1. Chapter 16 Commodities and Financial Futures

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-2 Commodities and Financial Futures Learning Goals 1.Describe the essential features of a futures contract and explain how the futures market operates. 2.Explain the role that hedgers and speculators play in the futures market, including how profits are made and lost. 3.Describe the commodities segment of the futures market and the basic characteristics of these investment vehicles.

3. Commodities and Financial Futures Learning Goals (cont’d) 4.Discuss the trading strategies investors can use with commodities, and explain how investment returns are measured. 5.Explain the difference between a physical commodity and a financial future, and discuss the growing role of financial futures in the market today. 6.Discuss the trading techniques that can be used with financial futures, and note how these securities can be used in conjunction with other investment vehicles.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-4 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

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-5 Table 16.1 Futures Contract Dimensions

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-6 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-7 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 whenprices are often low Commodities can provide an inflation hedge

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-8 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-9 Options versus Futures Contracts Options 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-10 Futures Exchanges Chicago Board of Trade (CBT) began in 1848 Eight U.S. commodities exchanges –CBT is largest –Chicago Mercantile and New York Mercantile also active –80% - 90% of U.S. commodities trade on these three exchanges U.S. exchanges use “open cry auction” European exchanges are rapidly growing and using more electronic technology

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-11 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 use 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-13 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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-14 Table 16.3 Major Classes of Commodities

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-15 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

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-16 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

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-17 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

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-18 Components of a Commodities Contract

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-19 Return on Invested Capital Commodities allow use of leverage for potentially high returns Return to investors is based upon amount of money actually invested

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-20 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

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-21 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

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-22 Types of Financial Futures: Foreign Currency Types of Currency Futures –British pound –Swiss franc –Mexican peso –Canadian dollar –Japanese yen –Australian dollar –Euro

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-23 Types of Financial Futures: Interest Rates Types of Interest Rate Futures –U.S. Treasury bills –U.S. Treasury notes –U.S. Treasury bonds –U.S. agency notes (GNMA, FNMA) –Muni bond index –Interest rate swaps –Foreign government bonds

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-24 Types of Financial Futures: Stock-Indexes Types of Stock-Index Futures –Dow Jones Industrial Average –S&P 500 Index –S&P MidCap 400 Index –NYSE Composite Index –Nasdaq 100 Index –Russell 2000 Index

25. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-25 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.

26. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-26 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

27. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-27 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

28. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-28 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.

29. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-29 Chapter 16 Review Learning Goals 1.Describe the essential features of a futures contract and explain how the futures market operates. 2.Explain the role that hedgers and speculators play in the futures market, including how profits are made and lost. 3.Describe the commodities segment of the futures market and the basic characteristics of these investment vehicles.

30. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16-30 Chapter 16 Review (cont’d) Learning Goals (cont’d) 4.Discuss the trading strategies investors can use with commodities, and explain how investment returns are measured. 5.Explain the difference between a physical commodity and a financial future, and discuss the growing role of financial futures in the market today. 6.Discuss the trading techniques that can be used with financial futures, and note how these securities can be used in conjunction with other investment vehicles.