Chapter 12 Futures Basic Terminology Spot

Chapter 12 Futures

Basic Terminology • Spot market: market for immediate delivery of some commodity, such as wheat or Government bonds • Forward contract: customized, nonstandard contractual agreement to trade specified commodity or financial instrument at agreed-upon price, settlement date, quantity, and location • Futures contracts: standardized contracts that can be bought and sold on an exchange

Difference between Futures Owner and Option Holder • Futures buyer has obligation to accept and pay for specified quantity of asset at specified price at specified time • Option holder has right—but not obligation—to buy or sell specified quantity of asset at specified price over specified time period

Differences Between Forward Contract and Futures Contract • Forward contract: nonstandardized (unique) contract between parties to accept delivery (buy) and deliver (sell) specified commodity or financial instrument at agreedupon price, settlement date, quantity and location. – There is no organized exchange for trading forward contracts. • Futures contract: standardized contract divided into two contracts—one to buy and one to sell—a specified commodity or financial instrument. – Futures trade on organized exchange that sets contract terms, establishing price, quantity, delivery location, and date.

Exchanges • Oldest is Chicago Board of Trade • In 2003, 19 exchanges listed in WSJ

Types of Professional Futures Market Traders • Firm representatives: hedge needs or outputs of commodity-related firms • Scalpers: look for temporary misalignments of prices, hold positions for a few minutes at most • Day traders: short-run traders who close their positions each day • Position traders: may hold positions for several days based on fundamental or technical factors • Arbitrageurs: seek to exploit departures from expected relative price relationships, but may hold positions for extended time periods

Regulation of the Futures Markets • Primary regulator: Commodity Futures Trading Commission (CFTC) – mission : protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets

Types of Contracts • Agricultural – cattle, hogs, chickens, wheat, oats, corn • Mineral – crude oil, natural gas, gasoline, copper, zinc • Financial – interest rate, stock market index, foreign currency

Ingredients for Good Contract · Relatively competitive spot market · Meaningful, standardized contract (for example, a well-defined deliverable) · Storability or its equivalence (that is, ongoing production) · Sufficient price volatility to attract (or require) speculative and hedging interest · Significant business use for product

Characteristics of Contracts • Many contracts per commodity (e. g. , differ by delivery date) • Each contract has large dollar value

Clearinghouse • Clearinghouse critical to futures market • Trade technically with clearinghouse, not person on other side • Clearinghouse guarantees terms of contract

Long and Short Transactions Long transaction • Contract to make a purchase in the future • Going long Short transaction • Entering into contractual agreement to deliver asset in future at specified price • Going short

Closing Out a Position • In options or futures trading, using an offsetting transaction to remove investor from further exposure to investment and to lock in profits or limit losses

Closing vs. Delivery • Majority of commodity contracts are closed out • Inconvenient for shorts to make delivery and longs to take delivery • When hedging, people close out hedge and buy/sell in their local cash market

Round-Trip Fee • Total commission costs of executing transaction in futures market paid at time of contract’s formation

Large $ Value &Earnest Money • Most contracts have large $ value • Dollar price per unit usually “small”, but most contracts are for a large # of units • Margin deposit that serves as security to guarantee performance of contract by buyer and seller of a futures contract (5 – 15% of market value) • In general, money put on deposit to guarantee honoring of contract’s terms

Mark to the Market • Recompute value of equity position on daily basis • Ensures that, as prices fluctuate, amount held in margin or escrow account remains sufficient to meet minimum requirements • Brokerage firms mark to the market to reduce risk that client might default.

Daily Price Limits • Rule established by futures exchanges for maximum range of price movement permitted between settle price of previous day and opening price of next day of trading for any given commodity • Once limit is reached, trading must stop until next trading session.

Open Outcry • No specialists • Traders deal directly with one another • Desired contract indicated by position on floor • Hand signals are critical for communication

Trading Strategies • Hedging: taking opposite positions to reduce risk exposure on one of positions • Speculating: the act of committing funds in anticipation of specific price movement • Spreading: creating a combination trade, such as both long and short position in the futures market

Hedging • Person must take position in commodity for business reason – Example: a farmer is long the crop in his field • While crop is growing, farmer is exposed to price risk—risk spot market price of crop will fall • If farmer sells a futures contract, he replaces price risk with basis risk

Basis Risk • Basis = cash market price – futures market price • In perfect hedge, basis does not change • Basis risk = risk that basis will change • Hedger substituting basis risk for price risk • Hedge successful as long as basis risk is less than price risk

Short and Long Hedges • Short hedge – Hedger is short the futures contract and long the commodity • Example: farmer is long the crop in the field, and takes short position in the futures contract • Long hedge – Hedger is long the futures contract and short the commodity • Example: builder has contracted to build home, and takes long position in a plywood futures contract

Short Hedge Example • Farmer plants 30, 000 bushels of corn Current spot (cash) market price = $5. 20/bu. If corn harvested and sold today, proceeds = 30, 000 x $5. 20 = $156, 000 • Farmer sells 6 futures contracts at $5/bu. • Basis = $5. 20 – $5. 00 = $. 20 • Farmer provides broker with margin (continued)

Short Hedge Example (continued) • Time to harvest arrives Cash price = $4. 50/bu. Futures price = $4. 30/bu. Basis still = $. 20 (turns out to be perfect hedge) • Farmer harvests & sells corn for: 30, 000 x $4. 50 = $135, 000 (continued)

Short Hedge Example (continued) • Farmer closes out futures position ($5. 00 – $4. 30) x 30, 000 = $21, 000 profit • Farmers total proceeds with hedge: Proceeds from sale of crop: Profit on futures hedge: Total Proceeds $135, 000 21, 000 $156, 000

Speculating & Spreading • Speculating: maximum risk exposure – Investor thinks he or she knows something others do not • Spreading – Offsetting positions in related contracts – Betting on change in the differential – E. G. , Dec corn will rise relative to March corn

Differences between Markets in Commodities Futures and Stocks Commodities Futures • • Limited term Maximum daily price moves Margins of 5% to 15% Long interest equal to short interest by definition No short selling restrictions No interest charged on unpaid margin Market has no specialist system Positions must be opened and closed with same brokerage firm Stocks • • Unlimited term No limit on daily price moves Margins of 50% or more Short interest usually small fraction of long interest Short sales not permitted on a downtick Interest incurred on margin debt Market making by specialists No restriction on opening and closing positions with different firms

Interest Rate Futures • Futures contract calling for delivery of a debt security, such as Treasury bills or longterm government bonds • Because value of debt securities varies inversely with market interest rates, people can speculate on interest rate changes by trading futures contracts on debt securities.

Stock Market Index Futures • Futures contract on stock index that does not require delivery of underlying stock index but is instead settled in dollars according to difference between price agreed to in the contract and the actual closing price of the index

Cash Settlement • Stock index futures require cash settlement because: – Awkward or impossible to deliver index bundle – Potentially expensive to deliver index • Cash settlement process: – At close of last day of contract life, open positions are treated as closed out at index price

Futures Options • An option on a futures contract • In theory, treated like any other option contract

Program Trading • Any large-volume, mechanical trading system • Involves the simultaneous execution of trades in a number of stocks • Allows one to hedge or arbitrage a stock index futures contract with the underlying portfolio • Leads to concept of portfolio “insurance”