03. Futures - Introduction
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Futures - Introduction
Ravi - IBA
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Futures Contract
• A fnancial contract obligating the buyer to purchasean asset (or the seller to sell an asset), such as aphysical commodity or a fnancial instrument, at apredetermined uture date and price!
• Futures contracts detail the "uality and "uantity othe underlying asset# they are standardized tofacilitate trading on a futures exchange!
• $ome utures contracts may call or physical delivery
o the asset, %hile others are settled in cash! &heutures mar'ets are characteried by the ability touse very high leverage relative to stoc' mar'ets!
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Futures Contract
Futures can be used either to hedge orto speculate on the price movement othe underlying asset!
For eample, a producer o corn coulduse utures to loc' in a certain priceand reduce ris' (hedge)! *n the other
hand, anybody could speculate on theprice movement o corn by going longor short using utures!
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Futures Contract
• Futures contract+ standardized agreement betweentwo parties committing one to buy and the other tosell at a set price on or before a given date in thefuture
– argin+ perormance bonds or good-aith depositsto insure contract perormance
– Initial argin+ inimum amount re"uired toinitiate a trade
– aintenance margin+ inimum amount re"uiredat all times to sustain a mar'et position
– argin call+ %hen margin level is lo%er thanmaintenance margin
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Futures characteristics
• $even maor underlying asset groups• .elivery
– physical delivery (only /0 to 10)
– cash settlement• 2ong position+ buyer o a uture contract
$hort position+ seller o a uture contract• &rading
–
open-outcry+ by voice and hand signals – 3lectronically+ by net%or'
• Floor bro'er and dual trader eecute customerorders
• Can be terminated by an o4setting transaction
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Contractual 5rovisions
• 6nderlying asset+ Commodity,currency, fnancial instrument inde or
other item• Amount and "uality o the underlying
asset
• .elivery cycle+ months or %hich the
utures contracts can be traded• 3piration date
• $ettlement echanism and .elivery2ocation
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Futures Daily Settlement
• Daily settlement is the process where theclosing market price is determined at the endof each trading day in order to settle the prot orloss between the long and the short.
• Yes, prots and losses are settled between thelong and the short at the end of each trading day.
• It is actually a risk control measure in force byclearinghouses and exchanges all over the world
so that losses would not accumulate, leading to problems when it comes to fullment ofobligations.
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ar'-to-mar'et• .aily settlement o gains and losses
bet%een buyers and sellers! – I spot price rises, sellers pay buyers in cash
or the change in price
– I spot prices alls, buyers o%e sellers
– I a utures trader losses too much, moremoney %ill need t be put in the marginaccount!
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Important di4erences bet%eenFutures 7 For%ards
/! Anonymous Counterparties
1! $tandard Contracts
8! .aily $ettlement
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Important di4erences bet%eenFutures 7 For%ards
/! Anonymous Counterparties + 6nli'e parties to aor%ard, the buyer and seller o a uturescontract don9t 'no% each other! &he echangeta'es care o matching o buyers and sellers!
1! $tandard Contracts + 3changes also provideli"uidity by strictly defning the terms o everycontract eecuted! &he type, "uantity andgrade o underlier# its delivery price and date#even the delivery location are spelled out ingreat detail! A prospective buyer or seller mustchoose rom one o these predefned contracts!
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Important di4erences bet%eenFutures 7 For%ards
• 8! .aily $ettlement + &his is the biggie! 5arties to aor%ard realie their payo4 on delivery# or on someearlier date i they agree to cancel or un%ind acontract!
• 5arties to uture contract ho%ever realie a payo4at the end o every trading day! &his help to reducethe ris' o party ailing to meet its obligations!
• Futures are generally more li"uid than or%ards
and a carry a smaller degree o deault ris'!• :: percent o all utures contracts are e4ectively
cancelled beore any delivery actually occurs!
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Futures some ino!
