Download - Futures Topic 10 I. Futures Markets. A. Forward vs. Futures Markets u 1. Forward contracting involves a contract initiated at one time and performance.

Futures

Topic 10Topic 10

I. Futures MarketsI. Futures Markets

A. Forward vs. Futures Markets

1. Forward contracting involves a contract 1. Forward contracting involves a contract initiated at one time and performance in initiated at one time and performance in accordance with the terms of the contract accordance with the terms of the contract occurring at a subsequent time. occurring at a subsequent time. – Example: A highly prized St. Bernard has just given Example: A highly prized St. Bernard has just given

birth to a litter of pups. A buyer agrees to buy one pup birth to a litter of pups. A buyer agrees to buy one pup for $400. The exchange cannot take place for 6 weeks. for $400. The exchange cannot take place for 6 weeks. The buyer and seller agree to exchange (sell) the pup in 6 The buyer and seller agree to exchange (sell) the pup in 6 weeks for $400. This is a forward contract; both parties weeks for $400. This is a forward contract; both parties are obligated to go through with the deal.are obligated to go through with the deal.

A. Forward vs. Futures Markets (continued)

2. Differences b/w Forward and Futures 2. Differences b/w Forward and Futures MarketsMarkets– a. The Organized Exchangea. The Organized Exchange– b. Contract Terms--standardized itemb. Contract Terms--standardized item– c. The Clearinghouse--takes no active position c. The Clearinghouse--takes no active position

in the market, but interposes itself between all in the market, but interposes itself between all parties to every transaction. The number of parties to every transaction. The number of contracts bought must always equal the number contracts bought must always equal the number of contracts sold.of contracts sold.


– d. The Requirement for Daily d. The Requirement for Daily Resettlement Resettlement

Assume that the contract closes on May 2 at Assume that the contract closes on May 2 at 168¢/bushel. This means that A has 168¢/bushel. This means that A has sustained a loss of 3¢. Since there are 5000 sustained a loss of 3¢. Since there are 5000 bu. in the contract this represents a loss of bu. in the contract this represents a loss of $150. This amount is deducted from the $150. This amount is deducted from the margin deposited with the brokermargin deposited with the broker..


Assume initial margin was $1400 and Assume initial margin was $1400 and maintenance margin is $1100. A has already maintenance margin is $1100. A has already sustained a loss of $150 so the value of the sustained a loss of $150 so the value of the margin account is $1250. If the price drops margin account is $1250. If the price drops by 4¢ the following day another $200 loss is by 4¢ the following day another $200 loss is registered. The value of the margin account registered. The value of the margin account is down to $1050, below the maintenance is down to $1050, below the maintenance margin. This means A will be required to margin. This means A will be required to bring the margin account back to $1400bring the margin account back to $1400 ..

Table 1

Futures Market Obligations. The oat Futures Market Obligations. The oat contract is traded by the CBT. Each contract is traded by the CBT. Each contract is for 5000 bushels, and prices contract is for 5000 bushels, and prices quoted in cents per bushel.quoted in cents per bushel.

Table 1 (continued)A

May 1:Buys 1 Sept. contract for oats at 171 cents/bushel

ABuys 1 Sept. contract foroats at 171 cents/bushel

BSells 1 Sept. contract for oats at 171 cents/bushel

B

Sells 1 Sept. contract for oats at 171 cents/bushel

ClearinghouseAgrees to deliver to A a Sept. 1 contract for oats at 171 cents/bushel

ClearinghouseAgrees to receive from B a 1 Sept. contract for oats at 171 cents/bushel

Table 1 (continued)

3. A Reversing Trade--brings a trader’s net 3. A Reversing Trade--brings a trader’s net position in some futures contract back to position in some futures contract back to zero. Without a reversing trade the investor zero. Without a reversing trade the investor will be required to either deliver the product will be required to either deliver the product at the contract price (if the contract was at the contract price (if the contract was sold), or purchase the product (if the sold), or purchase the product (if the contract was purchased).contract was purchased).

