© 2002 South-Western Publishing 1

Chapter 8

Fundamentals of the Futures Market

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Outline

A. The concept of futures contracts

B. Market mechanics

C. Market participants

D. The clearing process

E. Principles of futures contract pricing

F. Hedging

G. Spreading with commodity futures

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A. The Concept of Futures Contracts

Introduction The futures promise Why we have futures contracts Ensuring the promise is kept - the role of

the Clearing House

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Introduction

A futures contract is a legally binding agreement to buy or sell something in the future

The ‘futures market’ is represented by both the exchange traded futures contract and contracts that are established in what is know as the ‘over the counter’ or OTC market.

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Introduction (cont’d)

The person who initially sells the contract promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month

The other party to the trade promises to pay a predetermined price for the goods upon delivery

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Introduction

The futures market enables various entities to lessen price risk, the risk of loss because of uncertainty over the future price of a commodity or financial asset

As with options, the two major market participants are the hedger and the speculator

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The Futures Promise

Futures compared to options Futures compared to forwards Futures regulation Trading mechanics

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Futures Compared to Options

Both involve a predetermined price and contract duration

The person holding an option has the right, but not the obligation, to exercise the put or the call

With futures contracts, a trade must occur if the contract is held until its delivery deadline

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Forward Markets

Customized or tailored to the the customer requirements - underlying product and length of contract

Unregulated - recent events such as the Enron Corporation bankrupcty and other trading ‘irregularities’ may lead to change

Private market - transaction between two parties with no details divulged to the public

larger transactions in size Credit risk is assumed by both parties

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Futures Compared to Forwards

A futures contract is more similar to a forward contract than to an options contracts

A forward contract is an agreement between a business and a financial institution to exchange something at a set price in the future– Most forward contracts initially involved foreign

currencies - interbank market– Forward markets have developed for many financial

instruments and commodities in recent years Futures and Forward marketsco-exist

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Futures Compared to Forwards (cont’d)

Forwards are different from futures because:– Forwards are not marketable

Once a firm enters into a forward contract there is no convenient way to trade out of it

– Forwards are not marked to market The two parties exchange assets at the agreed upon

date with no intervening cash flows

– Futures are standardized, forwards are customized

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Recent OTC MarketTrading Events

Trading with the former Enron Corporation and other trading firms are OTC trades where the financial integrity of the trading activity rests with the trading firm - the firms need to be well capitalized and with access to reasonably priced capital

Downgrading of many trading firms debt instruments has resulted in much higher capital costs and to cutbacks in trading operations

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Oil & Gas/Energy OTC Activity

Participants include oil & gas producers, Pipeline companies, gas processors and other mid-stream players, electricity generators refiners, etc.

Common element is exposure to forward price risk

Active OTC risk management as well as usage of futures exchanges

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Futures Regulation

In 1974, Congress passed the Commodity Exchange Act establishing the Commodity Futures Trading Commission (CFTC)

– Ensures a fair futures market– Performs much the same function with futures

as the SEC does with shares of stock or the OSC and ASC in Canada.

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Futures Regulation (cont’d)

A self-regulatory organization, the National Futures Association was formed in 1982

– Enforces financial and membership requirements and provides customer protection and grievance procedures

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Market and Trading Mechanics

The purpose is generally not to provide a means for the transfer of goods

Most futures contracts are eliminated before the delivery month– The speculator with a long position would sell a

contract, thereby canceling the long position– The hedger with a short position would buy a

contract, thereby canceling the short position

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Trading Mechanics (cont’d)

Gain or Loss on Futures Speculation

Suppose a speculator purchases a July soybean contract at a purchase price of $6.12 per bushel. The contract is for 5,000 bushels of No. 2 yellow soybeans at an approved delivery point by the last business day in July.

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Trading Mechanics (cont’d)

Gain or Loss on Futures Speculation (cont’d)

Upon delivery, the purchaser of the contract must pay $6.12(5,000) = $30,600. At the delivery date, the price for soybeans is $6.16. This equates to a profit of $6.16 - $6.12 = $0.04 per bushel, or $200.

If the spot price on the delivery date were only $6.10, the purchaser would lose $6.12 - $6.10 = $0.02 per bushel, or $100.

