1. © 2002 South-Western Publishing 1 Chapter 8 Fundamentals of the Futures Market

2. 2 Outline A. The concept of futures contracts B. Market mechanics C. Market participants D. The clearing process E. Principles of futures contract pricing F. Hedging G. Spreading with commodity futures

3. 3 A. The Concept of Futures Contracts Introduction The futures promise Why we have futures contracts Ensuring the promise is kept - the role of the Clearing House

4. 4 Introduction A futures contract is a legally binding agreement to buy or sell something in the future The ‘futures market’ is represented by both the exchange traded futures contract and contracts that are established in what is know as the ‘over the counter’ or OTC market.

5. 5 Introduction (cont’d) The person who initially sells the contract promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month The other party to the trade promises to pay a predetermined price for the goods upon delivery

6. 6 Introduction The futures market enables various entities to lessen price risk, the risk of loss because of uncertainty over the future price of a commodity or financial asset As with options, the two major market participants are the hedger and the speculator

7. 7 The Futures Promise Futures compared to options Futures compared to forwards Futures regulation Trading mechanics

8. 8 Futures Compared to Options Both involve a predetermined price and contract duration The person holding an option has the right, but not the obligation, to exercise the put or the call With futures contracts, a trade must occur if the contract is held until its delivery deadline

9. 9 Forward Markets Customized or tailored to the the customer requirements - underlying product and length of contract Unregulated - recent events such as the Enron Corporation bankrupcty and other trading ‘irregularities’ may lead to change Private market - transaction between two parties with no details divulged to the public larger transactions in size Credit risk is assumed by both parties

10. 10 Futures Compared to Forwards A futures contract is more similar to a forward contract than to an options contracts A forward contract is an agreement between a business and a financial institution to exchange something at a set price in the future – Most forward contracts initially involved foreign currencies - interbank market – Forward markets have developed for many financial instruments and commodities in recent years Futures and Forward marketsco-exist

11. 11 Futures Compared to Forwards (cont’d) Forwards are different from futures because: – Forwards are not marketable Once a firm enters into a forward contract there is no convenient way to trade out of it – Forwards are not marked to market The two parties exchange assets at the agreed upon date with no intervening cash flows – Futures are standardized, forwards are customized

12. 12 Recent OTC MarketTrading Events Trading with the former Enron Corporation and other trading firms are OTC trades where the financial integrity of the trading activity rests with the trading firm - the firms need to be well capitalized and with access to reasonably priced capital Downgrading of many trading firms debt instruments has resulted in much higher capital costs and to cutbacks in trading operations

13. 13 Oil & Gas/Energy OTC Activity Participants include oil & gas producers, Pipeline companies, gas processors and other mid-stream players, electricity generators refiners, etc. Common element is exposure to forward price risk Active OTC risk management as well as usage of futures exchanges

14. 14 Futures Regulation In 1974, Congress passed the Commodity Exchange Act establishing the Commodity Futures Trading Commission (CFTC) – Ensures a fair futures market – Performs much the same function with futures as the SEC does with shares of stock or the OSC and ASC in Canada.

15. 15 Futures Regulation (cont’d) A self-regulatory organization, the National Futures Association was formed in 1982 – Enforces financial and membership requirements and provides customer protection and grievance procedures

16. 16 Market and Trading Mechanics The purpose is generally not to provide a means for the transfer of goods Most futures contracts are eliminated before the delivery month – The speculator with a long position would sell a contract, thereby canceling the long position – The hedger with a short position would buy a contract, thereby canceling the short position

17. 17 Trading Mechanics (cont’d) Gain or Loss on Futures Speculation Suppose a speculator purchases a July soybean contract at a purchase price of $6.12 per bushel. The contract is for 5,000 bushels of No. 2 yellow soybeans at an approved delivery point by the last business day in July.

18. 18 Trading Mechanics (cont’d) Gain or Loss on Futures Speculation (cont’d) Upon delivery, the purchaser of the contract must pay $6.12(5,000) = $30,600. At the delivery date, the price for soybeans is $6.16. This equates to a profit of $6.16 - $6.12 = $0.04 per bushel, or $200. If the spot price on the delivery date were only $6.10, the purchaser would lose $6.12 - $6.10 = $0.02 per bushel, or $100.

