1 Chapter 12 Futures

2 Student Learning Objectives Basic Terminology Who regulates the futures markets? What’s required for a futures markets? Who uses futures? What types of contracts are used? What are the roles of the Clearinghouse? How are futures used to hedge? What other types of derivatives are there?

3 Basic Terminology Spot market: market for immediate delivery of some commodity, such as wheat or Government bonds Forward contract: customized, nonstandard contractual agreement to trade specified commodity or financial instrument at agreed-upon price, settlement date, quantity, and location Futures contracts: standardized contracts that can be bought and sold on an exchange Futures buyer has obligation to accept and pay for specified quantity of asset at specified price at specified time Option holder has right—but not obligation—to buy or sell specified quantity of asset at specified price over specified time period

4 Types of Market Traders Firm representatives: hedge needs or outputs of commodity-related firms Scalpers: look for temporary misalignments of prices, hold positions for a few minutes at most Day traders: short-run traders who close their positions each day Position traders: may hold positions for several days based on fundamental or technical factors Arbitrageurs: seek to exploit departures from expected relative price relationships, but may hold positions for extended time periods Hedgers: seeking to protect asset positions against adverse price moves

5 Who Regulates Futures Markets? Primary regulator: Commodity Futures Trading Commission (CFTC)  mission : protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets

6 Requirements for a Futures Market 1. Standardization (contract quantity, quality) 2. Active demand 3. Ability to store asset for a period of time 4. Relatively high value in proportion to bulk 5. Relatively high value in proportion to storage and other carrying costs 6. Availability of numerous maturities.

7 Who Uses Futures Markets? Speculators  Betting that prices will move in direction expected.  Speculators tend to be net long in the market Hedgers  Minimizing the risk of an asset position  The Hedger may be short the spot asset – need to buy in the future  The Hedger may be long the spot asset – need to sell in the future.

8 Types of contracts Physical commodities  Agricultural products  Nonagricultural products Financial futures  Currency futures  Stock index futures  Interest rate futures

9 Organization of Futures Exchanges Exchange members own the exchange.  Memberships are limited and can be traded Three areas of membership activity  Commission brokers trading for others  Local traders trading (for own acct.)  Dual traders performing both functions Trading by “Open Outcry”  Each commodity has its own “pit”.  Traders use variety of methods for communicating with other traders.

10 C.F. Clearinghouse Clearinghouse critical to futures market Trade technically with clearinghouse, not person on other side Clearinghouse guarantees terms of contract  Makes delivery when short position cannot.  Takes delivery when long position cannot.  Takes corrective action against those that fail to live up to their obligations.

11 “Positions” “Longs”: open contract (s) to profit if prices rise before contract matures.  Or looking to buy asset at contract price. “Shorts”: open contract (s) to profit if prices decline before contract matures.  Or looking to sell assets at contract price. Buying or Selling (“settlement”) occurs ONLY during the maturity month.  Assignment is handled by CFCH (FIFO)

12 “Positions” Closing a position (prior to maturity month):  In options or futures trading, using an offsetting transaction to remove investor from further exposure and to lock in profits or limit losses. Roundtrip Fees  Paid once up front and held by CFCH.

13 “Positions” Contract Value = Contract Quantity * Price Contract Margin Requirements.  Generally speaking, 5% to 8% of the current value of the contract.  Example: 40,000 bu wheat contract with current estimate of the future price, $3.50/bu suggests this contract is worth $140,000.  At 5%, the initial margin required is $

14 Marking to Market Recompute value of equity position on daily basis at the close of trading. Ensures that, as prices fluctuate, amount held in margin or escrow account remains sufficient to meet minimum requirements Brokerage firms mark to the market to reduce risk that client might default.

15 Daily Price Limits Rule established by futures exchanges for maximum range of price movement permitted between settle price of previous day and opening price of next day of trading for any given commodity Once limit is reached, trading must stop until next trading session.

16 CF Clearinghouse Clearinghouse critical to futures market Trade technically with clearinghouse, not person on other side Clearinghouse guarantees terms of contract  Make or take delivery Holds margin funds

17 Types of Strategies Hedging: taking opposite positions to reduce risk exposure on one of positions Speculating: the act of committing funds in anticipation of specific price movement Spreading: creating a combination trade, such as both long and short position in the futures market

18 How Do Futures Markets Work? Role of the Futures Clearinghouse  Clearinghouse is non-profit corporation owned by members of the exchange:  C/h is intermediary and guarantor to every trade.  Every trade has a short and a long position. Make delivery and take delivery of the asset at the agreed price and time. Both parties must meet their obligations.  The clearinghouse guarantees that both parties fulfill their obligations.

