several questions, in market risk part A

[itsyourz]

Hi David!

i have several question regarding to market risk part A slides

1) could you explain about short squeez roughly ?

2) the relationship between forward and futures prices,
i want to know the reason why both of them are affected by strong correlation and contract life,
could you explain it intuitively? or mathematically if it's not too hard

3) last question about delivery options in the futures market
it says. if futures price is increasing function of time to maturity, short should deliver as early as possible
increasing function means contango? doesn't it? and the other situation is about backwardation isnt't it?
i dont get it why seller should deliver at either beginning or end of the period depending on the the function of future price.

thanks!

Suk

 

[David Harper CFA FRM]

Hi Suk,

1) The short uses borrowed shares to sell them today, with the goal of subsequently purchasing them at a lower price. A squeeze is when the broker can no longer borrow the shares and requires the short to close out the position (purchase them earlier than he'd prefer). These short shares are initially sold on "borrowed time."

2) Here is a long thread exploring this. See Hull 120.
The theory is that the PV of a forward position is equal to:
1. Cash invested today at the discounted forward price (F0*exp[-rT]) so that the cash is available for the forward in the future plus
2. The underlying asset received (per the long forward) in the future. If E(St) is future expected spot, then E(St)*EXP[(-r)(T)] is its PV.

So value of forward = -cash outlay + expected benefit = -F0*exp[-rT]) + E[St]*EXP[-rT]

But, here is the key: the E[St]*EXP[-rt] is discounted at (k) instead of (r), where k is the investor's disount rate. So the above reduces to: forward F0 = E(St)*EXP[(r-k)*T]. And with positive correlation, k > r; i.e., the investor's discount rate (k) must be greater than the riskless rate (r).

There is a simpler way to think about this: with capital asset pricing model (CAPM).
Correlation (asset, market) = beta * vol(asset)/vol(market).
Higher correlation = higher beta = higher expected return and higher expected return implies a lower current price paid for the forward. In this way higher correlation/beta implies higher expected return and this requires a lower current price today.

3) yes, an increasing forward curve is the very definition of contango. Contango implies cost of owning is more than benefit of owning (convenience yield); i.e., the forward who does not own will need to pay more in the future to the owner who bears the burden of ownership. So, if that is the case, then the owner (make delivery to satisfy the short) wants to release the asset sooner rather than later. If backwardation, convenience of ownership outweighs cost and short will want to hold asset as long as possible

David