19. 19 Why We Have Futures Contracts Futures contracts allow buyers and manufacturers/users to lock into prices and costs, respectively The commodities futures market allows for the transfer of risk from one participant to another - from one hedger to another - typically a buyer/user and a seller/producer of the commodity or between a hedger and a speculator willing to accept the risk

20. 20 Transfer of Risk Gas Producer Gas User Gas Producer/ /Gas user Speculator Futures Market Futures Market Risk Transfer

21. 21 Hedging Using Futures – If a firm wants oil/gas, it buys contracts, promising to pay a set price in the future (long hedge) or ‘buying forward’ – A oil/gas producer sells contracts, promising to deliver the gas (short hedge) or ‘selling forward’

22. 22 Ensuring the Promise is Kept Each exchange has a Clearing Corporation that ensures the integrity of the futures contract The Clearing Corporation ensures that contracts are fulfilled – Becomes party to every trade – Assumes responsibility for member’s positions when a member is in financial distress

23. 23 Ensuring the Promise is Kept (cont’d) Strict financial requirements are a condition of membership on the exchange NYMEX requires deposits to a guarantee fund Margin requirements or ‘Good faith deposits’ ( performance bonds) are required from every member on every contract to help ensure that members have the financial capacity to meet their obligations

24. 24 Ensuring the Promise is Kept (cont’d) Selected Good Faith Deposit Requirements Data as of 21 January 2001 ContractSizeValueInitial Margin per Contract Soybeans5,000 bushels$23,837$700 Gold100 troy ounces$26,640$1,350 Treasury Bonds$100,000 par$103,188$1,735 S&P 500 Index$250 x index$339,625$23,438 Heating Oil42,000 gallons$36,918$4,050

25. 25 B. Market Mechanics Types of orders Ambience of the marketplace Creation of a contract

26. 26 Types of Orders A broker in commodity futures is a futures commission merchant (not the individual who places the order) When placing an order, the client should specify the type of order

27. 27 Types of Orders (cont’d) A market order instructs the broker to execute a client’s order at the best possible price at the earliest opportunity With a limit order, the client specifies a time and a price – E.g., sell five December soybeans at 540, good until canceled or good for the day, etc.

28. 28 Types of Orders (cont’d) A stop order becomes a market order when the stop price is touched during trading action – When executed, stop orders close out existing commodity positions – E.g., a short seller may use a stop order to protect himself against rising commodity prices – The price may not ultimately be the stop price given that the stop order becomes a market order

29. 29 Ambience of the Marketplace Trades occur by open outcry of the floor traders – Traders stand in a sunken pit and bark their offers to buy or sell at certain prices to others – Traders often use hand signals to signal their wishes concerning quantity, price, etc. – On the pulpit, representatives of the exchange’s Market Report Department enter all price changes into the price reporting system

30. 30 Ambience of the Marketplace (cont’d) The perimeter of the exchange is lined with hundreds of order desks, where telecommunications personnel from member firms receive orders from clients

31. 31 Ambience of the Marketplace (cont’d) Jargon – “see through the pit” means little trading activity – “Acapulco trade” is an unusually large trade by someone who normally trades just a few contracts – “busted out” or “gone to Tapioca City” means traders incorrectly assess the market and lose all their capital

32. 32 Ambience of the Marketplace (cont’d) Jargon (cont’d) – “fire drill” is a sudden rush of put activity for no apparent reason – “lights out” is a big price move – “O’Hare Spread” refers to traders riding a winning streak

33. 33 Creation of a Contract Two traders confirm their trade verbally and with hand signals Each of them fills out a card – One side is blue for recording purchases – One side is red for sales – Each commodity has a symbol, and each delivery month has a letter code

34. 34 Creation of a Contract (cont’d) At the conclusion of trading, traders submit their cards (their deck) to their clearinghouse

35. 35 C. Market Participants Hedgers - long and short positions Processors Speculators/traders – Scalpers

36. 36 Hedgers A hedger is someone engaged in a business activity where there is an unacceptable level of price risk – E.g., a farmer can lock into the price he will receive for his soybean crop by selling futures contracts

37. 37 Processors A processor earns his living by transforming certain commodities into another form – Putting on a crush means the processor can lock in an acceptable profit by appropriate activities in the futures market – E.g., a soybean processor buys soybeans and crushes them into soybean meal and oil

38. 38 Speculators A speculator finds attractive investment opportunities in the futures market and takes positions in futures in the hope of making a profit (rather than protecting one) The speculator is willing to bear price risk The speculator has no economic activity requiring use of futures contracts

39. 39 Speculators (cont’d) Speculators may go long or short, depending on anticipated price movements A position trader is someone who routinely maintains futures positions overnight and sometimes keeps a contract for weeks A day trader closes out all his positions before trading closes for the day

40. 40 Scalpers Scalpers are individuals who trade for their own account, making a living by buying and selling contracts – Also called locals Scalpers help keep prices continuous and accurate

41. 41 Scalpers (cont’d) Scalping With Treasury Bond Futures Trader Hennebry just sold 5 T-bond futures to ZZZ for 77 31/32. Now, a sell order for 5 T-bond futures reaches the pit and Hennebry buys them for 77 30/32. Thus, Hennebry just made 1/32 on each of the 5 contracts, for a dollar profit of 1/32% x $100,000/contract x 5 contracts = $156.25

