The Black model should not be used for valuing American options on currency futures because it may be optimal to exercise the options early in the same way as it may be optimal to exercise options on the spot currency early. The binomial or the Barone-Adesi and Whaley models may be used for valuing those options.

The early exercise potential of American options on futures is different to that of options on the spot. Futures prices do not exhibit the discrete jumps that accompany spot market assets when the underlying spot asset makes discrete distributions. However, as the carry basis of the future converges to zero at delivery, the futures price converges to the spot price in an orderly manner. Read more »

Posted: June 22nd, 2008 under Currency Futures, Futures Options, Futures Prices, Swap Futures, investment.
Comments: 4

This section explains two of the many uses of options that rely upon the ability of the option buyer to abandon the option at no extra cost. The first is the purchase of options to insure against a fall in the value of a currency. The second is the hedging of the currency risk in a foreign currency tender.

Purchasing options as a form of insurance

If a US investment manager has strong expectations of a rise in the value of Sterling but wishes to insure against being totally wrong, slightly out-of-the money puts will provide the required insurance. Read more »

Posted: June 21st, 2008 under Commodities Futures, Equity Futures, Foreign Exchange Futures, Future Fund, Future Investing, Futures Options, Futures Prices, Futures Spreads, Futures Trading System, Managed Futures, Stock Futures, Stock Market Futures.
Comments: 5

As with all other forms of futures contract, the fair price of short-term interest rate futures should preclude any arbitrage possibilities between the futures market and the underlying cash market. In the case of bank deposit interest rate futures, there should be no arbitrage possibilities between the forward interest rate implied by the future and the forward interest rate available on the appropriate type of bank deposit. For example, a three-month eurodollar futures contract that has 135 days to maturity should not provide any arbitrage possibility with the 135-day forward rate on a three-month eurodollar deposit. Read more »

Posted: June 20th, 2008 under Future Trading, Futures Contracts, Futures Market, Futures Prices, Interest Rate Futures.
Comments: 5

It was shown that it is possible to lock in a forward rate of interest. However, depositors will only lock in a forward deposit if the rate that results is at least as favourable as the rate that they expect to prevail at the future point in time. If the forward rate implied by the current rates was above investors’ expectations, theinvestors would increase their borrowing for 90 days, causing upward pressure on that rate, and increase their deposits for 180 days, causing downward pressure on that rate, thereby bringing the 90-day forward rate down to current expected levels.

Conversely, if the implied forward rate were below expectations, investors would borrow for the longer term, raising that rate, and deposit for the shorter term, lowering that rate, until the implied forward rate matched expectations. Read more »

Posted: June 20th, 2008 under Future Exchange, Futures Contracts, Futures Market, Futures Prices, Interest Rate Futures.
Comments: 6

As the name implies, an FRA is an agreement to buy or sell a forward rate of interest on a notional principal amount. Remembering that interbank deposit rate futures also relate to forward rates of interest, the similarity between the two instruments will be obvious. Conceptually, the seller of the FRA undertakes to provide an agreed rate of interest on a notional deposit of a specified size at a previously agreed future date. Thus the FRA locks in the rate of interest on a forward deposit, the forward rate of interest.

An FRA relating to the interest rate on a six-month deposit starting in three months time is referred to in FRA market parlance as a 3 against 9 (or a 3 vs 9) FRA. This clearly indicates that, in this example, the appropriate interest rate is the six- month forward rate three months hence. Read more »

Posted: June 18th, 2008 under Futures Contracts, Futures Prices.
Comments: 3

Bonds are frequently purchased to fund future liabilities because of the relative certainty of the cash flows which are set contractually. However, the certainty as to the value of the terminal value of those future cash flows depends upon two factors:

the rate at which the future coupons can be reinvested remaining unchanged;

if the bond has a maturity longer than the desired holding period, the level of interest rates is the same at the beginning and end of the holding period. Read more »

Posted: June 17th, 2008 under Crude Oil Futures, Futures Options, Futures Prices, Futures Spreads, Short Futures, Silver Futures.
Comments: 5

Term structure based option-pricing models

Term structure models of pricing contingent claims have followed one of two approaches. One approach followed by Cox, Ingersoll and Ross (1985) actually model the expected returns from movements in the term structure in order to price the contingent claims. In effect, the term structure becomes endogenous to the pricing of the contingent claim.

The second approach followed by Ho and Lee (1986), Heath, Jarrow and Morton (1989), Black, Derman and Toy (1990) and Hull and White (1990) utilizes the volatilities of the various sectors of the term structure to derive a probability distribution of an arbitrage-free binomial, trinomial or multinomial lattice of the term structure. From this lattice, contingent claims are priced. These models all have one thing in common: they allow for the whole-term structure to be stochastic instead of the price of a single underlying instrument or a single interest rate. The whole-term structure is represented at each node of the binomial, trinomial or even multinomiaf lattice. Read more »

Posted: June 15th, 2008 under Currency Futures, Future Fund, Future Management, Future Trading, Futures Index, Futures Market, Futures Prices, Futures Spreads, Futures Trader, Futures Trading System, Managed Futures, S&P Futures, Stock Futures, investment.
Comments: 3

Asset swaps are different, in that they are linked to the purchase of an asset and the swapping of the cash flows of that asset. They are therefore used synthetically to engineer an asset structure rather than a liability structure.

The idea behind an asset swap is to enhance returns to the investor rather than hedging or lowering costs to a borrower. The objective is to find some underpriced fixed rate bond which is then purchased by an investor that would prefer a floating rate investment. The coupons are then swapped with a bank that has fixed rate liabilities at a lower cost. The bank thereby receives a fixed payment that is higher than the cost of its existing fixed rate debt. Read more »

Posted: June 8th, 2008 under Future Management, Futures Index, Futures Market, Futures Options, Futures Prices, Futures Spreads, Futures Trading System, Managed Futures, Swap Futures.
Comments: 3

The granddaddy of commodity indexes is the KR-CRB Futures Price Index. The initials stand for Knight-Ridder Commodity Research Bureau. Developed in 1957, The KR-CRB Index was designed to monitor the broad-based price movement of the commodity market as a whole. It answers an important question, i.e., “Are commodity prices going up or down at any given point in time?” It is made up of futures contracts on the following commodities:

• Meats—cattle, hogs, pork bellies
• Metals—gold, silver, platinum
• Imports—coffee, cocoa, sugar
• Industrials—crude oil, cotton, copper, unleaded gas, heating oil, lumber
• Grains—corn, wheat, soybeans, soybean oil, soybean meal
• Miscellaneous—orange juice

None of the financial markets were included since they did not exist in the ’50s. Since it does include physical commodities, which are so heavily influenced by inflation and deflation, bond traders love its inverse correlation with their market. Read more »

Posted: March 10th, 2008 under Futures Contracts, Futures Prices.
Comments: 4

The professionals within this industry have their own trade association, the Managed Futures Association. Its function is to assist members, to promote the industry, and to advance the industry. They produce an excellent monthly professional journal that discusses issues important to members, everything from legislation, regulatory compliance, trade execution, to marketing. Their annual membership directory is an excellent source to find CTAs and CPOs.

Commodity pool operators are the individuals or corporations who structure funds. These are pools of commingled money from a number of individual investors. Most of the funds are large enough to require multiple CTAs. If the funds are properly selected, this further reduces risk, as we saw earlier. Most CPOs closely follow the performance of a large number of CTAs and analyze their performance. For this reason, CPOs can be excellent consultants in CTA selection. Read more »

Posted: March 4th, 2008 under Futures Index, Futures Market, Futures Options, Futures Prices, Futures Trading System, Managed Futures, investment.
Comments: 4