B. Purposes of Futures Markets

– Meets the needs of three groups of futures Meets the needs of three groups of futures market users:market users:1. Those who wish to discover information 1. Those who wish to discover information

about future prices of commodities (suppliers)about future prices of commodities (suppliers)2. Those who wish to speculate (speculators)2. Those who wish to speculate (speculators)3. Those who wish to transfer risk to some 3. Those who wish to transfer risk to some

other party (hedgers)other party (hedgers)

C. Taxation of Futures Contracts

All paper gains and losses on futures All paper gains and losses on futures positions must be treated as though positions must be treated as though they were realized at the end of the tax they were realized at the end of the tax year. The IRS must get it’s due on an year. The IRS must get it’s due on an annual basis.annual basis.

Futures

Topic 10Topic 10

II. Futures MarketsII. Futures Markets

A. Reading Futures Prices (Contracts)

– 1. The Product1. The Product

– 2. The Exchange2. The Exchange

– 3. Size of the Contract3. Size of the Contract

– 4. Method of Valuing Contract4. Method of Valuing Contract

– 5. The delivery month5. The delivery month

A. Reading Futures Prices (Prices)

– 1. Opening1. Opening

– 2. High2. High

– 3. Low3. Low

– 4. Settlement--Price at which the 4. Settlement--Price at which the contracts are settled at the close of contracts are settled at the close of trading for the day. Typically the last trading for the day. Typically the last trading price for the day.trading price for the day.

B. The Basis

...is the current cash price of a ...is the current cash price of a particular commodity minus the price particular commodity minus the price of a futures contract for the same of a futures contract for the same commodity.commodity.

BASIS = CURRENT CASH PRICE - FPBASIS = CURRENT CASH PRICE - FP

B. The Basis (continued)

Example: Gold Prices and the Basis:Example: Gold Prices and the Basis: 12/16/92 12/16/92

BasisBasisCashCash $441.50$441.50DECDEC 441.50 441.50 .50 .50MAR ‘96MAR ‘96 449.20 449.20 - $7.70- $7.70JUNJUN 459.40 459.40 -$17.90-$17.90SEPSEP 469.90 469.90 -$28.40-$28.40DECDEC 480.70 480.70 -$39.20-$39.20MAR ‘97MAR ‘97 491.80 491.80 -$50.30-$50.30


Basis

Prices

Present MaturityTime

Futures

Cash


1. Relation between Cash & Futures1. Relation between Cash & Futures 2. Spreads2. Spreads

– The difference between two futures The difference between two futures prices (same type of contract) at two prices (same type of contract) at two different points in time.different points in time.

Futures

Topic 10Topic 10

III. Trading CommoditiesIII. Trading Commodities

A. Margin

Sometimes called the deposit, it Sometimes called the deposit, it represents security to cover any loss in represents security to cover any loss in the market value of the contract that the market value of the contract that may result from adverse price changes. may result from adverse price changes. This is the cost of trading in the This is the cost of trading in the futures market.futures market.

B. Speculating

Assume a speculator buys a JUNE contract Assume a speculator buys a JUNE contract at $459.40 by depositing the required at $459.40 by depositing the required margin of $3,500.margin of $3,500.

One gold contract = 100 troy ounces, it has One gold contract = 100 troy ounces, it has a market value of $45,940.a market value of $45,940.

Hence margin is: $3,500/45,940 = 7.62%Hence margin is: $3,500/45,940 = 7.62%

B. Speculating (continued)

1. If Gold contract goes up to $500/ounce 1. If Gold contract goes up to $500/ounce by May, then:by May, then:– Profit = $500 - $459.40 = $40.60 * 100Profit = $500 - $459.40 = $40.60 * 100– Return = $4060/$3500 = 116%Return = $4060/$3500 = 116%

2. If Gold contract goes down to 2. If Gold contract goes down to $410.00/ounce by May, then:$410.00/ounce by May, then:– Profit = $410 - $459.40 = - 49.40 * 100Profit = $410 - $459.40 = - 49.40 * 100

- 4940/3500 = -1.41 or - 4940/3500 = -1.41 or– Return = 141%Return = 141%

B. Speculating (continued)

3. Assume the speculator shorts by 3. Assume the speculator shorts by selling the JUNE contract. If price selling the JUNE contract. If price decreases thendecreases then::– Receives: (459.40 - 410) = 49.40 * 100Receives: (459.40 - 410) = 49.40 * 100– Profit: 4940Profit: 4940– Return: 4940/3500 = +141%Return: 4940/3500 = +141%

C. Spreading

Combining two or more different Combining two or more different contracts into one investment contracts into one investment position that offers the potential for position that offers the potential for generating a modest profit.generating a modest profit.