42. 42 D. The Clearing Process Matching trades Accounting supervision Intramarket settlement Settlement prices Delivery

43. 43 Matching Trades Every trade must be cleared by or through a member firm of the Board of Trade Clearing Corporation (for the CBOT) or other clearing arms on the other exhcanges – An independent organization with its own officers and rules

44. 44 Matching Trades (cont’d) Each trader is responsible for making sure his deck promptly enters the clearing process – Scalpers normally use only one clearinghouse – Brokers typically submit their cards periodically while trading

45. 45 Matching Trades (cont’d) After the Clearing Corporation receives trading cards – The information on them is edited and checked by computer – Cards with missing information are returned to the clearing member – Once all cards have been edited, the computer attempts to match cards for all trades that occurred that day

46. 46 Matching Trades (cont’d) Mismatches (out trades) result in an Unmatched Trade Notice being sent to each clearing member – Traders must reconcile their out trades and arrive at a solution – “house out” means an incorrect member firm is listed on the trading card – “quantity out” means the number of contracts is in dispute

47. 47 Matching Trades (cont’d) After resolving all out trades, the computer prints a daily Trade Register – Shows a complete record of each clearing member’s trades for the day – Contains subsidiary accounts for each customer clearing through the firm

48. 48 Accounting Supervision The accounting problem is formidable because futures contracts are marked to market every day - see table 8-5 – 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 Different from trading volume since a single futures contract might be traded often during its life

49. 49 Account Supervision (cont’d) Volume vs Open Interest for Soybean Futures June 16, 2000 DeliveryOpenHighLowSettleChangeVolum e Open Jul 20005144 50405046-523200446746 Aug 200050705074500450124788919480 Sep 2000498049944950496044396015487 Nov 20005020504249945006562262962655 Jan 200151105130508451005410056305 Mar 20015204 516051805410154987 May 2001524052705230 44156202 July 2001529053305280529040534187 Nov 2001538054005330 30371371

50. 50 Intramarket Settlement Commodity prices may move so much in a single day that good faith deposits for many members are seriously eroded before the day ends – The President of the Clearing Corporation may issue a market variation call for members to deposit more funds into their account

51. 51 Settlement Prices The settlement price is analogous to the closing price on the stock exchanges The settlement price is normally an average of the high and low prices during the last minute of trading Settlement prices are constrained by a daily price limit – The price of a contract is not allowed to move by more than a predetermined amount each trading day

52. 52 Delivery Delivery can occur anytime during the delivery month Several days are of importance: – First Notice Day – Position Day – Intention Day Several reports are associated with delivery: – Notice of Intention to Deliver – Long Position Report

53. 53 E. Principles of Futures Contract Pricing Basic concepts & terms Spot market or price Futures market or price Relationship between the spot price and the futures price – ‘Basis’ is the difference between the spot and futures price Relationship between futures prices for different delivery months - – intracommodity spread

54. 54 Principles of Futures Pricing Expected future price for

55. 55 Futures Pricing Three main theories of futures pricing” – The expectations hypothesis – A full carrying charge market – Normal backwardation & risk aversion – Reconciling the three theories

56. 56 The Expectations Hypothesis The expectations hypothesis states that the futures price for a commodity is what the marketplace expects the cash or spot price to be when the delivery month arrives – the presence of speculators in the marketplace ensures that the futures price approximates the expected future cash or spot price - a divergence creates speculative opportunities – Price discovery is an important function performed by futures - linked to the expectations hypothesis

57. 57 A Full Carrying Charge Market A full carrying charge market occurs when the futures price reflects the cost of storing and financing the commodity until the delivery month This theory suggests the futures price is equal to the current spot price plus the carrying charge:

58. 58 Carrying Charge The Cost of Carry may include: – storage costs – transportation costs – insurance costs – financing costs

59. 59 A Full Carrying Charge Market (cont’d) An Arbitrage opportunity exists if someone can buy a commodity, store it at a known cost, and get someone to promise to buy it later at a price that more than covers the cost of storage In a full carrying charge market, the basis cannot weaken because that would produce an arbitrage situation

60. 60 Normal Backwardation & Risk Aversion Speculators expect to be compensated for taking on risk John Maynard Keynes: – Locking in a future price that is acceptable eliminates price risk for the hedger – The speculator must be rewarded for taking the risk that the hedger was unwilling to bear – Keynes theory is that speculators typically take a long position in the futures market and thus expect futures prices rising over the life of the contract and converging to the cash price

