Chapter 16

Commodities and Financial Futures

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Learning Goals Understand the essential features of a

futures contact Understand motivations of hedgers and

speculators Describe the commodities segment of

the futures market

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Learning Goals (continued)

Discuss the various trading strategies employed

Explain the difference between a physical commodity and a financial future

Discuss the trading techniques used and how they can be used in conjunction with other investments

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Commodities & Financial Futures The organized futures market offers

standardized contracts in commodities and financial futures

Recent growth is due to an increase in available futures contracts and the acceptance of use in financial and investment management

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The Cash Market and The Futures Market The cash market

where transactions involving present exchanges are conducted.

The futures market involves transactions which require

exchange at a specified future time

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A Futures Contract A futures contract

obligates the holder to buy or sell a specified amount of a given commodity at a stated price by a stated date, usually within a year

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Commodities & Financial Futures Unlike options, futures have unlimited

downside risk The delivery month specifies when the item

must be delivered Trading hours for futures vary with the

commodity (or financial future) and are shorter than stock market hours

All trading is on margin basis

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Options vs. Futures Contracts Options differ from futures contracts:

A futures contract obligates a person to buy or sell a specified amount of a given commodity on or before a stated date

An option gives the holder the right to buy or sell, but NO obligation

Options have a specified price - not stated on a futures contract

Futures contracts have no downside limits

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Futures Futures have been traded on a

negotiated or OTC basis since biblical times, but on organized exchanges in the U.S. only since the Chicago Board of Trade opened in 1848. These exchanges have experienced rapid growth

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Futures Trading Futures trading is through the open

outcry auction method, in which a series of shouts, body motions, and hand signals are used

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Types of Traders Hedgers

producers and processors, including financial institutions and corporate treasurers

use futures to protect a cash position or interest in the underlying commodity or financial instrument

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Types of Traders (continued)

Speculators give the market liquidity, and take the

risks, in order to attempt to profit from expected price changes in the underlying asset

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Trading Futures Investors trade futures through a broker A special commodity trading account must be

established Buying a contract is a long position Selling a contract is a short position Commissions amount to $50 to $80 per round

trip (buy and sell) transaction

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Trading Futures (continued)

Required margin is 2- 10% There are no borrowed funds as such, the

margin is to protect any loss in a contract's market value due to adverse price movements

The initial deposit is the amount an investor must deposit with the broker at the time of the futures transaction

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The Maintenance Deposit The maintenance deposit is the

minimum amount of margin which must be kept in the margin account at all times If the margin falls below this deposit,

the investor will receive a margin call to deposit enough cash to bring the deposit back to the required level

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Mark-to-Market Mark-to-market is a daily check of an

investor's margin position, determined at the end of each session, at which time the broker debits or credits the account as needed

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Trading Futures Each contract has its own specifications which

include: The product The exchange on which the contract is traded The size of the contract (and in what units: bushels, pound,

etc.) The pricing unit (such as cents per pound) The delivery month Settle price is the closing price (last price of the day) for

commodities and financial futures Open interest is the number of contracts currently

outstanding on a commodity or financial future

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Commodity Prices Move up and down in relation to economic,

political and international pressure, as well as the weather These pressures cause the prices of the

underlying commodities to change The large size of commodity contracts

magnify small changes in the price of an underlying commodity into substantial changes in the commodity futures price

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Commodity Prices To restrict daily price movements on

commodity futures, a daily price limit has been established

The maximum daily price range represents the maximum a price can change within a day-it is twice the daily price limit

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Return on Invested Capital Futures have only one source of return. Return on invested capital (ROI)

ROI = (Selling price - purchase price) of contract amount of margin deposit

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Speculators Speculators attempt to profit from the wide

price swings of commodity futures contracts Speculators go long when they feel the

price of an underlying security (commodity) will appreciate

They go short when they feel the underlying security (commodity) price will fall

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Speculators (continued)

