In and Out of Futures Mike Knapp

Background Dōjima Rice Exchange in Japan, 1730s First futures exchange market Samurai paid in rice Bad rice harvests affected rice conversion to coin Samurai wanted stable conversion to coin

Background U.S. futures market in the 19 th century Farmers & Agriculture wholesalers Hedge against seasonal price differences Lock in prices for crops prior to harvest/planting Now futures have developed for financial futures I.e. Stock indexes

Futures Contract One buyer & one seller 3 Key Elements Futures price Settlement/delivery date Underlying Need an exchange/clearinghouse to be a futures

Long Position Buyer of futures contract Profit Loss Futures Price When does long position make profit? And loss?

Short Position Seller of futures contract Profit Loss Futures Price When does short position make profit? And loss?

Clearinghouse Two functions Guarantee Function Takes opposite position of both long and short Removes default risk for buyer/seller Place for unwinding position Futures Buyer  Futures Seller Futures Buyer  Clearinghouse Seller & Clearinghouse Buyer  Futures Seller Without Clearinghouse With Clearinghouse

Mark to Market Realize gains and losses daily Initial Margin Deposit for contract How clearinghouse has guarantee function Settlement Price Mark to market investor’s position Maintenance Margin Minimum level that equity position may fall Margin Call Request to bring equity position up to initial margin

Futures Contract Two liquidating options Take offsetting position in same contract Long becomes short Sell same number of futures contracts Wait until settlement date Long accepts delivery Short delivers at the agreed-upon price This is undesirable in most futures contracts

2 player Hedge Example Buyer = Long position Seller = short position Long Short Day 1: Market Price = $10 per pound Contract: Long sells 100 pounds of watermelons to short at $10 per pound in 30 days

2 player Hedge Example LongShort Clearinghouse: Initial Margin: 10% of contract = $1,000 x 0.1 = $100 Maintenance Margin: $50 Initial Margin: $100 Maintenance Margin: $50 Initial Margin: $100 Maintenance Margin: $50

2 player Hedge Example LongShort Clearinghouse: Initial Margin: $100 Maintenance Margin: $50 Day 2: Settlement Price = $10.25 per pound $0.25 x 100 pounds = + $25 $0.25 x 100 pounds = - $25

2 player Hedge Example LongShort Clearinghouse: Initial Margin: $100 Maintenance Margin: $50 Day 3: Settlement Price = $10.75 per pound $0.75 x 100 pounds = + $75 $0.75 x 100 pounds = - $75 Short’s equity position is at $25, must bring equity back to $100

2 player Hedge Example LongShort Day 29: Settlement Price = $11.00 per pound $1.00 x 100 pounds = + $100 $1.00 x 100 pounds = - $100 But….Long and Short decide to take offsetting positions in the contract LongShort Contract 2: Long sells 100 pounds of watermelons to short at $11 per pound in 1 day

2 player Hedge Example Contract 1-Long = $10 x 100 pounds = - $1,000 Day 30: Settlement Price = $11.00 per pound Contract 2-Short = $11 x 100 pounds = + $1,100 Contract 1-Short = $10 x 100 pounds = + $1,000 Contract 2-Long = $11 x 100 pounds = - $1,100 +$100 -$100

2 player Hedge Example Futures Contracts total = + $100 But supposed to be zero-sum game when hedging…… Market purchase price of 100 $11 per pound = - $100 Total = Futures + Market = $ 0 Futures Contracts total = - $100 Market selling price of 100 $11 per pound = + $100 Total = Futures + Market = $ 0

Questions

References How a forward/futures contracts work: What is a clearinghouse: futures.pdf T177&dq=D%C5%8Djima+Rice+Exchange&source=bl&ots=v_bsmO6P 7K&sig=ihVbjfoTZG5MCIrwils4zmQlSzk&hl=en&sa=X&ei=e4OaUfbT M46UjAK0w4HYDA&ved=0CEIQ6AEwBTgK