1. 1 Introduction to Futures and Options Contracts Risk Management Solutions to the Dairy Industry This information brought to you by: edairy.fcstone.com

2. 2 Outline Futures Contracts Basic Concepts Characteristics of Market Participants Futures Exchanges Open-Outcry vs Electronic Trading The Trading Process Margins Options on Futures Terminology Option Volatility

3. 3 An obligation to buy, sell, or cash-settle a commodity that meets set grades and standards on some future date. Futures contracts are standardized based on: Commodity:What is being traded including grade and quality specifications including grade and quality specifications Contract month:When the contract will expire open contracts must be delivered or cash- settled open contracts must be delivered or cash- settled Quantity:The size of one contract pounds, bushels, barrels, etc. pounds, bushels, barrels, etc. What is a Futures Contract?

4. 4 Examples of Futures Contracts Commodity:Number 2 yellow corn Contract month:Nov, Dec, Jan, Mar, May, Jul, Sep Quantity:5,000 bushels Commodity:Class III fluid milk Contract month:All months available Quantity:200,000 pounds

5. 5 What About Price? The price of a futures contract is determined through a competitive auction. Someone who wants to buy the commodity will bid Someone who wants to sell the commodity will offer

6. 6 Who trades commodities? Hedgers Produce or use the commodity traded Produce or use the commodity traded Utilize futures contracts to manage price risk Utilize futures contracts to manage price risk Speculators Speculators Trade solely for profit Trade solely for profit Add liquidity to the market Add liquidity to the market

7. 7 Buyers and Sellers Buyers and sellers meet two different ways: In person, on an exchange trading floor In person, on an exchange trading floor The “open outcry” system still accounts for the majority of domestic futures volume Electronically Electronically Increasingly popular, especially in foreign countries

8. 8 Futures Exchanges Futures exchanges are organized gatherings of buyers and sellers. Futures exchanges are located throughout the United States and the world. A few examples: Chicago Mercantile Exchange Chicago Board of Trade Tokyo Grain Exchange London International Financial Futures and Options Exchange Chicago Mercantile Exchange

9. 9 Futures Exchanges Each commodity has its own trading pit on the exchange floor where buyers and sellers meet. Traders on the floor of the Chicago Mercantile Exchange

10. 10 Futures Exchanges Traders in the pits use voice or hand signals to bid, offer, and trade commodity contracts

11. 11 Below is an example of an electronic trading platform screen. Electronic Trading Many CME contracts are traded both in trading pits and on the GLOBEX® platform (right). GLOBEX® terminal

12. 12 Electronic Trading Similar to open-outcry trading, except: Bids and offers are posted electronically Bids and offers are posted electronically An order-matching system executes trades An order-matching system executes trades Electronic trading dominates in Europe and is rapidly gaining popularity in the U.S. Eurex:Fully electronic CME:Electronic (GLOBEX®) and open outcry CBOT:Electronic (a/c/e) and open outcry

13. 13 Most CME contracts are still traded by open-outcry

14. 14 Where Do I Begin? Establish a hedging account with a broker. Brokers place buy and sell orders for their customers.Brokers place buy and sell orders for their customers. A fee, or commission, is charged for this service.A fee, or commission, is charged for this service. Your broker may also: Help you open your accountHelp you open your account Provide advice on appropriate trading strategiesProvide advice on appropriate trading strategies Answer your questions about futures tradingAnswer your questions about futures trading

15. 15 How Do I Trade a Futures Contract? 1.Call your broker and place an order 2.The broker routes your order to the trading pit via the brokerage firm’s central order desk 3.A floor broker executes the trade 4.Your broker calls you back to confirm your order has been filled

16. 16 Margins You have taken a position in the futures market. Now what? Initial margin funds must be posted for each contract bought or sold. Since futures contracts are simply an agreement to buy or sell something at a future date, no cash changes hands when the position is opened. Instead, a good-faith deposit must be made to guarantee performance.