19 Futures Trading Accounts margin depositsmargin maintenance Futures transactions require posting margin deposits and meeting margin maintenance requirements settlement price A settlement price is established at the end of each trading day to calculate traders’ margins marked to market Each account is marked to market each day, adjusting each trader’s margin account by the change in settlement price

20 Daily Limits Since futures trading is done on margins, limits are established for the maximum daily change in price on a contract: limit up limit down  If the contract price moves up or down by the maximum amount - it is said to be limit up or limit down - no further trading can take place.  Daily limits may be increased in some circumstances by the exchange.

21 Delivery Procedure Many traders have no intention of taking delivery of or delivering the asset on which they trade futures- purely speculative  If delivery is to occur, the contract procedures must be followed.  The short position initiates  The short position initiates the delivery procedure.  Commodity delivered subject to quality and quantity standards.

22 Futures Price Quotations Open interest Open interest refers to the number of contracts outstanding at a point in time  Open interests peak a few weeks before the delivery date and then decline sharply Basis Basis is the difference between the spot price and futures price for an asset Convergence Convergence occurs as the delivery date approaches.  The difference between spot and futures price goes to zero at maturity.

23 Risk Bearing Services of Speculators Hedgers may be net short in the market, leaving speculators net long.  Hedgers fear price may drop.  Speculators hope price will rise. futures price is below the expected spot price Speculators will take long positions only if the futures price is below the expected spot price  If the expected price holds, then the futures price will move to meet the [future] spot price providing a return to speculators for assuming risk that hedgers wish to avoid.

24 USES OF FUTURES CONTRACTS Hedging with Futures  Futures help traders hedge cash positions perfect hedge  C +  F = 0 (perfect hedge = zero change)  Short hedge:  Short hedge: short futures to offset a long position in the cash market Farmer worries that prices will fall before the crop gets to market and takes a short position in the futures market  Long hedge: long futures to offset a short position in the cash market

25 Basis Risk Basis = cash market price – futures market price In perfect hedge, basis does not change Basis risk = risk that basis will change Hedger substituting basis risk for price risk Hedge successful as long as basis risk is less than price risk

26 Short Hedge Example Farmer plants 30,000 bushels of corn  Current spot (cash) market price = $5.20/bu.  If corn harvested and sold today,  Proceeds = 30,000 x $5.20 = $156,000 Farmer sells 6 futures contracts at $5/bu.  A short hedge (wins if prices decline) Basis = $5.20 – $5.00 = $.20 Farmer provides broker with margin

27 Short Hedge Example Time to harvest arrives  Cash price = $4.50/bu. (decline from $5.20)  Futures price = $4.30/bu.  Basis still = $.20 (turns out to be perfect hedge) Farmer harvests & sells corn for:  30,000 x $4.50 = $135,000 Farmer closes out futures position ($5.00 – $4.30) x 30,000 = $21,000 profit

28 Short Hedge Example Farmers total proceeds with hedge:  Proceeds from sale of crop:$135,000  Profit on futures hedge: 21,000  Total Proceeds$156,000 Recall: Spot Price = $5.20 Future Price = $5.00 Farmer Sold Corn for $4.50

29 Financial (Interest Rate) Futures Treasury bill futures  Delivery dates in March, June, September, and December  Face value per contract is $1,000,000 of T- bills  Delivery of T-bills with maturity of 90 days Treasury bills are sold at discount with no stated interest rate Contract values are based on IMM index Rates go up – [bond] values go down

30 Options on futures Calls and puts are available on most actively traded futures contracts Buying a call option instead of a futures contract limits the loss and sacrifices some of the potential profit Using a call option to protect a short futures position

31 Stock Index Futures Cash Settlement  At close of last day of contract life, open positions are treated as closed out at index price Futures also available for individual stocks  Expire once each quarter for each stock.

32 Differences between Markets in Commodities Futures and Stocks Commodities Futures Limited term Maximum daily price moves Margins of 5% to 15% Long interest equal to short interest by definition No short selling restrictions No interest charged on unpaid margin Market has no specialist system Positions must be opened and closed with same brokerage firm Stocks Unlimited term No limit on daily price moves Margins of 50% or more Short interest usually small fraction of long interest Interest incurred on margin debt Market making by specialists No restriction on opening and closing positions with different firms