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Why We Have Futures Contracts

Futures contracts allow buyers and manufacturers/users to lock into prices and costs, respectively

The commodities futures market allows for the transfer of risk from one participant to another - from one hedger to another - typically a buyer/user and a seller/producer of the commodity or between a hedger and a speculator willing to accept the risk

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Transfer of Risk

Gas Producer Gas User

Gas Producer//Gas user

Speculator

FuturesMarket

Futures Market

Risk Transfer

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Hedging Using Futures

– If a firm wants oil/gas, it buys contracts, promising to pay a set price in the future (long hedge) or ‘buying forward’

– A oil/gas producer sells contracts, promising to deliver the gas (short hedge) or ‘selling forward’

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Ensuring the Promise is Kept

Each exchange has a Clearing Corporation that ensures the integrity of the futures contract

The Clearing Corporation ensures that contracts are fulfilled– Becomes party to every trade– Assumes responsibility for member’s positions

when a member is in financial distress

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Ensuring the Promise is Kept (cont’d)

Strict financial requirements are a condition of membership on the exchange

NYMEX requires deposits to a guarantee fund Margin requirements or ‘Good faith deposits’ (

performance bonds) are required from every member on every contract to help ensure that members have the financial capacity to meet their obligations

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Ensuring the Promise is Kept (cont’d)

Selected Good Faith Deposit Requirements

Data as of 21 January 2001Contract Size Value Initial Margin

per Contract

Soybeans 5,000 bushels $23,837 $700

Gold 100 troy ounces $26,640 $1,350

Treasury Bonds $100,000 par $103,188 $1,735

S&P 500 Index $250 x index $339,625 $23,438

Heating Oil 42,000 gallons $36,918 $4,050

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B. Market Mechanics

Types of orders Ambience of the marketplace Creation of a contract

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Types of Orders

A broker in commodity futures is a futures commission merchant (not the individual who places the order)

When placing an order, the client should specify the type of order

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Types of Orders (cont’d)

A market order instructs the broker to execute a client’s order at the best possible price at the earliest opportunity

With a limit order, the client specifies a time and a price– E.g., sell five December soybeans at 540, good

until canceled or good for the day, etc.

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Types of Orders (cont’d)

A stop order becomes a market order when the stop price is touched during trading action– When executed, stop orders close out existing

commodity positions– E.g., a short seller may use a stop order to protect

himself against rising commodity prices– The price may not ultimately be the stop price given

that the stop order becomes a market order

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Ambience of the Marketplace

Trades occur by open outcry of the floor traders– Traders stand in a sunken pit and bark their

offers to buy or sell at certain prices to others– Traders often use hand signals to signal their

wishes concerning quantity, price, etc.– On the pulpit, representatives of the exchange’s

Market Report Department enter all price changes into the price reporting system

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Ambience of the Marketplace (cont’d)

The perimeter of the exchange is lined with hundreds of order desks, where telecommunications personnel from member firms receive orders from clients

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Ambience of the Marketplace (cont’d)

Jargon

– “see through the pit” means little trading activity– “Acapulco trade” is an unusually large trade by

someone who normally trades just a few contracts

– “busted out” or “gone to Tapioca City” means traders incorrectly assess the market and lose all their capital

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Ambience of the Marketplace (cont’d)

Jargon (cont’d)

– “fire drill” is a sudden rush of put activity for no apparent reason

– “lights out” is a big price move– “O’Hare Spread” refers to traders riding a

winning streak

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Creation of a Contract

Two traders confirm their trade verbally and with hand signals

Each of them fills out a card– One side is blue for recording purchases– One side is red for sales– Each commodity has a symbol, and each

delivery month has a letter code

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Creation of a Contract (cont’d)

At the conclusion of trading, traders submit their cards (their deck) to their clearinghouse

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C. Market Participants

Hedgers - long and short positions Processors Speculators/traders

– Scalpers

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Hedgers

A hedger is someone engaged in a business activity where there is an unacceptable level of price risk

– E.g., a farmer can lock into the price he will receive for his soybean crop by selling futures contracts

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Processors

A processor earns his living by transforming certain commodities into another form

– Putting on a crush means the processor can lock in an acceptable profit by appropriate activities in the futures market

– E.g., a soybean processor buys soybeans and crushes them into soybean meal and oil

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Speculators

A speculator finds attractive investment opportunities in the futures market and takes positions in futures in the hope of making a profit (rather than protecting one)

The speculator is willing to bear price risk The speculator has no economic activity

requiring use of futures contracts

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Speculators (cont’d)

Speculators may go long or short, depending on anticipated price movements

A position trader is someone who routinely maintains futures positions overnight and sometimes keeps a contract for weeks

A day trader closes out all his positions before trading closes for the day

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Scalpers

Scalpers are individuals who trade for their own account, making a living by buying and selling contracts– Also called locals

Scalpers help keep prices continuous and accurate

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Scalpers (cont’d)

Scalping With Treasury Bond Futures

Trader Hennebry just sold 5 T-bond futures to ZZZ for 77 31/32. Now, a sell order for 5 T-bond futures reaches the pit and Hennebry buys them for 77 30/32. Thus, Hennebry just made 1/32 on each of the 5 contracts, for a dollar profit of