C. Spreading (continued)

Ex: Buy 1 Corn contract at 258Ex: Buy 1 Corn contract at 258– Sell (short) 1 Corn contract at 270Sell (short) 1 Corn contract at 270– Close out by:Close out by:

1. Selling the long contract at 264.1. Selling the long contract at 264. 2. Buy a short contract at 273.2. Buy a short contract at 273.

– Profit:Profit: Long: 264-258 =Long: 264-258 = 6¢6¢ Short: 270-273 = -Short: 270-273 = - 3¢3¢ 3¢3¢ 3¢ * 5000 bu = $150 Net3¢ * 5000 bu = $150 Net

D. Hedging

...is an attempt to protect a position in a ...is an attempt to protect a position in a commodity.commodity.– Example: Suppose a manufacturer uses Example: Suppose a manufacturer uses

platinum as a basic raw material in the platinum as a basic raw material in the production of catalytic converters.production of catalytic converters.

– Assume: Platinum sells for $180/ounce today. Assume: Platinum sells for $180/ounce today. By years end the price is expected to increase By years end the price is expected to increase substantially.substantially.

Hedging Example (continued)

– 1. Producer buys Platinum futures at $205. 1. Producer buys Platinum futures at $205. Assume spot price increases in 8 months to Assume spot price increases in 8 months to $280/ounce. And the price of the contract has $280/ounce. And the price of the contract has increased to $325/ounce. One contract represents increased to $325/ounce. One contract represents 50 ounces.50 ounces.

– 2. Profit:2. Profit: a. In the contract:a. In the contract: $325 - $205 = $120 * 50 = $6000$325 - $205 = $120 * 50 = $6000 b. In the spot market:b. In the spot market: $280 - $180 = $100 * 50 = $280 - $180 = $100 * 50 = ($5000)($5000)

Hedging Example (continued)

The producer would have experienced a The producer would have experienced a $5000 additional cost if he did not buy $5000 additional cost if he did not buy futures contracts. The net result of this futures contracts. The net result of this hedge is that the producer has eliminated hedge is that the producer has eliminated the potential loss in profits by buying the the potential loss in profits by buying the futures contract: In essence the producer futures contract: In essence the producer has actually netted has actually netted $1000.$1000.

Futures

Topic 10Topic 10

IV. Financial FuturesIV. Financial Futures

A. Assets

1. Foreign currencies1. Foreign currencies 2. Interest Rates2. Interest Rates 3. Stocks3. Stocks

B. Markets 1. Foreign Currencies1. Foreign Currencies

– a. British Pounda. British Pound– b. German Markb. German Mark– c. Swiss Francc. Swiss Franc– d. Canadian Dollard. Canadian Dollar– e. Mexican Pesoe. Mexican Peso– f. Japanese Yenf. Japanese Yen– g. Dutch Guilderg. Dutch Guilder– h. French Franch. French Franc

B. Markets (continued) 2. Interest Rates2. Interest Rates

– a. 90-day T-billsa. 90-day T-bills– b. 1-Year T-billsb. 1-Year T-bills– c. 90-day Bank CD’sc. 90-day Bank CD’s– d. 90-day Eurodollar Depositsd. 90-day Eurodollar Deposits– e. GNMA pass thru Certificatese. GNMA pass thru Certificates– f. US Treasury Notesf. US Treasury Notes– g. US Treasury Bondsg. US Treasury Bonds

B. Markets (continued)

3. Stock Index Futures3. Stock Index Futures– a. S & P Stock Indexa. S & P Stock Index

– b. NYSE Composite Stock Indexb. NYSE Composite Stock Index

– c. Value Line Compositec. Value Line Composite

C. Contract Specifications

1. On currencies, contracts entitle 1. On currencies, contracts entitle holders to claim on a certain holders to claim on a certain amount of foreign currency.amount of foreign currency.

