1. 1 Chapter 21 Principles of the Futures Market

2. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board of Trade, at least 95% of the sales of that Board are of this fictitious character, where no property is actually owned, no property sold or delivered, r expected to be delivered but simply wagers or bets as to what that property may be worth at a designated time in the future….wheat and cotton have become as much gambling tools as chips on the farobank table. - Senator William D. Washburn

3. 3 Outline u Introduction u Futures contracts u Market mechanics u The clearing process u Principles of futures contract pricing u Foreign currency futures

4. 4 Introduction u Futures contracts can lessen price risk for: Businesses Financial institutions Farmers

5. 5 Introduction (cont’d) u The two major groups of futures market participants are: Hedgers Speculators

6. 6 Futures Contracts u What futures contracts are u Why we have futures contracts u How to fulfill the futures contract promise

7. 7 What Futures Contracts Are u Futures contracts are promises: The futures seller promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month The futures buyer promises to pay a predetermined price for the goods upon delivery

8. 8 What Futures Contracts Are (cont’d) u With futures contracts, a trade must occur if someone holds the contract until its delivery date u Most futures contracts are eliminated before the delivery month The contract obligation can be satisfied by making an offsetting trade Only 2% of futures contracts actually result in delivery

9. 9 Why We Have Futures Contracts u If suppliers and future buyers of a commodity could not agree on the future price of the commodity today: There would be added price risk and The price to the consumer would be significantly higher

10. 10 Why We Have Futures Contracts (cont’d) u The basic function of the commodity futures market is to transfer risk from the hedger to the speculator The speculator assumes the risk because of the opportunity for profit

11. 11 How to Fulfill the Futures Contract Promise u The futures market would not work if people could back out of the trade without fulfilling their promise Trades actually become sales to or by the clearing corporation of the exchange

12. 12 How to Fulfill the Futures Contract Promise (cont’d) u Each exchange has a clearing corporation: Ensures the integrity of the futures contract Assumes the responsibility for those position when a member is in financial distress Requires good faith deposits to help ensure the member’s financial capacity to meet the obligations

13. 13 Market Mechanics u The marketplace u Creation of a contract u Market participants

14. 14 The Marketplace u Commodity trades are made by open outcry of the floor traders Traders shout their offers to buy or sell Traders use hand signals to indicate their willingness to buy or sell and desired quantities Traders are located in the pit

15. 15 The Marketplace (cont’d) u The pit: Is either octagonal or polygonal Contains a raised structure called the pulpit: –Representatives of the exchange’s market report department enter all price changes Is surrounded by electronic wallboards reflecting price information

16. 16 The Marketplace (cont’d) u Pit lingo: “See through the pit” is a day with little trading activity An “Acapulco trade” is an unusually large trade Traders who lose all their trading capital have “busted out” (gone to “Tapioca City”) A “fire drill” is a sudden rush of trading activity without apparent reason A big price move is a “lights-out” move

17. 17 The Marketplace (cont’d) u The Chicago Board of Trade (CBOT) is the world’s largest futures exchange: Has more than 3,600 members Has 1,402 full members –Have the right to trade in any of the commodities at the exchange Has associate members –Allowed to trade financial instrument futures and certain other designated markets

18. 18 Creation of A Contract u Buyers and sellers fill out cards to record their trades One side of the card is blue (buy trades) One side of the card is read (sell trades) Each commodity has a symbol –E.g., “US” means Treasury bonds

19. 19 Creation of A Contract (cont’d) u Buyers and sellers fill out cards to record their trades (cont’d) Each delivery month has a letter code –E.g., “U” means September Letters identify time blocks at which the trade occurred –E.g., “A” is the first thirty minutes of trading

20. 20 Creation of A Contract (cont’d) u Example of a trading card (see next slide): Dan Hennebry buys: –5 September Treasury bond futures contracts –From trader ZZZ working for firm OOO –At a price of 77 31/32 of par –In the first thirty minutes of trading

21. 21 Creation of A Contract (cont’d)

