McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 16 Commodities and Financial Futures

16-2 Objectives Explain how commodities and financial futures can be used for speculation or for hedging Explain how commodities and financial futures can be used for speculation or for hedging Describe the different types of commodities and financial futures contracts that are available Describe the different types of commodities and financial futures contracts that are available Explain how margin is used in the futures markets to magnify gains (or losses) Explain how margin is used in the futures markets to magnify gains (or losses)

16-3 Objectives cont. Explain the difference between the cash and the futures markets Explain the difference between the cash and the futures markets Describe how currency futures and interest rate futures are currently utilized in a business environment Describe how currency futures and interest rate futures are currently utilized in a business environment Explain the role of interest rate swaps as an alternative to futures Explain the role of interest rate swaps as an alternative to futures

16-4 Commodities and Financial Futures Types of Commodities and Exchanges Types of Commodities and Exchanges Actual Commodities Contract Actual Commodities Contract Reading Market Quotes Reading Market Quotes The Cash Market and the Futures Market The Cash Market and the Futures Market The Futures Market for Financial Instruments The Futures Market for Financial Instruments Currency Futures Currency Futures Interest Rate Futures Interest Rate Futures Options as Well as Futures Options as Well as Futures Interest Rates Swaps Interest Rates Swaps

16-5 Futures Contract An agreement that provides for delivery of a specific amount of a commodity of a specific amount of a commodity at a designated time in the future at a designated time in the future at a given price at a given price

16-6 Futures Contract continued Almost all commodities futures contracts closed out (reversed) before actual transaction occurs Almost all commodities futures contracts closed out (reversed) before actual transaction occurs Tremendous volume of activity but,Tremendous volume of activity but, Few actual items ever change hands Few actual items ever change hands

16-7 Hedge Futures markets originally set up to allow grain & livestock producers & processors to hedge (protect) their positions in a given commodity Futures markets originally set up to allow grain & livestock producers & processors to hedge (protect) their positions in a given commodity

16-8 Example 1- Wheat Producer 5 month lead from planting to harvesting 5 month lead from planting to harvesting Current price of wheat: $5.50/bushel Current price of wheat: $5.50/bushel High risk of price drop before delivery High risk of price drop before delivery Produce can hedge position by offering to SELL futures contracts for the delivery of wheat Produce can hedge position by offering to SELL futures contracts for the delivery of wheat

16-9 Example 1- Wheat Producer continued If price of wheat declines, producer sells crop for less than anticipated If price of wheat declines, producer sells crop for less than anticipated Producer makes up the difference in the futures marketProducer makes up the difference in the futures market Buys futures back for less then he sold them Buys futures back for less then he sold them If price of wheat increases, producer sells crop for more than anticipated If price of wheat increases, producer sells crop for more than anticipated Extra profit is given back in the futures marketExtra profit is given back in the futures market Buys futures back for more then he sold them Buys futures back for more then he sold them

16-10 Example 2 - Miller processing Wheat Opposite dilemma of wheat producer Opposite dilemma of wheat producer Afraid price of wheat might go up Afraid price of wheat might go up Cut into profit margin Cut into profit margin Hedge position by BUYING futures contracts in wheat Hedge position by BUYING futures contracts in wheat If price of wheat goes up, extra production cost is offset by the profits on futures contracts

16-11 Speculators in the Futures Market Take purely long or short positions without intent to hedge actual ownership Take purely long or short positions without intent to hedge actual ownership

16-12 Types of Commodities

16-13 Table 16-1 Categories of Commodities and Financial Futures

16-14 Commodity Exchanges

16-15

16-16 Size of Commodity Contracts

16-17

16-18 Margin Requirements Commodity trading uses Commodity trading uses MarginsMargins NOT actual cash dollarsNOT actual cash dollars Typically 2% to 5% of Typically 2% to 5% of the value of the contract Margin requirements may vary Margin requirements may vary Over timeOver time Among exchanges for a given commodityAmong exchanges for a given commodity

16-19 Margin Maintenance Requirement 60 to 80% of the value of initial margin If initial margin is reduced due to losses on contract MUST deposit more money to cover margin position if not position will be closed out (resulting in loss)

16-20 Example - Margin Requirements Value of wheat contract: $27,500 Value of wheat contract: $27,500 (from Table 16-3) (from Table 16-3) Margin requirement:$1,000 (in 2006) Margin requirement:$1,000 (in 2006) $1,000 is 3.6 percent of $27,500 $1,000 is 3.6 percent of $27,500 Margin maintenance requirement: Margin maintenance requirement: 70% × $1,000 = $700

16-21 Gains and LossesExample Gains and Losses - Example Buy Dec. futures contract for $5.50/bushel Price goes up to $5.70/bushel One contract = 5,000 bushels $0.20 increase per bushel Gain = $1,000 (5,000 bushels x $0.20) Initial margin requirement = $1,000 Percentage profit =100%

16-22 Gains and LossesExample continued Gains and Losses – Example continued What if the price dropped? What if the price dropped? If maintenance margin requirement is $700, how much would the price of wheat have to decline for us to get a margin call to increase our deposit? If maintenance margin requirement is $700, how much would the price of wheat have to decline for us to get a margin call to increase our deposit? Answer: With 5,000-bushel contract:

16-23 Market Conditions Market conditions affect price of commodities Market conditions affect price of commodities What key variables influence value of contract? What key variables influence value of contract? For wheat, factors could be For wheat, factors could be WeatherWeather Crop conditions in the MidwestCrop conditions in the Midwest Price of corn as a substitute productPrice of corn as a substitute product Carryover of supply from last yearCarryover of supply from last year

16-24 Market Conditions Export of wheat to other countriesExport of wheat to other countries Imports from other countriesImports from other countries Currency fluctuationsCurrency fluctuations Wheat lobby in Washington?Wheat lobby in Washington? Can you think of any other factors?Can you think of any other factors?

16-25 Price Movement Limitations Hi risk of gains/losses in commodities Hi risk of gains/losses in commodities Limit maximum daily price movements in commodity Limit maximum daily price movements in commodity Examples shown in Table 16–4 Examples shown in Table 16–4

16-26

16-27 Price Movement Limitations Daily limits affect efficiency of the market Daily limits affect efficiency of the market If market conditions indicate price of wheat should decline by $0.30 but daily limit is $0.20, then,If market conditions indicate price of wheat should decline by $0.30 but daily limit is $0.20, then, price of wheat not in equilibrium as it opens next morning price of wheat not in equilibrium as it opens next morning Desire to stop market panics tends to override desire for total market efficiency Desire to stop market panics tends to override desire for total market efficiency Potential intraday trading range is still large Potential intraday trading range is still large

16-28 Reading Market Quotes

16-29 Price Quotes for Corn Contracts

16-30 The Cash Market and the Futures Market Many commodity futures exchanges provide areas where Many commodity futures exchanges provide areas where Buyers and sellers negotiate cash (or spot) pricesBuyers and sellers negotiate cash (or spot) prices Cash price Cash price actual dollar paid for immediate transfer of a commodityactual dollar paid for immediate transfer of a commodity Must be a transfer of physical possession of goods Must be a transfer of physical possession of goods Prices somewhat dependent on prices in futures market Prices somewhat dependent on prices in futures market

16-31 The Futures Market for Financial Instruments  Foreign currencies  Interest rates  Stock indexes V O L A T I L I T Y in  Corporate treasurers  Investors  Borrowers/Lenders  Bankers Hedge position

16-32 The Futures Market for Financial Instruments Ideal for speculators because of Low margin requirements & Low margin requirements & Wide swings in value Wide swings in value

16-33 Currency Futures Futures are available in Euro Japanese yen Australian dollar Mexican peso Canadian dollar Russian ruble

16-34 Currency Futures The currency futures market has Standardized contracts & Strong secondary market Marked-to-market daily

16-35 Interest-Rate Futures GNMA certificates Treasury notes Treasury bills Municipal bonds Federal funds Eurodollars

16-36 Hedging with Interest-Rate Futures Corporate treasurer Awaiting new debt Borrowing under a floating prime rate Mortgage banker Pension fund manager Commercial banker for loans Used by

16-37 Options As Well As Futures Futures contract requires initial margin Options require payment of option premium

16-38 Interest-Rate Swaps A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans One company may have access to One company may have access to lower fixed rates and another company may have access to lower floating rates... so they trade

16-39 WebsitesComments Chicago Mercantile Exchange Chicago Board of Trade London International Financial Futures and Options Exchange Kansas City Board of Trade Minneapolis Grain Exchange New York Board of Trade

16-40 Examples of futures Example 1 (click here) Example 1 (click here) Example 1 (click here) Example 1 (click here) Example 2 (click here) Example 2 (click here) Example 2 (click here) Example 2 (click here)