1. Finance 300 Financial Markets Lecture 23 © Professor J. Petry, Fall 2002 http://www.cba.uiuc.edu/broker/fin300/fin300pp.htm

2. 2 Housekeeping Bond project is due in one week. Everyone should be done with the analysis and be writing it up. All groups should run their analysis by the TAs prior to turning it in to make sure you are giving them what you want. They are there to help with this project. Please make use of them. UISES: Invest wisely.

3. 3 Margin Account & Trading Example Day 1: 631 is current price Susan Q. buys 10 contracts at 631 per bushel. The contract specifies that she will buy 50,000 bushels of soybeans at 631 per bushel for a total of $315,500. To guarantee this contract she is required to deposit $11,250. George Q sells 10 soybean contracts at 631, saying he will sell 50,000 bushels of soybeans at 631 bushels for a total of $315,500. To guarantee this contract he deposits $11,250 to his margin account. Day 2: Settlement price = 641 Susan makes a profit of $5,000. Her equity is now 16,250. George loses $5,000. He must deposit +5,000 to bring his equity back to 11,250. Day 3: Settlement price = 642 Susan makes a profit of $500. Her equity is now 16,750. George loses $500. His equity is 10,750.

4. 4 Margin Account & Trading Example Day 4: Settlement price = 630 Susan loses $6,000. Her equity is now 10,750. George gains $6,000. His equity is now 16,750. Day 5: Settlement price = 636 Susan makes a profit of $3,000. Her equity is now 13,750. George loses $3,000. His equity is 13,750. If Nov soybeans remain at 636 until the close on the last day of trading, what is George’s final position? A) Assume he enters into an offsetting futures trade B) Assume he delivers on his futures position

5. 5 Margin Account & Trading Example How does George realize his loss in the first case? The second case? What is the net income to George from soybean farming?

6. 6 Margin Account & Trading Example Now assume that initial margin is $810 per contract, and maintenance margin is $600 per contract. Answer the following TTD using the summary of the price movements contained on the next slide. TTD: IX-1 In April George sold 10 November soybean contracts at 431. Since then he has deposited to his margin account a total of $10,600 in initial and maintenance margin. If November soybeans settle at 436 on the last day of trading: A)what is George’s final position if he delivers on his contracts? B)what is George’s final position if he unwinds his futures position on the last day of trading at 436?

7. 7

8. 8

9. 9 Futures Trading: Price Limits Like in other markets, there is considerable evidence that futures markets often experience an overreaction to “events”. To limit the vulnerability to this overreaction, the futures exchange has established price limits for each product traded. Futures may trade within a certain range of the previous day’s close. Trading outside this limit is not permitted without a delay. In the case of soybeans for instance, this limit is +/- 45 cents from the prior day’s close. If the price settled at 630 on a Tuesday, the price could only trade between 585 and 675 on Wednesday. If prices moved below this limit on news of a huge bumper crop, the limit for Thursday would be 585 +/-45 cents or 540 - 630. If there was still no trading, the limit for Friday would be 495 - 585.

10. 10 Things To Do: IX-2 In April George sold 10 Nov soybean contracts at 431. Since then he has deposited to his margin account a total of $10,600 in initial margin and maintenance margin. In May John Q. Investor bought 10 Nov soybean contracts at 436 and deposited to his margin account a total of $8,100. On August 1 Nov soybeans settle at 436. A.On August 2 Hurricane Elisabeth destroys the entire Illinois soybean crop and nobody is willing to sell futures for less than 600. With a.45 daily price limit, how many days will pass before trading resumes? B.Assuming that the broker marks to market at the theoretical limit each day, calculate daily and cumulative paper profit, deposit to margin, and equity position for George Q. Farmer from day to day until trading resumes at 600. C.Do the same for John Q. Investor.

11. 11

12. 12 Futures Positions: Speculation and Hedging Futures markets principal function is to transfer price risk from those that don’t want it (hedgers) to those that do (speculators). George Q. Farmer is definitely a hedger. George would want a short hedge. He sells the crop now via futures to protect against a future price decline. He has offset his long position (crops in the field) with a corresponding short position in the futures market. He no longer has price risk. If price goes up he makes money in long position, but looses it in short position. If price goes down, vice versa. Another hedger might be Tofu, Inc (someone does actually use soybeans), which also wants to hedge, but against the opposite risk. Tofu, Inc is short the commodity, they benefit from a decline in price as it stands. But what if the price goes up before they buy it? They want to long hedge. (Go long in the futures market, buying futures, to offset their short position). If prices go up, what position makes a profit? Which makes a loss? A textbook hedge occurs when the gain exactly offsets the loss.

13. 13 Futures Positions: Speculation and Hedging Hedgers are not free from all risk however. They are trading price risk for basis risk. The change in the basis is what determines whether someone who has hedged is fully protected (hence a textbook hedge). Basis: The difference between the futures price and the spot price. Basis Risk: Risk attributable to uncertain movements in the spread between a futures price and a spot price. –If investors hold the contract to maturity, basis risk vanishes, as it is recognized beforehand that this basis will converge to zero by maturity of the futures contract. –It is during the life of the futures contract where basis risk is present.

14. 14 Futures Positions: Speculation and Hedging –Example: Consider an investor holding 100 troy ounces of gold, who is short one gold futures contract (100 troy ounces). Gold today sells for $291 an ounce, and the futures price for June delivery is $296. Hence, basis is $5. Tomorrow, the spot price might increase to $294, while the futures price increases to $299 (basis still $5). The investors gains and losses are: –Gain on holdings of gold (per ounce)294 – 291 = $3.00 –Loss on gold futures position (per ounce)299 – 296 = $3.00 –Net gain (or loss) = $0.00 Now assume spot goes to 294, but futures to 298.5. Gains/losses? And if spot goes to 296, futures to 300.5. Gains/losses? And if spot goes to 294, but futures go to 300. Gains/losses?