17. 17 Class III/IV Margins Initial margin: deposit made when position is entered, $800/contract for hedgers Initial margin: deposit made when position is entered, $800/contract for hedgers Maintenance margin: minimum balance that must remain in the account, $800/contract Maintenance margin: minimum balance that must remain in the account, $800/contract Exchanges set minimum margins for each commodity based on historical volatility and expected market conditionsExchanges set minimum margins for each commodity based on historical volatility and expected market conditions Margin funds may be withdrawn when the hedge is exited Margin funds may be withdrawn when the hedge is exited

18. 18 Margins Margin accounts are “marked to market” each day to reflect changes in position value. BuyerSeller Price Rises May withdraw margin excess Must deposit additional margin Price Declines Must deposit additional margin May withdraw margin excess

19. 19 Margin Example On March 7, a dairy producer sold one Class III contract at $12.20 and an end-user purchased an identical contract Margin Adjustment DatePriceProducerEnd-User March 7$12.20Post $800 initial margin March 8$12.26-$120$120 March 11$12.27-$20$20 March 12$12.21$120-$120 March 13$12.26-$100$100 March 14$12.26$0 March 15$12.22$80-$80 March 18$12.05$340-$340

20. 20 The Clearing House For each matched trade, the exchange’s Clearing House: 1. Is substituted as the buyer to the seller 2. Is substituted as the seller to the buyer Eliminates counter-party credit risk (the clearing house guarantees performance)Eliminates counter-party credit risk (the clearing house guarantees performance) Futures positions can be offset by executing an equal but opposite transaction with anyone, not necessarily the original partyFutures positions can be offset by executing an equal but opposite transaction with anyone, not necessarily the original party

21. 21 The Clearing House The Clearing House is made up of brokerage firms that are clearing members. In the case of a customer default, financial liability rests with: 1. The customer’s margin money/equity 2. The customer’s clearing member firm 3. All clearing member firms 4. The exchange No clearing firm has ever defaulted on its financial obligations.

22. 22 Options on Futures Options are the right, but not the obligation, to buy or sell a futures contract at a specified price.  Call Option: The right to buy futures at a predetermined price  Put Option: The right to sell futures at a predetermined price For every option buyer, there must be a seller.

23. 23 Options on Futures Option buyers: Receive price insurance Receive price insurance Protect against rising or falling prices Protect against rising or falling prices Must pay a premium Must pay a premium Risk limited to the premium paid (plus commissions and fees) Risk limited to the premium paid (plus commissions and fees) Option Sellers: Collect the premium Collect the premium Are obligated to take the opposite side of a futures trade if the buyer chooses Are obligated to take the opposite side of a futures trade if the buyer chooses Risk unlimited (unless position is covered with futures, another option, or the cash commodity) Risk unlimited (unless position is covered with futures, another option, or the cash commodity)

24. 24 Option Example July Class III Milk $12.50 put Commodity Month Strike Price Put/Call Buyer Has the right to sell one July Class III contract at $12.50 Seller Has the obligation to buy one July Class III contract at $12.50 if the owner of the put chooses to exercise it

25. 25 Options Terminology Intrinsic value: The value of the option if it were exercised today Time value: The remainder of the option premium Date: April 10 August futures price: $13.20 Strike / TypePremiumIntrinsic ValueTime value Aug $12.75 Put$.48$0.00$0.48 Aug $13.25 Put$.72$0.05$0.67 Aug $13.00 Call$.79$0.20$0.59 Aug $13.50 Call$.56$0.00$0.56

26. 26 Options Terminology At-the-money option: Option strike price is identical to the price of the futures contract In-the-money option: An option with intrinsic value Out-of-the-money option: An option with no intrinsic value (only time value) In-the-money call: Futures price is currently above option strike price In-the-money put: Futures price is currently below option strike price

27. 27 Margins on Options Buyers: Pay entire option premium up front Pay entire option premium up front No margin calls No margin callsSellers: Margin will vary Margin will vary Based on risk characteristics of the option Based on risk characteristics of the option Never exceeds the futures margin Never exceeds the futures margin

28. 28 Option Valuation The 4 primary factors that impact the price of an option: 1.Option strike price In-the-money vs. Out-of-the-money 2. Current underlying price 3. Time until option expiration 4. Volatility of the underlying

29. 29 What is Volatility? The degree to which prices fluctuate over time The price of the underlying, not the price of the option itself! Measured as the standard deviation of daily price changes Rising volatility (usually accompanies a big move or report) Falling volatility (market settling down)

30. 30 Types of Volatility Historical:Based on daily data from past trading days Implied:Use quoted option price to back out volatility (market’s estimate of future volatility) Future volatility is the key to option value! The more volatile the underlying commodity is expected to be, the more an option is worth. Historical volatility is a guide to what future volatility may be.