22. 22 Market Participants u Hedgers u Speculators u Scalpers

23. 23 Hedgers u A hedger is someone engaged in some type of business activity with an unacceptable level of price risk E.g., a farmer’s welfare depends on the price of the crop at harvest –The farmer wants to transfer the price risk to a speculator using the futures market –The farmer cannot eliminate the risk of a poor crop through futures

24. 24 Hedgers (cont’d) u Hedgers normally go short in agricultural futures A short hedge –E.g., the farmer promises to deliver u Hedgers sometimes go long A long hedge –E.g., a manufacturer of college class rings wants to lock in the price of gold

25. 25 Speculators u Speculators: Have no economic activity requiring the use of futures contracts Find attractive investment opportunities in the futures market Hope to make a profit rather than protecting one

26. 26 Speculators (cont’d) u Speculators normally go long Speculating on price increases u It is possible for speculators to go short Speculating on price declines

27. 27 Speculators (cont’d) u Speculators are either day traders or position traders: Day traders close out all their positions before trading closes for the day Position traders: –Routinely maintain futures positions overnight –Sometimes keep a contract open for weeks

28. 28 Scalpers u Scalpers: Are really speculators Trade for their own account Make a living by buying and selling contracts in the pit

29. 29 Scalpers (cont’d) u Scalpers (cont’d): May buy and sell the same contract many times during a single trading day Contribute to the liquidity of the futures market Are also called locals

30. 30 The Clearing Process u Introduction u Matching trades u Accounting supervision u Intramarket settlement u Settlement prices u Delivery

31. 31 Introduction u The clearing process performs the following functions: Matching trades Supervising the accounting for performance bonds Handling intramarket settlements Establishing settlement prices Providing for delivery

32. 32 Matching Trades u All traders are responsible for ensuring that their card decks are entered into the clearing process u The clearing corporation: Receives the members’ trading cards Edits and checks the information on the cards by computer Returns cards with missing information to the clearing member for correction

33. 33 Matching Trades (cont’d) u Unmatched trades are called outtrades: Result in an Unmatched Trade Notice being sent to each of the clearing corporation members Regardless of the reason for the Notice, it is the trader’s individual responsibility to resolve the error Outtrade clerks (employed by the exchange) assist in the process of reconciling trades

34. 34 Matching Trades (cont’d) u Examples of outtrades: A “price out” means two traders wrote down different prices for a given trade A “house out” means the trading card lists an incorrect member firm A “quantity out” occurs when the number of contracts is in dispute

35. 35 Matching Trades (cont’d) u Examples of outtrades (cont’d): A “strike out” occurs when the striking price is in dispute A “time out” occurs when the delivery month is in dispute A “side out” occurs when both parties marked either buy or sell

36. 36 Accounting Supervision u Performance bonds deposited by member firms remain with the clearing corporation until the member either: Closes out her position by making an offsetting trade or Closes out her position by delivery of the commodity

37. 37 Accounting Supervision (cont’d) u When successful delivery occurs: Good faith deposits are returned to both parties Payment for the commodity is received from the buyer and remitted to the seller The warehouse receipt for the goods is delivered to the buyer

38. 38 Accounting Supervision (cont’d) u Futures contracts are marked to market every day Can create accounting problems

39. 39 Accounting Supervision (cont’d) u Open interest is a measure of how many futures contracts in a given commodity exist at a particular time Increases by one every time two opening transactions are matched Published by the clearinghouse in the financial pages on a daily basis

40. 40 Intramarket Settlement u Commodity prices may move so much in a single day that good faith deposits for members are eroded before the day ends May result in a market variation call: –A call on members to deposit more funds into their accounts during the day

41. 41 Settlement Prices u Settlement prices: Are analogous to the closing price on the stock exchanges Are normally an average of the high and low prices during the last minute or so of trading Are established by the clearing corporation

42. 42 Settlement Prices (cont’d) u Many commodity futures prices are constrained by a daily price limit: The price of a contract is not allowed to move by more than a predetermined about each trading day Commodities may be up the limit or down the limit when big price moves occur –Trading will stop for the day once a limit move has occurred

