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Transcript of Chapter 8
© 2004 South-Western Publishing 1
Chapter 8
Fundamentals of the Futures
Market
22
Outline
The concept of futures contracts Market mechanics
Market participants The clearing process
Principles of futures contract pricing Spreading with commodity futures
33
The Concept of Futures Contracts
Introduction The futures promise
Why we have futures contracts Ensuring the promise is kept
44
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
55
The Futures Promise
A futures contract is a legally binding agreement to buy or sell something in the
future 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
66
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
77
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 pre-set price in the future– Most forward contracts involve foreign currency
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
88
Trading Mechanics
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
99
Trading Mechanics (cont’d)
Gain or Loss on Futures SpeculationGain 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.
1010
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.
1. At the delivery date, the price for soybeans is At the delivery date, the price for soybeans is $6.16,$6.16,
This equates to a profit of $6.16 - $6.12 = $0.04 per bushel, or = $200 (5,000 * $0.04).
2. If the spot price on the delivery date were only If the spot price on the delivery date were only $6.10$6.10,
The purchaser would lose $6.12 - $6.10 = $0.02 per bushel, or = $100 (5,000 * $0.02).
1111
Why We Have Futures Contracts
Futures contracts allow buyers and manufacturers to lock into prices
and costs, respectively– If a firm wants gold, it buys contracts,
promising to pay a set price in the future (long hedge)
– A gold mining company sells contracts, promising to deliver the gold (short
hedge)
1212
Ensuring the Promise is Kept
The Clearing Corporation ensures that contracts are fulfilled:
– Becomes party to every trade,– Ensures the integrity of the futures contract,
– Assumes responsibility for those positions when a member is in financial distress.
Good faith deposits (or performance bonds) are required from every member
on every contract to help ensure that members have the financial capacity to
meet their obligations.
1313
Ensuring the Promise is Kept (cont’d)
Selected Good Faith Deposit Requirements
Data as of January 2, 2004Contract Size Value Initial Margin
per Contract
Soybeans 5,000 bushels $39,700 $1,620
Gold 100 troy ounces $41,600 $2,025
Treasury Bonds $100,000 par $108,000 $2,565
S&P 500 Index $250 x index $278,500 $20,000
Heating Oil 42,000 gallons $38,346 $3,375
1414
Market Mechanics
Types of orders Ambience of the marketplace
Creation of a contract
1515
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
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
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
1616
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
The perimeter of the exchange is lined with hundreds of order desks, where
telecommunications personnel from member firms receive orders from clients
1717
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– “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
1818
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
At the conclusion of trading, traders submit their cards (their deck) to their clearinghouse
In 2003, nearly 7 million futures and options orders were electronically sent directly to floor brokers using special order receipts
called electronic clerks
1919
Market Participants
Hedgers Processors
Speculators Scalpers
2020
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
2121
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
2222
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
Speculators may go long or short, depending on anticipated price movements
A position trader is someone who routinely maintains futures positions overnight and
sometimes keep a contract for weeks A day trader closes out all his positions
before trading closes for the day
2323
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
2424
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
2525
The Clearing Process
Matching trades Accounting supervision Intramarket settlement
Settlement prices Delivery
2626
Matching Trades
Every trade must be cleared by or through a member firm of the Board of Trade Clearing Corporation
– An independent organization with its own officers and rules
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
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
2727
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
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
2828
Accounting Supervision
The accounting problem is formidable because futures contracts
are marked to market every day– Open interest is a measure of how many
futures contracts in a given commodity exist at a particular time
Different from trading volume since a single futures contract might be traded often during
its life
2929
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
3030
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
3131
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
3232
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
3333
Principles of Futures Contract Pricing
The expectations hypothesis Normal backwardation
A full carrying charge market Reconciling the three theories
3434
The Expectations Hypothesis
The expectations hypothesis states that the futures price for a commodity is what
the marketplace expects the cash price to be when the delivery month arrives– Price discovery is an important function
performed by futures
There is considerable evidence that the expectations hypothesis is a good
predictor
3535
Normal Backwardation
Basis is the difference between the future price of a commodity and the
current cash price– Normally, the futures price exceeds the
cash price (contango market)– The futures price may be less than the
cash price (backwardation or inverted market)
3636
Normal Backwardation (cont’d)
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 Thus, at delivery, the cash price will likely
be somewhat higher than the price predicated by the futures market
3737
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
The futures price is equal to the current spot price plus the carrying
charge:CSF t
3838
A Full Carrying Charge Market (cont’d)
Arbitrage 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 exceeds the cost of
storage
In a full carrying charge market, the basis cannot weaken because that
would produce an arbitrage situation
3939
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
4040
Reconciling the Three Theories (cont’d)
Because the hedger is really obtaining price insurance with
futures, it is logical that there be some cost to the insurance
4141
Spreading with Commodity Futures
Intercommodity spreads Intracommodity spreads
Why spread in the first place?
4242
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– Risky because there is no assurance that
your hunch will be correct
4343
Intercommodity Spreads (cont’d)
With an intermarket spread, a speculator takes opposite positions
in two different markets– E.g., trades on both the Chicago Board
of Trade and on the Kansas City Board of Trade
4444
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 what might
buy September and sell December
4545
Why Spread in the First Place?
Most intracommodity spreads are basis plays
Intercommodity spreads are closer to two separate speculative positions than
to a spread in the stock option sense Intermarket spreads are really arbitrage
plays based on discrepancies in transportation costs or other
administrative costs