Presentation on theme: "Commodities and Financial Futures"— Presentation transcript:
1 Commodities and Financial Futures Chapter 15Commodities and Financial Futures
2 Commodities and Financial Futures Learning GoalsDescribe the essential features of a futures contract and explain how the futures market operates.Explain the role that hedgers and speculators play in the futures market, including how profits are made and lost.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)Discuss the trading strategies investors can use with commodities, and explain how investment returns are measured.Explain the difference between a physical commodity and a financial future, and discuss the growing role of financial futures in the market today.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 The Futures MarketCash Market: a market where a product or commodity changes hands in exchange for a cash price paid when the transaction is completedFutures Market: the organized market for the trading of futures contractsFutures Contract: a commitment to deliver a certain amount of some specified item at some specified date in the future
6 Characteristics of Futures Contracts Transaction will not be completed until some agreed-upon date in the futureDelivery date and quantity are all set when the financial future is createdSeller has legally binding obligation to make delivery on specified dateBuyer/holder has legally binding obligation to take delivery on specified dateFutures may be held until delivery date or traded on futures marketAll trading is done on a margin basis
7 Advantages of Using Futures Contracts Potential for very high returnsMargin buying allows use of leverageLeverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total returnAllows producers to hedge pricesDon’t have to sell crops at harvest time when prices are often lowCommodities 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 lossInvolves considerable amount of speculationRequires specialized investor skills and patience
9 Options versus Futures Contracts Right to buyStrike price specified in option contractLoss limited to price paid for optionFuturesObligation to buyDelivery price set by supply and demandNo limit on potential loss
10 Futures Exchanges Chicago Board of Trade (CBT) began in 1848 More than a dozen U.S. commodities exchangesChicago Mercantile Exchange (CME) is largestChicago Board of Trade and New York Mercantile also active95% of U.S. commodities trade on these three exchangesMost U.S. exchanges use “open cry auction”European exchanges are rapidly growing and using more electronic technology
11 Players in the Futures Markets HedgersProducers and processorsProtecting their interests in underlying commodity or financial instrumentProvide the actual products being soldSpeculatorsInvestorsTrying to earn profit on expected swings in prices of futures contractsProvide liquidity
12 Trading Mechanics Contracts are easily traded on futures markets Bought and sold through brokerage officesSame types of orders are used as stocksMarketLimitLong position—buying a contractInvestor wants contract price to go upShort position—selling a contractInvestor wants contract price to go downLong and short positions can be liquidated by executing an offsetting transactionAbout 1% of futures contracts are settled by delivery
13 Margin Trading All futures contracts are traded on margin No borrowing is requiredInitial margin depositAmount deposited with broker at time of commodity transaction to cover any loss in market value of futures contract due to price movementsMargin requirements range from 2% to 10%Maintenance depositMinimum amount of deposit required at all timesMargin call occurs if value drops below allowed amountMark-to-the-market occurs daily
15 Components of Commodity Contract Type of productExchange where contract is tradedSize of contract (in bushels, pounds, tons)Method of valuing contract (e.g., cents per pound, dollars per ton)Delivery monthOpen Interest: the number of contracts currently outstanding on a commodity or financial future
16 Factors in Commodity Price Behavior Weather and crop forecastsEconomic factorsPolitical factorsInternational pressuresSettle Price: the closing price (last price of the day) for commodities and financial futures
17 Commodity Price Behavior Prices change dailyChanges can be sizableBecause of leverage, small unit price changes can cause large total dollar changes in contract priceTo protect investors, daily price change limits are set:Daily price limit: restriction on the day-to-day change in priceMaximum daily price range: the amount a commodity price can change during the day; usually equal to twice the daily price limit
19 Return on Invested Capital Commodities allow use of leverage for potentially high returnsReturn to investors is based upon amount of money actually invested
20 Trading Strategies with Commodities SpeculatingCapitalizing on wide swings that are characteristic of many commoditiesSpreadingUsed by producers and processors to protect a position in a product or commodityProducer or grower attempts to hedge as high a price as possibleProcessor or manufacturer attempts to hedge as low a price as possibleNo limit to the amount of loss that can occur with a futures contract
21 Financial FuturesFinancial Futures: future contract in which the commodity is a financial asset, such as debt securities, foreign currencies or market baskets of common stocksOften used by large institutional investors to hedge specific types of risk:Offset interest rate risk on debt instrumentsMinimize foreign currency rate risk on overseas business transactionsMinimize market risk on common stock investments
22 Examples of Financial Futures: Foreign Currency Examples of Currency FuturesBritish poundSwiss francCanadian dollarJapanese yenEuroOther currencies
23 Examples of Financial Futures: Interest Rates Examples of Interest Rate FuturesU.S. Treasury securitiesFederal FundsInterest rate swapsEuromarket depositsForeign government bonds
24 Examples of Financial Futures: Stock-Indexes Examples of Stock-Index FuturesDow Jones Industrial AverageS&P 500 IndexNasdaq 100 IndexRussell 2000 Index
25 Financial Futures Contract Specifications Similar to commodities contractsControl large sums of underlying financial instrumentsHave varying delivery datesStock-index futures are settled in cash rather than underlying stocks of the specific stock index.
26 Speculating in Financial Futures Allows large quantities of financial instruments to be controlled through future contractLeverage 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 Hedging with Financial Futures Effective way of protecting stock or other securities holdings in a declining marketStock-index futures used to hedge stock portfoliosInterest rate futures used to hedge bond portfoliosForeign currency futures used to hedge significant exposure to foreign exchange rate risk
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 priceA 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 Chapter 15 Review Learning Goals Describe the essential features of a futures contract and explain how the futures market operates.Explain the role that hedgers and speculators play in the futures market, including how profits are made and lost.Describe the commodities segment of the futures market and the basic characteristics of these investment vehicles.
30 Chapter 15 Review (cont’d) Learning Goals (cont’d)Discuss the trading strategies investors can use with commodities, and explain how investment returns are measured.Explain the difference between a physical commodity and a financial future, and discuss the growing role of financial futures in the market today.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.