43. 43 Delivery u A seller who wishes to deliver fills out a Notice of Intention to Deliver with the clearing corporation Indicates the intention of delivering the commodity on the next business day u Delivery can occur any time during the delivery month

44. 44 Delivery (cont’d) u First notice day is the first business day prior to the first day of the delivery month u Position day is the day prior to first notice day Long position members must submit a Long Position Report u On intention day, the clearing corporation may assign delivery to the member with the oldest long position in the particular commodity

45. 45 Delivery (cont’d) u Speculators tend to move out of the market a few days prior to first notice day

46. 46 Principles of Futures Contract Pricing u Expectations hypothesis u Normal backwardation u Full carrying charge market u Reconciling the three theories

47. 47 Expectations Hypothesis u The expectations hypothesis states that the futures price for a commodity is what the marketplace expects the cash price to be when the delivery month arrives u One of the major functions of the futures market is price discovery: The market’s consensus about likely future prices for a commodity

48. 48 Normal Backwardation u Normal backwardation: Is attributed to John Maynard Keynes Argues that the futures price is a downward- biased estimate of the future cash price –The hedger essentially buys insurance –The speculator must be rewarded for taking the risk the hedger was unwilling to bear

49. 49 Full Carrying Charge Market u A full carrying charge market is one where the prices for successive delivery months reflect the cost of holding the commodity The futures price (FP) is equal to the current cash price (CP) plus the carrying charges (c) until the delivery month: FP = CP + c

50. 50 Full Carrying Charge Market (cont’d) u Basis is the difference between the futures price and the current cash price: In a contango market, the futures price is greater than the cash price In an inverted market, the cash price is greater than the futures price

51. 51 Full Carrying Charge Market (cont’d) u Basis is the difference between the futures price and the current cash price (cont’d): If the gap between the futures price and the cash price narrows, the basis strengthens If the gap between the futures price and the cash price widens, the basis weakens

52. 52 Full Carrying Charge Market (cont’d) u The basis is often very close to the carrying costs between the two points in time Arbitrage would be possible if this were not the case –Exists if someone can buy a commodity, store it at a known rate, and get someone to promise to buy it later at a price that exceeds the cost of storage

53. 53 Reconciling the Three Theories u The three theories are compatible: The expectations hypothesis says that a futures price is the expected cash price at the delivery date A full carrying charge market adds costs of carry to the cash price to determine the futures price Normal backwardation says that hedgers are willing to take a bid less than the actual expected future cash price

54. 54 Foreign Currency Futures u Hedging and speculating with foreign currency futures u Pricing of foreign exchange futures contracts

55. 55 Hedging and Speculating With Foreign Currency Futures u Goods and services traded between countries must be valued in a currency u Relative exchange rates fluctuate daily due to changes in: The world political situation International interest rates Inflationary fears

56. 56 Hedging and Speculating With Foreign Currency Futures u U.S. importers purchasing goods denominated in a foreign currency engage in two transactions: Buying the foreign currency Paying for the imported goods

57. 57 Hedging and Speculating With Foreign Currency Futures u Foreign currency futures can eliminate the price risk Go long in foreign currency futures to lock in the future price for the foreign currency: –If the currency appreciates, the gain in the futures market offsets the higher cost of the currency –If the currency depreciates, the lower cost in the cash market is offset by a loss in the futures market

58. 58 Pricing of Foreign Exchange Futures Contracts u The cost of holding a currency is an opportunity cost measured by differences in the interest rates prevailing in the two countries Interest rate parity states that securities with similar characteristics should differ in price by an amount equal to (but opposite in sign from) the difference between national interest rates in the two countries

59. 59 Pricing of Foreign Exchange Futures Contracts (cont’d) u A basic model for pricing foreign currency futures contracts:

60. 60 Pricing of Foreign Exchange Futures Contracts (cont’d) Example Interest rates are 6 percent in Europe, and the prevailing eurodollar deposit rate is 7.5 percent. The current dollar price for a euro is $0.90. For how much should a 90-day futures contract on euros sell?

61. 61 Pricing of Foreign Exchange Futures Contracts (cont’d) Example (cont’d) Solution: Using the pricing model for foreign currency futures: