Forward Market Relationships
Futures Trading and Its Changing Face in
Indonesia
Jakarta June 13, 2001
Robert I. Webb
University of Virginia
© 2001
Hedging
• Hedging is analogous to putting on a spread
position.
• That is, there is one long leg and one short
leg of the hedge.
• The idea is that the losses (gains) on the
short leg will partially or fully offset the
gains (losses) on the long leg of the hedge.
Perfect Hedge
• A perfect hedge means that losses on one
leg of the hedge fully and exactly offset
gains on the other leg of the hedge.
• In practice, most hedges are imperfect.
That is, the gains on one leg will not exactly
offset the losses on the other leg.
• This is known as basis risk.
Hedging
• Losses on hedged positions may arise for a
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number of reasons including:
Maturity mismatches;
Hedging vehicle mismatches (that is, crosshedging)
Incorrect hedge ratio
Liquidity crises.
Hedging
• Basis risk exists for many hedge positions.
• Normally, the basis risk is less than the risk
of holding a position outright.
• During a liquidity crisis one may experience
losses on both legs of the hedge.
Synthetic Securities
• Basically, a perfect hedge is equivalent to a
default-free Treasury bill position.
• Put differently, one may regard the creation
of hedge positions as equivalent to the
creation of synthetic treasury bills.
Synthetic T-Bill Position
• A hedged position is equal to a comparable
maturity synthetic Treasury bill position.
• S – F = PV(X)
• That is, a long spot market position and
short forward position equals the present
value of a zero coupon bond.
When Yields on Synthetic and
Actual Treasury Bills Differ
• Not surprisingly, occasionally the prices or yields
of synthetic Treasury Bills will differ from the
yields on actual Treasury bills.
• This creates an arbitrage profit opportunity.
• If actual Treasury bills yield more than synthetics
one can invest in actual Treasury bills and finance
the investment by selling synthetics (that is,
borrowing at a lower risk free rate).
When Yields on Synthetic and
Actual Treasury Bills Differ
• Similarly, if actual Treasury bills yield less
than synthetic Treasury bills then one can
sell the actual and buy the synthetic.
• This is tantamount to being able to borrow
at the same rate the Treasury can and invest
at a higher but still risk-free yield.
Synthetic Cash Market Position
• Not surprisingly, one can create synthetic long
cash market positions by combining an investment
in Treasury bills with a long futures position.
• S = F + PV(X)
• Conversely, one can create a synthetic short cash
market position by combining a short futures
position with a short Treasury bill position (that is,
borrowing at the Treasury bill rate.
• -S = -F – PV(X)
Implied Repo Rate
• The “repo” or repurchase agreement market
is a collateralized short-term loan market.
• The yield on a perfect hedge is known as
the implied repo rate.
Exploiting Yield Discrepancies
• If the implied repo rate (IRR) exceeds the Tbill yield then one should create a synthetic
long T-bill position and sell the actual T-bill.
• If the implied repo rate is less than the
actual T-bill yield one should create a
synthetic short T-bill position and buy the
actual T-bill.
Synthetic Spot Position
• Solving the previous equation for S yields:
• S = F + PV(X)
• That is, a synthetic cash market position can
be replicated by combining a long forward
position with a long T-bill position.
Synthetic Forward Position
• Solving the earlier equation for F yields:
• F = S – PV(X)
• A forward position can be thought of as a
levered cash market position. Initially, S =
PV(X) because no money changes hands
when a forward position is opened.
Synthetic Short Security
Positions
• Synthetic short security positions can be
easily created by multiplying through any of
the above equations by a –1.
• -S = -PV(X) –F
• -F = PV(X) –S
• -PV(X) = F-S
Uses of Futures
• Futures allow one to quickly change the risk
profile of a portfolio without changing the
composition of the cash market position.
• This can be very important when the sale or
purchase of cash market securities would be
very time consuming. When illiquid
securities are involved quick sales or
purchases may have a price impact.