1/32% x $100,000/contract x 5 contracts = $156.25

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D. The Clearing Process

Matching trades Accounting supervision Intramarket settlement Settlement prices Delivery

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Matching Trades

Every trade must be cleared by or through a member firm of the Board of Trade Clearing Corporation (for the CBOT) or other clearing arms on the other exhcanges

– An independent organization with its own officers and rules

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Matching Trades (cont’d)

Each trader is responsible for making sure his deck promptly enters the clearing process

– Scalpers normally use only one clearinghouse– Brokers typically submit their cards periodically

while trading

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Matching Trades (cont’d)

After the Clearing Corporation receives trading cards– The information on them is edited and checked

by computer– Cards with missing information are returned to

the clearing member– Once all cards have been edited, the computer

attempts to match cards for all trades that occurred that day

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Matching Trades (cont’d)

Mismatches (out trades) result in an Unmatched Trade Notice being sent to each clearing member– Traders must reconcile their out trades and

arrive at a solution– “house out” means an incorrect member firm is

listed on the trading card– “quantity out” means the number of contracts is

in dispute

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Matching Trades (cont’d)

After resolving all out trades, the computer prints a daily Trade Register

– Shows a complete record of each clearing member’s trades for the day

– Contains subsidiary accounts for each customer clearing through the firm

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Accounting Supervision

The accounting problem is formidable because futures contracts are marked to market every day - see table 8-5– Open interest is a measure of how many futures

contracts in a given commodity exist at a particular time

Increases by one every time two opening transactions are matched

Different from trading volume since a single futures contract might be traded often during its life

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Account Supervision (cont’d)

Volume vs Open Interest for Soybean FuturesJune 16, 2000

Delivery Open High Low Settle Change Volume

Open

Jul 2000 5144 5144 5040 5046 -52 32004 46746

Aug 2000 5070 5074 5004 5012 4 7889 19480

Sep 2000 4980 4994 4950 4960 44 3960 15487

Nov 2000 5020 5042 4994 5006 56 22629 62655

Jan 2001 5110 5130 5084 5100 54 1005 6305

Mar 2001 5204 5204 5160 5180 54 1015 4987

May 2001 5240 5270 5230 5230 44 15 6202

July 2001 5290 5330 5280 5290 40 53 4187

Nov 2001 5380 5400 5330 5330 30 37 1371

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Intramarket Settlement

Commodity prices may move so much in a single day that good faith deposits for many members are seriously eroded before the day ends

– The President of the Clearing Corporation may issue a market variation call for members to deposit more funds into their account

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Settlement Prices

The settlement price is analogous to the closing price on the stock exchanges

The settlement price is normally an average of the high and low prices during the last minute of trading

Settlement prices are constrained by a daily price limit

– The price of a contract is not allowed to move by more than a predetermined amount each trading day

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Delivery

Delivery can occur anytime during the delivery month

Several days are of importance:– First Notice Day– Position Day– Intention Day

Several reports are associated with delivery:– Notice of Intention to Deliver– Long Position Report

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E. Principles of Futures Contract Pricing

Basic concepts & terms Spot market or price Futures market or price Relationship between the spot price and the futures

price – ‘Basis’ is the difference between the spot and futures price

Relationship between futures prices for different delivery months - – intracommodity spread

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Principles of Futures Pricing

Expected future price for

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Futures Pricing

Three main theories of futures pricing”– The expectations hypothesis– A full carrying charge market– Normal backwardation & risk aversion– Reconciling the three theories

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The Expectations Hypothesis

The expectations hypothesis states that the futures price for a commodity is what the marketplace expects the cash or spot price to be when the delivery month arrives– the presence of speculators in the marketplace

ensures that the futures price approximates the expected future cash or spot price - a divergence creates speculative opportunities

– Price discovery is an important function performed by futures - linked to the expectations hypothesis

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A Full Carrying Charge Market

A full carrying charge market occurs when the futures price reflects the cost of storing and financing the commodity until the delivery month

This theory suggests the futures price is equal to the current spot price plus the carrying charge:

CSF t

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Carrying Charge

The Cost of Carry may include:– storage costs– transportation costs– insurance costs– financing costs

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A Full Carrying Charge Market (cont’d)

An Arbitrage opportunity exists if someone can buy a commodity, store it at a known cost, and get someone to promise to buy it later at a price that more than covers the cost of storage

In a full carrying charge market, the basis cannot weaken because that would produce an arbitrage situation

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Normal Backwardation & Risk Aversion

Speculators expect to be compensated for taking on risk

John Maynard Keynes:– Locking in a future price that is acceptable eliminates price

risk for the hedger– The speculator must be rewarded for taking the risk that the

hedger was unwilling to bear– Keynes theory is that speculators typically take a long

position in the futures market and thus expect futures prices rising over the life of the contract and converging to the cash price