When speculators hit, they can hit it big because of the high leverage

There is also high risk of loss due to the high leverage

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Spreading Spreading combines two or more

commodity futures contracts in order to restrict exposure to loss A spreader simultaneously buys one

contract and sells another Spreading allows for a potential

profit, but not as high as with the pure speculative approach

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Hedging Hedging is used to protect a position in

a product or commodity Nabisco (needs wheat in 2 months) might

buy a futures contract which has a two-month maturity. This lets Nabisco know the price today and thus reduce his risk

A wheat farmer can short a futures contract and eliminate the risk of an unknown selling price

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Commodities Commodities appeal to individual

investors because of: high rates of return commodities often act as a hedge against

inflation

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Commodities (continued)

Require time and special knowledge In the past, the overall return to individuals

active in the commodities market has been negative

Mutual funds which invest in commodities give investors diversification and professional management

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Financial Futures A type of futures contracts in which the

underlying 'commodity' is a financial asset debt securities, foreign currencies, or

market baskets of common stocks currency futures are futures contracts on

foreign currencies, traded much like commodities

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Foreign Currencies Seven currencies are traded against the

dollar, and they are: British pound German mark Swiss franc Mexican peso Canadian dollar Japanese yen Australian dollar

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Interest Rate Futures Interest rate futures are futures contracts on

debt securities. Trading is carried out in a variety of US and foreign debt securities, including: US Treasury bills Notes, Bonds Foreign government bonds, such as those

of the UK, Germany, and Canada

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Stock Index Futures Stock index futures are futures

contracts written on broad-based measures of stock market performance (e.g., the S&P500 Stock Index)

Allow investors to participate in the general movements of the stock market

Stock indexes are quoted in terms of the index, but have a value of 500 times the index

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Index Price (1 of 3)

Index price is a technique used to price T-bill and other short-term securities futures contracts, by subtracting current yield from an index of 100

This index changes the normal discount quote to one more consistent with other futures

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Index Price (2 of 3)

By using this pricing index, a long position gains when the price goes up and a short position gains when the price goes down

The index price is not the actual contract price, it must be calculated using the following formula:

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Index Price (3 of 3)

Price of a 90-day contract =

$1,000,000 - security's yield x 90 x $10,000 360

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Trading Strategies & Objectives Similar for financial and commodity

futures Financial institutions, large multinational

firms, and pension funds and portfolio managers use interest rate, currency, and stock index futures to hedge

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Speculation with Foreign Currency Contracts Speculation with foreign currency

contracts investing with the expectation that the

foreign currency will appreciate (long position) or depreciate (short position) relative to the US dollar

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Speculating with Interest Rate Futures Speculating with interest rate futures

take position based on whether they feel interest rates will rise (short position because fixed-income security prices fall when interest rates rise) or fall (long position)

Financial futures are used for spreading just as with commodities contracts

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Stock Index Futures (1 of 4)

Relatively new and most investors use them to speculate or hedge. The stock index options are used the same way

Successful use of stock index futures requires accurate prediction of the future course of the stock market

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Stock Index Futures (2 of 4)

Speculators take long positions when they feel the market will rise and short positions when they feel the market will fall

An investor can hedge a diversified portfolio of stocks with a stock index future

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Stock Index Futures (3 of 4)

This is not likely to be a perfect hedge the investor's holdings are unlikely to

precisely match the composition of the index used in the contract

OTC and highly volatile stocks probably require more protection in the form of additional offsetting futures contracts it is hard to find appropriate indexes that

would represent such stocks

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Stock Index Futures (4 of 4)

With hedging, an investor can protect against a long (short) position. If he owns a foreign stock, the investor can hedge against the dollar declining relative to the currency of the foreign investment

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Financial Futures Financial futures can be used by

individual investors, but they must recognize the high risk and be prepared to cover some losses

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Options On Futures Puts and calls on futures contracts are offered

in the organized options and futures markets These are standardized options contracts

The key difference between futures and options on futures is that the option limits the investor's loss exposure to the price paid for the option-not so on the futures contract

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Case Review Billy Jo and Danielle Hobert

Review case and questions 4, 5, 17, 18, 19, 20 and 24, Volume III

Paul and Kristi Roth Review case and questions 7, 8, 9, 10, 11

12, 13, 18 and 20, Volume III