FUTURES DEFINITION Futures (forward) contracts are agreements between two agents where one agrees to purchase and the other to sell (deliver) a given amount of a specific commodity at a specific price at a future (prompt) date. Like an order for furniture, house, car, etc. at fixed price.
BASIC FEATURES • Both parties are "obliged" -> not optional • Buy (long) - sell (short) • Like options - zero sum - derivative security • No money changes hands initially - Margin put up • Mark to market daily - money moves between margin accounts • Delivery is seldom taken - only 2% (like options) • 70% of traders lose money - some win big (Hillary).
FUTURES VS. FORWARD CONTRACTS FUTURES CONTRACTS ARE STANDARDIZED • • • sold on exchanges - Chicago Board of Trade (1848) involve clearing house trading in pit - no specialist - different prices FORWARD CONTRACTS ARE NOT STANDARDIZED • • • sold over the phone (over the counter) no clearing house common for currency trading - banks 24 hour market no mark to market - end day settlement allow contingent delivery - sale of house etc.
Look at Futures Quotes – www. futuresource. com QUESTION: Which commodities are likely to have futures traded? commodity that can be graded - standardized - widely used - volatile price HOW USED - HELPS BUSINESSES PLAN • • hedging - farmer - short hedge -grain processor long hedge speculating - traders virtual company - trade crude against gas to earn change in refiner profit
EXAMPLE: ASSUME: Calculating returns on futures -speculator - It is January July wheat futures sell for 4. 84/bushel Each contract covers 3000 bushels Margin rate is 15% Trading commission is $30/roundtrip Buy 5 contracts Figure your investment = 5 x 3000 x 4. 84 x. 15 + (30 x 5) = 11, 040
A. Sell your futures in April when price is 4. 96 / bushel =. 149/4 months or 44. 8% annual B. Sell your futures in March when price is 4. 75/bushel = -. 136/3 months or -54. 3% annual
Hedging Locks in Profit SIMPLE HEDGING EXAMPLE - CORN Farmer - is a short hedger - hedges risk by selling futures. Kelloggs - is a long hedger - hedges risk by buying futures. Timing now later Farmer sell futures cost to grow Net Profit 5 -4 1 Kelloggs buy futures sell cereal -5 6 1
Price Changes Have No Net Impact Suppose corn price is $3 at prompt date. What do the Farmer and Kelloggs do? Farmer Kelloggs Sell corn in Iowa 3 Buy corn in Michigan -3 Buy back futures -3 Sell back futures 3 NET 0 0 What are the respective gains and losses for the Farmer and Kelloggs? Farmer Kelloggs Loss on corn sale -2 Gain on corn buy 2 Gain on futures 2 Loss on futures -2 NET 0 0
Futures Gain (Loss) Offsets Asset Loss (Gain) Suppose corn price is $6 at prompt date. What do they do then? Farmer Kelloggs Sell corn in Iowa 6 Buy corn in Michigan -6 Buy back futures -6 Sell back futures 6 NET 0 0 What are the respective gains and losses? Farmer Kelloggs Gain on corn sale 1 Loss on corn buy -1 Loss on futures -1 Gain on futures 1 NET 0 0
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