1. Chapter 15
Commodities and Financial Futures

2. The Futures Market
Cash Market: a market where a product or commodity changes hands in exchange for a cash price paid when the transaction is completed
Futures Market: the organized market for the trading of futures contracts
Futures Contract: a commitment to deliver a certain amount of some specified item at some specified date in the future

3. Table 15.1 Futures Contract Dimensions

4. Components of Commodity Contract
Type of product
Exchange where contract is traded
Size of contract (in bushels, pounds, tons)
Method of valuing contract (e.g., cents per pound, dollars per ton)
Delivery month
Open Interest: the number of contracts currently outstanding on a commodity or financial future

5. Components of a Commodities Contract

6. Characteristics of Futures Contracts
Transaction will not be completed until some agreed-upon date in the future
Delivery date and quantity are all set when the financial future is created
Seller has legally binding obligation to make delivery on specified date
Buyer/holder has legally binding obligation to take delivery on specified date
Futures may be held until delivery date or traded on futures market
All trading is done on a margin basis

7. Advantages of Using Futures Contracts
Potential for very high returns
Margin buying allows use of leverage
Leverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return
Allows producers to hedge prices
Don’t have to sell crops at harvest time when prices are often low
Commodities can provide an inflation hedge

8. Disadvantages of Using Futures Contracts
High risk of losing more than amount originally invested; no limit on exposure to loss
Involves considerable amount of speculation
Requires specialized investor skills and patience

9. Options versus Futures Contracts
Right to buy
Strike price specified in option contract
Loss limited to price paid for option
Futures
Obligation to buy
Delivery price set by supply and demand
No limit on potential loss

10. Futures Exchanges Chicago Board of Trade (CBT) began in 1848
More than a dozen U.S. commodities exchanges
Chicago Mercantile Exchange (CME) is largest
Chicago Board of Trade (CBOT) and New York Mercantile Exchange (NYMEX) also active
95% of U.S. commodities trade on these three exchanges
Although still operating independently, the CME, CBOT, and NYMEX have all been merged to form the CME Group
Most exchanges use a combination of electronic trading and open-outcry auction

11. Players in the Futures Markets
Hedgers
Producers and processors
Protecting their interests in underlying commodity or financial instrument
Provide the actual products being sold
Speculators
Investors
Trying to earn profit on expected swings in prices of futures contracts
Provide liquidity

12. Trading Mechanics Contracts are easily traded on futures markets
Bought and sold through brokerage offices
Same types of orders are used as stocks
Market
Limit
Long position—buying a contract
Investor wants contract price to go up
Short position—selling a contract
Investor wants contract price to go down
Long and short positions can be liquidated by executing an offsetting transaction
About 1% of futures contracts are settled by delivery

13. Margin Trading All futures contracts are traded on margin
No borrowing is required
Initial margin deposit
Amount deposited with broker at time of commodity transaction to cover any loss in market value of futures contract due to price movements
Margin requirements range from 2% to 10%
Maintenance deposit
Minimum amount of deposit required at all times
Margin call occurs if value drops below allowed amount
Mark-to-the-market occurs daily

14. Table 15.3 Major Classes of Commodities

15. Factors in Commodity Price Behavior
Weather and crop forecasts
Economic factors
Political factors
International pressures
Settle Price: the closing price (last price of the day) for commodities and financial futures

16. Commodity Price Behavior
Prices change daily
Changes can be sizable
Because of leverage, small unit price changes can cause large total dollar changes in contract price
To protect investors, daily price change limits are set:
Daily price limit: restriction on the day-to-day change in price
Maximum daily price range: the amount a commodity price can change during the day; usually equal to twice the daily price limit

17. Return on Invested Capital
Commodities allow use of leverage for potentially high returns
Return to investors is based upon amount of money actually invested

18. Trading Strategies with Commodities
Speculating
Capitalizing on wide swings that are characteristic of many commodities
Spreading
Used by producers and processors to protect a position in a product or commodity
Producer or grower attempts to hedge as high a price as possible
Processor or manufacturer attempts to hedge as low a price as possible
No limit to the amount of loss that can occur with a futures contract

19. Financial Futures
Financial Futures: future contract in which the commodity is a financial asset, such as debt securities, foreign currencies or market baskets of common stocks
Often used by large institutional investors to hedge specific types of risk:
Offset interest rate risk on debt instruments
Minimize foreign currency rate risk on overseas business transactions
Minimize market risk on common stock investments

20. Examples of Financial Futures:
Examples of Currency Futures
British pound
Swiss franc
Canadian dollar
Japanese yen
Euro
Other currencies
Examples of Interest Rate Futures
U.S. Treasury securities
Federal Funds
Interest rate swaps
Euromarket deposits
Foreign government bonds
Examples of Stock-Index Futures
Dow Jones Industrial Average
S&P 500 Index
Nasdaq 100 Index
Russell 2000 Index

21. Financial Futures Contract Specifications
Similar to commodities contracts
Control large sums of underlying financial instruments
Have varying delivery dates
Stock-index futures are settled in cash rather than underlying stocks of the specific stock index.

22. Speculating in Financial Futures
Allows large quantities of financial instruments to be controlled through future contract
Leverage can provide high returns (or losses)
“Long” positions are used if investor speculates values will go up
“Short” positions are used if investor speculates values will go down

23. Hedging with Financial Futures
Effective way of protecting stock or other securities holdings in a declining market
Stock-index futures used to hedge stock portfolios
Interest rate futures used to hedge bond portfolios
Foreign currency futures used to hedge significant exposure to foreign exchange rate risk

24. Combining Futures and Options
Futures Options: options that give the holders the right to buy or sell a single standardized futures contract for a specified period of time at a specified strike price
A significant advantage that a futures option has over a futures contract is that the option limits the buyer’s loss exposure to the price of the option.

25. Table 15.4 Futures Options: Puts and Calls on Futures Contracts