Finance 300 Financial Markets Lecture 24 © Professor J. Petry, Fall

2 Margin Account & Trading Example Day 1: 631 is current price Susan Q. buys 10 contracts at 631 per bushel. The contract specifies that she will buy 50,000 bushels of soybeans at 631 per bushel for a total of $315,500. To guarantee this contract she is required to deposit $11,250. George Q sells 10 soybean contracts at 631, saying he will sell 50,000 bushels of soybeans at 631 bushels for a total of $315,500. To guarantee this contract he deposits $11,250 to his margin account. Day 2: Settlement price = 641 Susan makes a profit of $5,000. Her equity is now 16,250. George loses $5,000. He must deposit +5,000 to bring his equity back to 11,250. Day 3: Settlement price = 642 Susan makes a profit of $500. Her equity is now 16,750. George loses $500. His equity is 10,750.

3 Margin Account & Trading Example Day 4: Settlement price = 630 Susan loses $6,000. Her equity is now 10,750. George gains $6,000. His equity is now 16,750. Day 5: Settlement price = 636 Susan makes a profit of $3,000. Her equity is now 13,750. George loses $3,000. His equity is 13,750. Things to Do: VIII-1 If Nov 98 soybeans remain at 636 until the close on the last day of trading, what is George’s final position? A) Assume he enters into an offsetting futures trade B) Assume he delivers on his futures position What is Susan’s final position? Assume she offsets.

4 Margin Account & Trading Example

5 Futures Trading: Price Limits Like in other markets, there is considerable evidence that futures markets often experience an overreaction to “events”. To limit the vulnerability to this overreaction, the futures exchange has established price limits for each product traded. Futures may trade within a certain range of the previous day’s close. Trading outside this limit is not permitted without a delay. In the case of soybeans for instance, this limit is +/- 45 cents from the prior day’s close. If the price settled at 630 on a Tuesday, the price could only trade between 585 and 675 on Wednesday. If prices moved below this limit on news of a huge bumper crop, the limit for Thursday would be 585 +/-45 cents or If there was still no trading, the limit for Friday would be Chapter VIII – Futures

6 Things To Do: VIII-2 Assume that in the previous example Nov 98 soybeans settled at 636. If a hurricane destroys the entire Illinois soybean crop and nobody is willing to sell soybean futures for less than 800, how many days will pass before trading resumes? Assuming that the broker marks to market at the theoretical limit on each day, calculate the daily and cumulative paper profit, deposit to margin, and equity position for both John Q. Investor (who bought 10 contracts at 636) and George Q. Farmer (who sold 10 contracts at 631) from day to day. Chapter VIII – Futures

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8 Things To Do: VIII-3 George Q. Farmer expects to harvest 50,000 bushels of soybeans in October, but there are no October futures in soybeans. Tofu, Inc wishes to buy 50,000 bushels of soybeans in October, but faces the same problem. The current spot price for soybeans is $6.20 and the price for November soybeans is 631. Initial margin is $1,125 per contract. A) Construct a hedge strategy for George and for Tofu Inc. B) In October the spot price for soybeans is $6.00 and the November futures price is 611. What is the basis on November soybeans? How do George and Tofu Inc. make out? How would George and Tofu made out had they not hedged? C) In October the spot price for soybeans is $7.00 and the November futures price is 714. Now how do George and Tofu make out? Why is this different than in Part B? Chapter VIII – Futures