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Normal Backwardation

Normally, the futures price exceeds the cash price and prices for more distant futures are higher than for nearby futures(contango/normal market)– futures prices are expected to rise over the life of

the contract The futures price may be less than the cash

price/distant futures prices are lower than nearby contracts(backwardation or inverted market)– futures prices are expected to fall over the life the

contract

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The ‘Basis’

One of the most important concepts in the futures markets......and for the process of hedging

Basis = Spot1 (Cash) Price - Futures Price Convergence - behaviour of the basis over time. The basis ‘converges’ to zero at the maturity of the

futures contract (except for transportation/transaction costs) The Basis can fluctuate substantially before maturity

1) cash price at a specific location

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The ‘Basis’

Spot (Cash) Price = Futures + Basis Natural gas futures example

Alberta spot gas = NYMEX futures + Basis – if a shift in price results in the same change in both the

cash market as in the futures market - then the basis has not changed

– however, if the cash price changes more or less than the futures price, the basis has changed - this has implications for the effectivness of a hedge

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The ‘Basis’

Factors affecting the Basis...... In the case of a commodity like natural gas,

transportation costs to the specified delivery point of the futures contract - Alberta gas has a different basis vs Texas gas for example

Local supply/demand factors - e.g. Weather related

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Reconciling the Three Theories

The expectations hypothesis says that a futures price is simply the expected cash price at the delivery date of the futures contract

People know about storage costs and other costs of

carry (insurance, interest, etc.) and we would not

expect these costs to surprise the market

Because the hedger is really obtaining price insurance

with futures, it is logical that there be some cost to the

insurance

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F. Hedging - Basic Concepts

Hedging is a transaction designed to reduce /eliminate risk via a transfer of risk.

Forward contracts and futures are used extensively as part of hedging strategies

Why hedge? Should all risk be eliminated - is risk not a part of business?– Why not let shareholders determine the

level of risk and act/hedge accordingly

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Hedging

Corporations enter into hedging transactions for a number of reasons:

to create an acceptable combination of return and risk

to lock in a return for a given project to add stability to the firm’s earnings/cash flow

– improve the firm’s ability to access capital markets or borrow money

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Hedging

Hedging reduces risk but may not eliminate it entirely

Eliminates upside opportunties - hedging reduces both the upside and downside risk– hedging needs to be selective - ‘indiscriminate

hedging’ does not lead to creation of shareholder value

Hedging involves ‘taking a position’ - concerned about an unfavourable movement and its impact

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Hedging

Short Hedge offsets or hedges a ‘long’ cash position in a

given commodity e.g. Gas producer risk with a long cash position is a decrease in

the price of the gas go ‘short’ in the futures market by selling gas

futures gains in the futures market offset losses in the

cash market

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Hedging

Long hedge Offsets a ‘short’ position in the cash market

- e.g a gas consumer risk is with increasing prices go ‘long’ in the futures market by buying

gas futures contracts gains in the futures market offset losses in

the cash market

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Hedging - How Many Contracts?

Hedge ratio - the number of futures contracts to hold (short or long) for a given position in the cash or commodity market

Recognizes that movements in the futures market will not be identical to movements in the cash market - the number of futures contracts needs to take this variance into consideration

It should be the one where the futures profit or loss offsets the cash position profit or loss

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Hedging - How Many Contracts

Regression analysis is used to determine the hedge ratio i.e. The number of futures contracts to hold to hedge the risk in the cash market - the ideal ratio is one where the gains and losses in the two markets exactly offset each other

R2 = portion or % of the total variance in the cash price changes statistically related to the futures prices changes

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Spreading with Commodity Futures

Intercommodity spreads Intracommodity spreads Why spread in the first place?

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Intercommodity Spreads

An intercommodity spread is a long and short position in two related commodities– E.g., a speculator might feel that the price of

corn is too low relative to the price of live cattle– Crack & Spark Spread, Ted Spread etc.– Speculator is anticipating changes in the price

relationship between the two related commodities

– hedger is locking in the margin

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Intercommodity Spreads (cont’d)

With an intermarket spread, a speculator takes opposite positions in two different markets for the same commodity

– E.g., trades on both the Chicago Board of Trade and on the Kansas City Board of Trade

– arbitrage type activity - speculator is looking for profit opportunities

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Intracommodity Spreads

An intracommodity spread (intermonth spread) involves taking different positions in different delivery months, but in the same commodity

– E.g., a speculator bullish on a commodity might buy September and sell December contracts

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Why Spread in the First Place?

Most intracommodity spreads are basis plays Intercommodity spreads are close to two

separate speculative positions (speculation) or to lock in a margin (hedging)

Intermarket spreads are really arbitrage plays based on discrepancies in transportation costs or other administrative costs