• Commodity Futures (Commodity underliers)
• Financial Futures (Financial underliers)
• As %ith any securities echange, you don9t
ust call a utures echange directly andplace a order!
• Rather an echange has clearing membersentitled to actually eecute trades, %ho canta'e orders rom bro'ers %ho ta'e ordersrom commerical traders and retailers!
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Characteristics o FuturesContracts
• &ransaction %ill not be completed until someagreed-upon date in the uture
• .elivery date and "uantity are all set %hen thefnancial uture is created
• $eller has legally binding obligation to ma'edelivery on specifed date
• Buyer7holder has legally binding obligation tota'e delivery on specifed date
•
Futures may be held until delivery date or tradedonutures mar'et
• All trading is done on a margin basis
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5ayo4 or utures positions
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Advantages o6sing Futures Contracts
• 5otential or very high returns
• argin buying allo%s use o leverage – Leverage+ the ability to obtain a given e"uity
position at a reduced capital investment,thereby magniying total return
• Allo%s producers to hedge prices – .on9t have to sell crops at harvest time %hen
prices are oten lo%
• Commodities can provide an in=ationhedge
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.isadvantages o6sing Futures Contracts
• >igh ris' o losing more than amountoriginally invested# no limit oneposure
to loss• Involves considerable amount
o speculation
• Re"uires specialied investor s'illsand patience
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Copyright ? 1@@<5earson Addison-esley!All rights reserved!
/;-/
*ptions versus FuturesContracts
*ptions
• Right to buy
• $tri'e price
specifed in optioncontract
• 2oss limited to
price paid oroption
Futures
• *bligation to buy
• .elivery price setby supply anddemand
• o limit onpotential loss
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Futures 3changes
• Chicago Board o &rade (CB&) began in/DED
• 3ight 6!$! commodities echanges –
CB& is largest – Chicago ercantile and e% or' ercantilealso active
– D@0 - :@0 o 6!$! commodities trade on thesethree echanges
• 6!$! echanges use Gopen cry auctionH• 3uropean echanges are rapidly gro%ing
and using more electronic technology
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5layers in the Futuresar'ets• >edgers
– 5roducers and processors – 5rotecting their interests in underlying
commodity or fnancial instrument – 5rovide the actual products being sold
• $peculators – Investors –
&rying to earn proft on epected s%ings inprices o utures contracts – 5rovide li"uidity
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&rading echanics
• Contracts are easily traded on utures mar'ets• Bought and sold through bro'erage oces• $ame types o orders are use as stoc's
– ar'et –
2imit• 2ong positionJbuying a contract
– Investor %ants contract price to go up
• $hort positionJselling a contract – Investor %ants contract price to go do%n
• 2ong and short positions can be li"uidated byeecuting an o4setting transaction – About /0 o utures contracts are settled by delivery
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argin &rading
• All utures contracts are traded on margin
• o borro%ing is re"uired
• Initial margin deposit – Amount deposited %ith bro'er at time o commodity
transactionto cover any loss in mar'et value o utures contract duetoprice movements
– argin re"uirements range rom 10 to /@0
•
aintenance deposit – inimum amount o deposit re"uired at all times – argin call occurs i value drops belo% allo%ed amount
• ar'-to-the-mar'et occurs daily
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Copyright ? 1@@<5earson Addison-esley!All rights reserved!
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Table 16.3 aor Classes o Commodities
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Copyright ? 1@@<5earson Addison-esley!All rights reserved!
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Components o CommodityContract
• &ype o product
• 3change %here contract is traded
• $ie o contract (in bushels, pounds, tons)
• ethod o valuing contract (e!g!, cents perpound, dollars per ton)
• .elivery month
• Open Interest+ the number o contractscurrently outstanding on a commodity orfnancial uture
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Factors in Commodity 5riceBehavior
• eather and crop orecasts
• 3conomic actors
•
5olitical actors• International pressures
• Settle Price+ the closing price (last
priceo the day) or commodities andfnancial utures
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Commodity 5rice Behavior
• 5rices change daily
• Changes can be siable
• Because o leverage, small unit price changes can
cause large total dollar changes in contract price• &o protect investors, daily price change limits are
set+
– Daily price limit+ restriction on the day-to-day change
in price – Maximum aily price range+ the amount a commodity
price can change during the day# usually e"ual to t%icethe daily price limit
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Copyright ? 1@@<5earson Addison-esley!All rights reserved!