C. Contract Specifications (continued)

ExamplesExamples– Foreign Currencies:Foreign Currencies:

25,000£ British25,000£ British 12,500,000 Japanese Yen12,500,000 Japanese Yen

– Financial Future:Financial Future: $100,000 GNMA & T-Bonds$100,000 GNMA & T-Bonds $1,000,000 T-Bills$1,000,000 T-Bills

– Stock Futures:Stock Futures: CASHCASH

D. Financial Futures Relationship with Interest

Rates 1. Long Position--involves the purchase of 1. Long Position--involves the purchase of

a futures contract and the expectation that a futures contract and the expectation that interest rates will fall. When the futures interest rates will fall. When the futures contract is purchased the underlying contract is purchased the underlying securities will increase in value when securities will increase in value when interest rates fall. Therefore, the value of interest rates fall. Therefore, the value of the futures contract will increase.the futures contract will increase.

D. Financial Futures Relationship with Interest

Rates Example: December T-Bonds Futures price Example: December T-Bonds Futures price

is 67-17. This translates to a value of 67 is 67-17. This translates to a value of 67 17/32% or .6753125 or an underlying value 17/32% or .6753125 or an underlying value of $67,531.25.of $67,531.25.– If interest rates go up then the value of the If interest rates go up then the value of the

futures contract will decrease.futures contract will decrease.– If interest rates go down then the value of the If interest rates go down then the value of the

futures contract will increase.futures contract will increase.

E. Financial Futures Relationship with Interest

Rates 2. Short Position--involves the sale of a 2. Short Position--involves the sale of a

futures contract and the expectation that futures contract and the expectation that interest rates will increase. When interest interest rates will increase. When interest rates increase, then the underlying assets rates increase, then the underlying assets will decrease in value and the contract will will decrease in value and the contract will also decrease in value. This enables you to also decrease in value. This enables you to purchase a contract (reverse trade) at a purchase a contract (reverse trade) at a lower price than you sold it for.lower price than you sold it for.

E. Financial Futures Relationship with Interest

Rates Example: Example: Assume you buy a December contract at Assume you buy a December contract at

67-17 and interest rates increase, thus resulting in a 67-17 and interest rates increase, thus resulting in a lower contract price, say down to 60-00.lower contract price, say down to 60-00.– Loss = 7 17/32% * $100,000 = - $7,531.25Loss = 7 17/32% * $100,000 = - $7,531.25

If you sold the contract originally, (short) you If you sold the contract originally, (short) you would have experienced a gain if interest rates would have experienced a gain if interest rates increased.increased.

Assume the same situation, then the Assume the same situation, then the shortshort gain is: gain is:

7 17/32% * $100,000 = 7 17/32% * $100,000 = +$7,531.25+$7,531.25

F. Hedging with Futures

Using Futures Contracts to Hedge Against Using Futures Contracts to Hedge Against Increasing Interest RatesIncreasing Interest Rates– 1. Assume interest rates increase over a six 1. Assume interest rates increase over a six

month period of March 1 to August from 11% month period of March 1 to August from 11% to 13% as measured by the prime rate.to 13% as measured by the prime rate.

– 2. Assume a Developer takes out a 2. Assume a Developer takes out a construction loan of $50 million at prime + 2 construction loan of $50 million at prime + 2 points for six months.points for six months.

F. Hedging with Futures (continued)

3. To hedge the loan the Hedge Position is 3. To hedge the loan the Hedge Position is determined by:determined by:

$50,000,000/100,000 = 500 futures contracts$50,000,000/100,000 = 500 futures contracts= 1:1 Hedge= 1:1 Hedge

4.At a price of 67-17 for December contracts the 4.At a price of 67-17 for December contracts the total value would be:total value would be:

$67,531.25/contract * 500 = $33,765,625$67,531.25/contract * 500 = $33,765,625

But the total cost to control these assets is margin/contract But the total cost to control these assets is margin/contract times 500.times 500.

