Accounting Futures Contracts and Clearing A A

Chapter 21: Futures © Oltheten & Waspi 2012 Futures  Spot  immediate delivery and payment (settlement is generally within three business days)  Forward  Delivery and payment at some specified future date  Future  Delivery and payment at some specified future date  The contract is standardized so that the identity of the buyer or seller is immaterial.  The only thing that needs to be negotiated is the price.

Chapter 21: Futures Soybean Futures 5,000 bushels No 2 yellow soybeans with a maximum of 14% moisture For delivery November (November 15 10:01 am Chicago) Buy Buy at: ________ ¢ per bushel Soybean Futures 5,000 bushels No 2 yellow soybeans with a maximum of 14% moisture For delivery November (November 15 10:01 am Chicago) Sell Sell at: ________ ¢ per bushel 431 The Contract

Chapter 21: Futures © Oltheten & Waspi 2012 Susan SpeculatorGeorge Q. Farmer Buy 10 Nov Soybean 431 Sell 10 Nov Soybean 431 In November Susan  will take delivery of 10*5,000 = 50,000 bushels  will pay 10*5,000*431 = $215,500 In November George  will deliver 10*5,000 = 50,000 bushels of soybeans  will receive 10*5,000*431 = $215,500 Open Interest is 10 contracts The Contract

Chapter 21: Futures © Oltheten & Waspi 2012 Contract Risk  Since settlement is months away there is always an incentive to renege on the contract by one of the contract parties.

Chapter 21: Futures © Oltheten & Waspi 2012 Susan SpeculatorGeorge Q. Farmer Buy 10 Nov Soybean 431 [$215,500] Sell 10 Nov Soybean 431 [$215,500] Contract Risk (price drops to 400) The soybeans Susan has promised to buy are worth $200,000 If I renege then I save myself the $15,500 loss

Chapter 21: Futures © Oltheten & Waspi 2012 Susan SpeculatorGeorge Q. Farmer Buy 10 Nov Soybean 431 [$215,500] Sell 10 Nov Soybean 431 [$215,500] Contract Risk (price rises to 500) The soybeans George has promised to sell are worth $250,000 If I renege then I save myself the $34,500 loss

Chapter 21: Futures © Oltheten & Waspi 2012 Contract Risk  As soon as the price moves the contract is at risk If the price goes down then honoring the contract loses me money If the price goes up then honoring the contract loses me money

Chapter 21: Futures © Oltheten & Waspi 2012 Contract Risk  A successful market for Futures contracts must guarantee that buyers and sellers honor their agreements, regardless of subsequent price movements.  This is the role of the Clearinghouse

Chapter 21: Futures © Oltheten & Waspi 2012 The Clearinghouse  The Clearinghouse, in order to guarantee delivery  Imposes an initial margin on both buyers and sellers  Marks to Market at the close of trading every trading day  Imposes daily maintenance margin on both buyers and sellers

Chapter 21: Futures © Oltheten & Waspi 2012 Contract Definition  On the CBOT Soybean future contract  One contract is 5,000 bushels #2 yellow soybeans  Initial margin is $810 per contract  Maintenance margin is $600 per contract  Price limit of 45¢ per day The Exchange defines the contract

Chapter 21: Futures The Contract November 15 Delivery Sell pay $8100 for the contract Buy pay $8100 for the contract Deliver 50,000 bushels receive $215,500 for the soybeans Take delivery of 50,000 bushels pay $215,500 for the soybeans

Chapter 21: Futures © Oltheten & Waspi 2012 Example  In the following example we will follow the actions of the Clearinghouse as prices change  Day 1: 431  Day 2: 441  Day 3: 442  Day 4: 430  Day 5: 436  Day 6: 436

Chapter 21: Futures Example Sell 10 * 5,000 bushels soybeans at 431 [$215,500] Buy 10 * 5,000 bushels soybeans at 431 [$215,500]

Chapter 21: Futures Buy 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8,100 Susan: Initial Margin Initial Margin is deposited to margin account Which creates Equity

Chapter 21: Futures Buy 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market $5,000 $13,100 Susan: day 2 $8, ,000. $13,100. Equity: If Susan could sell her contract at 441 she would get … her margin back ($8,100) plus profit ($5,000) $13,100.

Chapter 21: Futures © Oltheten & Waspi 2012 Buy 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market $5,000 $13, [$221,000] Mark to Market $500$5,500$13,600 Susan: day 3 $13, $13,600. $8, ,500. $13,600. Day-to-day Since inception

Chapter 21: Futures © Oltheten & Waspi 2012 Buy 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market $5,000 $13, [$221,000] Mark to Market $500$5,500$13, [$215,000] Mark to Market - $6,000- $500$7,600 $13, ,000. $7,600. $8, $7,600. Day-to-day Since inception Susan: day 4

Chapter 21: Futures © Oltheten & Waspi 2012 Buy 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market $5,000 $13, [$221,000] Mark to Market $500$5,500$13, [$215,000] Mark to Market - $6,000- $500$7, [$218,000] Mark to Market $3,000$2,500$10,600 Susan: day 5 $7, ,000. $10,600. $8, ,500. $10,600.

Chapter 21: Futures © Oltheten & Waspi 2012 Buy 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market $5,000 $13, [$221,000] Mark to Market $500$5,500$13, [$215,000] Mark to Market - $6,000- $500$7, [$218,000] Mark to Market $3,000$2,500$10,600 Sell 436 [$218,000] $0$2,500-$10,6000 Susan: Close margin back: $8,100. plus profit: $2,500. $10,600.

Chapter 21: Futures © Oltheten & Waspi 2012 Susan  Susan has earned a profit of $2500 on an initial investment of $8,100 That’s a return of 30.9% over 5 days. If I annualize that…

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8,100 George: Initial Margin Initial Margin is deposited to margin account Which creates Equity

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market - $5,000 $3,100 This is below the maintenance level of $600 per contract so George gets a margin call. George: Maintenance Margin $8, ,000. $3,100.

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] PriceAction Profit Deposit to Margin AccountEquity Day’sCumulativ e 431Initial Margin 00$8, [$220,500] Mark to Market Margin Call -$5,000 $5,000 $3,100 $8,100 The margin call requires George to bring his equity back to the initial level of $810 per contract. George: Margin Call $3,100. +margin call. $8,100.

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market Margin Call -$5,000 +$5,000 $3,100 $8, [$221,000] Mark to Market -$500-$5,500$7,600 Equity is still above the maintenance level so no margin call. $8, $7,600. $13,100. -$5,500. $7,600. George: day 3

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market Margin Call -$5,000 +$5,000 $3,100 $8, [$221,000] Mark to Market - $500- $5,500$7, [$215,000] Mark to Market +$6,000+ $500$13,600 George: day 4 $7, ,000. $13,600. $13, $13,600.

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market Margin Call - $5,000 $5,000 $6,100 $8, [$221,000] Mark to Market -$500-$5,500$7, [$215,000] Mark to Market + $6,000+ $500$13, [$218,000] Mark to Market - $3,000- $2,500$10,600 $13, ,000. $10,600. $13,100. -$2,500. $10,600. George: day 5

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] PriceAction Profit Margin AccountEquity Day’sCumulative 431Initial Margin 00$8, [$220,500] Mark to Market Margin Call - $5,000 $5,000 $6,100 $8, [$221,000] Mark to Market -$500-$5,500$7, [$215,000] Mark to Market + $6,000+ $500$13, [$218,000] Mark to Market Withdrawal - $3,000- $2,500 $10,600 $8,100 George: Withdrawal $10,600. -Withdrawal. $8,100. Equity is still above the maintenance level so no margin call.

Chapter 21: Futures © Oltheten & Waspi 2012 George  George has, in total, deposited $10,600 to margin. I am paying $10,600 to avoid the risk on my soybeans $8, ,000 -2,500. $10,600.

Chapter 21: Futures © Oltheten & Waspi 2012 Clearinghouse  What happens to George when Susan wants to close her position? Sell 10 contracts Buy 10 contracts I want my $2,500 profit I want out. I grow soybeans. I need those contracts

Chapter 21: Futures © Oltheten & Waspi 2012 Clearinghouse  What happens to George when Susan wants to close her position? The Clearinghouse cancels offsetting positions Sell 10 contracts Buy 10 contracts Sell 10 contracts Buy 10 contracts

Chapter 21: Futures © Oltheten & Waspi 2012 Clearinghouse  The Clearinghouse cancels offsetting positions. Sell 10 contracts Buy 10 contracts Sell 10 contracts Buy 10 contracts

Chapter 21: Futures © Oltheten & Waspi 2012 Clearinghouse  The Clearinghouse cancels offsetting positions,  allowing Susan to walk away with her profit/loss  matches George’s sell to John’s buy. $2,500.

Chapter 21: Futures © Oltheten & Waspi 2012 Clearinghouse  Technically, Susan, George, and John have contracts, not with each other, but with the Clearinghouse. George: Sell 10 Soybeans $215,500 John: Buy 10 Soybeans $218,000 Susan: Buy 10 Soybeans $215,500 Clearinghouse Sell 10 Soybeans $218,000

Chapter 21: Futures © Oltheten & Waspi 2012 Clearinghouse  Without the Clearinghouse  Susan would have to wait until November  Take delivery of 50,000 bushels of soybeans and pay $215,500  Deliver 50,000 bushels of soybeans and receive $218,000  The Clearinghouse allows her to realize her profits now without ever having to touch any soybeans

Chapter 21: Futures © Oltheten & Waspi 2012 Delivery  The contract trades until the business day before the 15th of the month  The contract delivers two business days after trading stops.  On the last day of trading  the futures price is 400¢  The spot price is $4.00  At delivery the Basis (spot – future) is 0

Chapter 21: Futures Sell 431 [$215,500] Total Margin deposited to date- $10,600 Deliver 50,000 bushels of soybeans on contractMargin Delivery $10,600 $215,500 Total income from soybean farming$215,500 George: Deliver

Chapter 21: Futures © Oltheten & Waspi 2012 Sell 431 [$215,500] Total Margin deposited to date- $10,600 Buy 400 [$200,000] on the last day of trading Margin Profit $10,600 $15,500 Sell 50,000 bushels of soybeans on the spot Total income from soybean farming$215,500 George: Reverse

Chapter 21: Futures © Oltheten & Waspi 2012 Futures Contracts  Less than 2% of futures contracts actually deliver  Even George finds it easier to sell his soybeans to his local grain elevator than to deliver to Chicago.  George uses futures contracts, not to sell soybeans, but to reallocate his price risk on soybeans to someone else.

Chapter 21: Futures © Oltheten & Waspi 2012 Price Limits  Price limit (CBOT Soybeans): 45¢ per day Can trade at 500

Chapter 21: Futures © Oltheten & Waspi 2012 Futures  Hedge  Speculate  Arbitrage

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