61. 61 Normal Backwardation Normally, the futures price exceeds the cash price and prices for more distant futures are higher than for nearby futures(contango/normal market) – futures prices are expected to rise over the life of the contract The futures price may be less than the cash price/distant futures prices are lower than nearby contracts(backwardation or inverted market) – futures prices are expected to fall over the life the contract

62. 62 The ‘Basis’ One of the most important concepts in the futures markets......and for the process of hedging Basis = Spot 1 (Cash) Price - Futures Price Convergence - behaviour of the basis over time. The basis ‘converges’ to zero at the maturity of the futures contract ( except for transportation/transaction costs) The Basis can fluctuate substantially before maturity 1) cash price at a specific location

63. 63 The ‘Basis’ Spot (Cash) Price = Futures + Basis Natural gas futures example Alberta spot gas = NYMEX futures + Basis – if a shift in price results in the same change in both the cash market as in the futures market - then the basis has not changed – however, if the cash price changes more or less than the futures price, the basis has changed - this has implications for the effectivness of a hedge

64. 64 The ‘Basis’ Factors affecting the Basis...... In the case of a commodity like natural gas, transportation costs to the specified delivery point of the futures contract - Alberta gas has a different basis vs Texas gas for example Local supply/demand factors - e.g. Weather related

65. 65 Reconciling the Three Theories The expectations hypothesis says that a futures price is simply the expected cash price at the delivery date of the futures contract People know about storage costs and other costs of carry (insurance, interest, etc.) and we would not expect these costs to surprise the market Because the hedger is really obtaining price insurance with futures, it is logical that there be some cost to the insurance

66. 66 F. Hedging - Basic Concepts Hedging is a transaction designed to reduce /eliminate risk via a transfer of risk. Forward contracts and futures are used extensively as part of hedging strategies Why hedge? Should all risk be eliminated - is risk not a part of business? – Why not let shareholders determine the level of risk and act/hedge accordingly

67. 67 Hedging Corporations enter into hedging transactions for a number of reasons: to create an acceptable combination of return and risk to lock in a return for a given project to add stability to the firm’s earnings/cash flow – improve the firm’s ability to access capital markets or borrow money

68. 68 Hedging Hedging reduces risk but may not eliminate it entirely Eliminates upside opportunties - hedging reduces both the upside and downside risk – hedging needs to be selective - ‘indiscriminate hedging’ does not lead to creation of shareholder value Hedging involves ‘taking a position’ - concerned about an unfavourable movement and its impact

69. 69 Hedging Short Hedge offsets or hedges a ‘long’ cash position in a given commodity e.g. Gas producer risk with a long cash position is a decrease in the price of the gas go ‘short’ in the futures market by selling gas futures gains in the futures market offset losses in the cash market

70. 70 Hedging Long hedge Offsets a ‘short’ position in the cash market - e.g a gas consumer risk is with increasing prices go ‘long’ in the futures market by buying gas futures contracts gains in the futures market offset losses in the cash market

71. 71 Hedging - How Many Contracts? Hedge ratio - the number of futures contracts to hold (short or long) for a given position in the cash or commodity market Recognizes that movements in the futures market will not be identical to movements in the cash market - the number of futures contracts needs to take this variance into consideration It should be the one where the futures profit or loss offsets the cash position profit or loss

72. 72 Hedging - How Many Contracts Regression analysis is used to determine the hedge ratio i.e. The number of futures contracts to hold to hedge the risk in the cash market - the ideal ratio is one where the gains and losses in the two markets exactly offset each other R 2 = portion or % of the total variance in the cash price changes statistically related to the futures prices changes

73. 73 Spreading with Commodity Futures Intercommodity spreads Intracommodity spreads Why spread in the first place?

74. 74 Intercommodity Spreads An intercommodity spread is a long and short position in two related commodities – E.g., a speculator might feel that the price of corn is too low relative to the price of live cattle – Crack & Spark Spread, Ted Spread etc. – Speculator is anticipating changes in the price relationship between the two related commodities – hedger is locking in the margin

75. 75 Intercommodity Spreads (cont’d) With an intermarket spread, a speculator takes opposite positions in two different markets for the same commodity – E.g., trades on both the Chicago Board of Trade and on the Kansas City Board of Trade – arbitrage type activity - speculator is looking for profit opportunities

76. 76 Intracommodity Spreads An intracommodity spread (intermonth spread) involves taking different positions in different delivery months, but in the same commodity – E.g., a speculator bullish on a commodity might buy September and sell December contracts

77. 77 Why Spread in the First Place? Most intracommodity spreads are basis plays Intercommodity spreads are close to two separate speculative positions (speculation) or to lock in a margin (hedging) Intermarket spreads are really arbitrage plays based on discrepancies in transportation costs or other administrative costs