$2000 * 500 = $1,000,000$2000 * 500 = $1,000,000


5. Assume on August 31, a developer 5. Assume on August 31, a developer “reverses” or closes his position by buying “reverses” or closes his position by buying back December futures contracts at 65-05. back December futures contracts at 65-05. The lower price is due to increased interest The lower price is due to increased interest rates.rates.– Profits:Profits:

(67-17) - (65-05) = 2-12 or 2 12/32%(67-17) - (65-05) = 2-12 or 2 12/32% .02375 * $100,000 = $2,375/contract.02375 * $100,000 = $2,375/contract or $1,187,500 for 500 contractsor $1,187,500 for 500 contracts


6. A “Do-Nothing” strategy would have 6. A “Do-Nothing” strategy would have resulted in $370, 558 interest (additional) resulted in $370, 558 interest (additional) due to the rising rates.due to the rising rates.

7. Therefore, the net hedge position would 7. Therefore, the net hedge position would result in a total gain of result in a total gain of $816,942$816,942i.e. ($1,187,500 - $370,558)i.e. ($1,187,500 - $370,558)


8. Hence, in this case a perfect hedge could 8. Hence, in this case a perfect hedge could have been achieved at a hedge ratio of:have been achieved at a hedge ratio of:

– 1 to .3121 to .312 [ 156/500 ][ 156/500 ]rather thanrather than

1 to 11 to 1 $370,558/2,375 = 156$370,558/2,375 = 156

G. Futures Options Relationship with Interest

Rates 1. Since the futures option represents a call (right 1. Since the futures option represents a call (right

to buy a futures contract at a specific price) or a to buy a futures contract at a specific price) or a put (right to sell a futures contract at a specific put (right to sell a futures contract at a specific price) then:price) then:– Call: decreases in value when the interest rates Call: decreases in value when the interest rates

increase because the underlying futures asset is increase because the underlying futures asset is decreasing in value.decreasing in value.

– Put: increases in value when the interest rates Put: increases in value when the interest rates increase because the underlying futures asset has increase because the underlying futures asset has decreased in value.decreased in value.

Futures Options Example

CallsCalls StrikeStrike JuneJune SeptSept DecDec

6666 2-312-31 2-362-36 2-322-32

6868 1-131-13 1-331-33 1-371-37

PutsPuts

6666 0-240-24 0-630-63 1-311-31

6868 1-051-05 1-591-59 2-162-16

H. Using Futures Options to Hedge

... Against Increasing Prime Rates... Against Increasing Prime Rates– 1. Assume same increasing rates.1. Assume same increasing rates.– 2. Since the Developer seeks protection against 2. Since the Developer seeks protection against

rising interest rates he must buy PUT options.rising interest rates he must buy PUT options.– 3. To establish a HEDGE Position similar to 3. To establish a HEDGE Position similar to

that of the futures example, the Developer buys that of the futures example, the Developer buys put options with a strike price of 68 with a put options with a strike price of 68 with a premium of 2-16 which is equal to:premium of 2-16 which is equal to: 2 16/64% * $100,000 = $2,250 per contract 2 16/64% * $100,000 = $2,250 per contract

H. Using Futures Options to Hedge (continued)

– To establish a 1:1 Hedge, the developer buys To establish a 1:1 Hedge, the developer buys 500 contracts.500 contracts. This establishes a comparative base with the futures This establishes a comparative base with the futures

contracts.contracts.

– 4. The Developer now closes out his position 4. The Developer now closes out his position in the options market on August 31 (same as in the options market on August 31 (same as futures example by selling the PUT options he futures example by selling the PUT options he purchased back in March. The price for the purchased back in March. The price for the December puts is now 3-23December puts is now 3-23

H. Using Futures Options to Hedge (continued)

– Therefore:Therefore: 3 23/64% $100,000 = $3,359.383 23/64% $100,000 = $3,359.38 Gain: $3,359.38 - $2,250.22 = $1,109.38 contractGain: $3,359.38 - $2,250.22 = $1,109.38 contract Total Gain: $1,109.38 * 500 = $554,690Total Gain: $1,109.38 * 500 = $554,690

– 5. Net Hedge position would result in a gain of: 5. Net Hedge position would result in a gain of: $554,690 - $370,558 = $184,132$554,690 - $370,558 = $184,132

– 6. A perfect Hedge could have been achieved with a 6. A perfect Hedge could have been achieved with a hedge ratio of:hedge ratio of: Int: 370,558/gain: 1,109.38 = 334Int: 370,558/gain: 1,109.38 = 334 334/500 = 1 to .668334/500 = 1 to .668