordifferent markets and in the same or differentdelivery months
ExampleBuy March corn on the CBOT and sale of Marchoats on the CBOT.
or
Buy June CPO on the Bursa Malaysia DerivativesExchange and sale of June Soybean oil on theCBOT
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ARBITRAGE
Simultaneous purchase and sale of the same
instruments in two different markets to profit frommispricing
Example buy physical gold and sell gold futures
Need to determine whether the futures price is tradingat itsfair value.
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Cost of carry model
irescontractfutureswhentimet
storageoftc
productcashtheonyieldy
ratefreeriskr
pricecashS
pricefuturesF
where
ycrSF t
exp
(%)cos
)1(
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Cost of Carry Calculation
EXAMPLE
If the cash price for gold is US$410 per oz, storagecosts for 1 year is US$8 per oz and the risk-freerate is 6%, what is the fair value price of a gold
futures contract expires three month from now?
92.417
)]410/8[06.01(410 12/3
FV
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Exercise If the cash price for CPO is RM3210 per MT,
storage costs for 1 month RM2 per MT and the
risk-free rate is 6%, what is the fair value price of aCPO futures contract expires three month fromnow?
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