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Componentso a Commodities Contract
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Return on Invested Capital
• Commodities allo% use o leverageor potentially high returns
• Return to investors is based uponamount o money actually invested
Return on invested capital =
Selling price of
commodity contract −
Purchase price of
commodity contract
Amount of margin deposit
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&rading $trategies %ithCommodities
• $peculating – Capitaliing on %ide s%ings that are characteristic o
many commodities
• $preading –
6sed by producers and processors to protect aposition in a product or commodity – 5roducer or gro%er attempts to hedge as high a price
as possible – 5rocessor or manuacturer attempts to hedge as lo%
a price as possible – o limit to the amount o loss that can occur %ith a
utures contract
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Financial Futures
• Financial Futures+ uture contract in%hich the commodity is a fnancial asset,such as debt securities, oreigncurrencies or mar'et bas'ets o commonstoc's
• *ten used by large institutional investorsto hedge specifc types o ris'+ –
*4set interest rate ris' on debt instruments – inimie oreign currency rate ris' on overseasbusiness transactions
– inimie mar'et ris' on common stoc'investments
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&ypes o Financial Futures+Foreign Currency
• &ypes o Currency Futures
– 6 $ .ollar
– British pound
– $%iss ranc
– eican peso
– Canadian dollar
–
Kapanese yen – Australian dollar
– 3uro
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&ypes o Financial Futures+Interest Rates
• &ypes o Interest Rate Futures
– 6!$! &reasury bills
– 6!$! &reasury notes
– 6!$! &reasury bonds
– 6!$! agency notes (LA, FA)
– uni bond inde
–
Interest rate s%aps – Foreign government bonds
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&ypes o Financial Futures+$toc'-Indees
• &ypes o $toc'-Inde Futures
– .o% Kones Industrial Average
– $M5
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Financial FuturesContract $pecifcations
• $imilar to commodities contracts
• Control large sums o underlyingfnancial instruments
• >ave varying delivery dates
• $toc'-inde utures are settled incashrather than underlying stoc's o thespecifcstoc' inde!
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$peculating in FinancialFutures• Allo%s large "uantities o fnancial
instruments to be controlled throughuture contract
•
2everage can provide high returns (orlosses)
• G2ongH positions are used i investorspeculates values %ill go up
• G$hortH positions are used i investorspeculates values %ill go do%n
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Copyright ? 1@@<
5earson Addison-esley!All rights reserved!
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>edging %ith FinancialFutures• 34ective %ay o protecting stoc' or other
securities holdings in a declining mar'et
• $toc'-inde utures used to hedge stoc'
portolios• Interest rate utures used to hedge bond
portolios
• Foreign currency utures used to hedgesignifcant eposure to oreign echangerate ris'
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Combining Futures and*ptions• Futures Opti!ns+ options that give
the holders the right to buy or sell asingle standardied utures contract
or a specifed period o time at aspecifed stri'e price
– A signifcant advantage that a uturesoption has over a utures contract is thatthe option limits the buyer9s losseposure to the price o the option!
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Sugar Futures "!ntract "!mm!ity Traing #xample"!ntract Speci$cati!ns
$ie o the Contract //1,@@@ lbsinimum 5rice Change
* one ounce /7/@@ cents7lb * one contract N//!1@Initial argin 2evel N@@aintenance argin 2evel NDay 2*pening Account Balance (rom .ay /) N;,;;E!@@5rice rises urther to close at
Day 3
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Day 3*pening Account Balance (rom .ay 1) Nargin call o N1,