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Finance 300 Financial Markets Lecture 23 © Professor J. Petry, Fall 2001

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Presentation on theme: "Finance 300 Financial Markets Lecture 23 © Professor J. Petry, Fall 2001"— Presentation transcript:

1 Finance 300 Financial Markets Lecture 23 © Professor J. Petry, Fall 2001 http://www.cba.uiuc.edu/broker/fin300/fin300pp.htm

2 2 Overview of Futures Futures are similar in basic concept to Forwards which we reviewed when discussing interest rates Forward - an agreement calling for a future delivery of an asset at an agreed-upon price Futures - similar to forward but feature formalized and standardized characteristics Key differences of Futures compared to Forwards –Secondary trading – liquidity Vast majority of contracts are reversed before delivery –Marked to market –Standardized contract units –Clearinghouse guarantees performance Chapter VIII – Futures

3 3 Overview of Futures Forwards, followed by futures, were first developed to eliminate the price risk in buying and selling of agricultural commodities for delivery sometime in the future. –Consider the risk that a farmer faces if the price for his only product goes down dramatically during the growing season? –Some years you may benefit from an increase in prices compared to the price when you are first planting your crops, but some years you may lose. –Given that this is likely your only crop, losing on price, could mean losing the farm. –Futures markets allow you to lock in a price months down the road, right now, with a buyer guaranteed. Then all you have to worry about is growing your product. Chapter VIII – Futures

4 4 Futures Quotes Contract Definition: futures on Soybeans, traded on Chicago Board of Trade, each contract is for 5,000 bushels, and prices are cents per bushel. Prices are for future month as indicated and represent the identical product. Open, Hi, Low: Quote for Nov delivery showed the contract opened at $6.32 on last trading day, reached a high of $6.37750 and a low of $6.3050 Chapter VIII – Futures

5 5 Futures Quotes Lifetime Hi, Low: Indicate full range of prices reached on this future since inception. The price on November (’93) delivery has ranged from $5.555 to $7.575 since trading first opened. Settle: The representative price over the closing period for the last trading day, as established by the exchange. In this case, the exchange uses the average price of the last two minutes of trading. The settlement is up +7 cents from the day prior at $6.37125 or $31,856.25 per contract. Open Interest: The number of outstanding contracts as of the close of trading. Open interest generally increases until a month before the contract matures, and then declines rapidly as investors reverse their positions. Chapter VIII – Futures

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8 8 Key Terms for Futures Contracts Futures price - agreed-upon price at maturity Long position - agree to purchase Short position - agree to sell Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot

9 9 Futures: Trading Mechanics Closing out positions –Reversing the trade –Take or make delivery –Most trades are reversed and do not involve actual delivery Clearinghouse - acts as a party to all buyers and sellers. –Obligated to deliver or supply delivery –Eliminates credit risk of transaction

10 10 Futures: Trading Mechanics Long Position Long Position Long Position Short Position Clearing house Money Commodity Money

11 11 Margin and Trading Arrangements Initial Margin - funds deposited to provide capital to absorb losses Marking to Market - each day the profits or losses from the new futures price are reflected in the account. Maintenance or variance margin - an established value below which a trader’s margin may not fall.

12 12 Margin and Trading Arrangements Margin call - when the maintenance margin is reached, broker will ask for additional margin funds Equity - the equity in your account represents what your broker would return to you if your position was unwound at the closing price Convergence of Price - as maturity approaches the spot and futures price converge Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement

13 13 Futures Market Participants Hedgers - Interested in insulating against price movement. –long hedge - protecting against a rise in price –short hedge - protecting against a fall in price Speculators - Interested in profiting from anticipated price movement. –short - believe price will fall –long - believe price will rise –Transactions costs lower and leverage higher than if speculating in actual good or asset

14 14 Basis and Basis Risk Basis - the difference between the futures price and the spot price –over time the basis will likely change and will eventually converge Basis Risk - the variability in the basis that will affect profits and/or hedging performance

15 15 Margin Account & Trading Example The initial margin requirement on soybeans is $1,125 per contract. This must be deposited with the exchange at the time of signing a futures contract. If the contract is for 10 contracts (50,000 bushels), the deposit is for $11,250 total. The minimum maintenance margin on soybeans is $900 per contract. Assume the following scenario: –Susan Q. Speculator buys 10 soybean contracts at 631 –George Q. Farmer sells 10 soybean contracts at 631

16 16 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 Q makes a profit of $5,000 (= 50,000*.10 = 50,000*641- 50,000*631). Her equity is now $11,250+5,000=16,250. George loses $5,000 (=50,000*-.10 = 50,000*631-50,000*641). George’s equity goes down by 5,000, from 11,250 to 6,250. He receives a margin call and must deposit +5,000 to bring his equity back to 11,250.

17 17 Margin Account & Trading Example Day 3: Settlement price = 642 Susan Q. –Profit/Loss for the day = –Equity = George Q. –Profit/Loss for the day = –Equity =

18 18 Margin Account & Trading Example Day 4: Settlement price = 630 Susan Q. –Profit/Loss for the day = –Equity = George Q. –Profit/Loss for the day = –Equity =

19 19 Margin Account & Trading Example Day 5: Settlement price = 636 Susan Q. –Profit/Loss for the day = –Equity = George Q. –Profit/Loss for the day = –Equity =


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