Got done with this reading today. First off, all the optional material really helped me in re-learning the gory details of Futures. After that, it was an easy ride, because most of the material builds upon the same formulae that were introduced in Reading 62. The only different part here would be Eurodollar futures and the problem in hedging because of them.
Eurodollar futures cannot be priced as easily as T-bill futures, because the expiration price of a Eurodollar futures of the underlying Eurodollar time deposit is based on 1 divided by a rate. The difference is small, but not zero. Hence, Eurodollar futures do not lend themselves to an exact pricing formula based on the notion of a cost of carry of the underlying.
The eurodollar time deposit is an add-on instrument, where as the eurodollar futures is a discount instrument, like a T-bill contract. So, the total position that we’re exposed will be:
1/[1+L(m)(m/360)] +f(h)- [1-L(m)(m/360)]
Even though f(h) is known during contract initiation, the rate m% is not known until the futures expiration after ‘h’ days. So the two m terms do not exactly off set.
Another important concept was the contango and the backwardation.
Futures price= FV of the spot rate +FV of (cost- benefit).
If FV(CB) is positive, (cost and interest charges >benefits), then futures price is greater than the spot rate, and this is known as contango.
On the other hand, if the benefits exceed the cost and interest charges, then FV(CB) is negative, and futures price will be less than the spot price. This is known as backwardation. Since we cannot predict the FV(spot) with certainty, we work with the expected FV of the spot rates. In this case, contango is called normal contango and backwardation is called normal backwardation.
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Four more readings in Derivatives left- I know all of them already…so shouldn’t take me more than 4 days in total. Then I’m going to start Economics.
Beat the Beast 