1. Chapter 12
Futures

2. Basic Terminology
Spot market: market for immediate delivery of some commodity, such as wheat or Government bonds
Forward contract: customized, nonstandard contractual agreement to trade specified commodity or financial instrument at agreed-upon price, settlement date, quantity, and location
Futures contracts: standardized contracts that can be bought and sold on an exchange

3. Difference between Futures Owner and Option Holder
Futures buyer has obligation to accept and pay for specified quantity of asset at specified price at specified time
Option holder has right—but not obligation—to buy or sell specified quantity of asset at specified price over specified time period

4. Differences Between Forward Contract and Futures Contract
Forward contract: nonstandardized (unique) contract between parties to accept delivery (buy) and deliver (sell) specified commodity or financial instrument at agreed-upon price, settlement date, quantity and location.
There is no organized exchange for trading forward contracts.
Futures contract: standardized contract divided into two contracts—one to buy and one to sell—a specified commodity or financial instrument.
Futures trade on organized exchange that sets contract terms, establishing price, quantity, delivery location, and date.

5. Exchanges Oldest is Chicago Board of Trade
In 2003, 19 exchanges listed in WSJ

6. Types of Professional Futures Market Traders
Firm representatives: hedge needs or outputs of commodity-related firms
Scalpers: look for temporary misalignments of prices, hold positions for a few minutes at most
Day traders: short-run traders who close their positions each day
Position traders: may hold positions for several days based on fundamental or technical factors
Arbitrageurs: seek to exploit departures from expected relative price relationships, but may hold positions for extended time periods

7. Regulation of the Futures Markets
Primary regulator: Commodity Futures Trading Commission (CFTC)
mission : protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets

8. Types of Contracts Agricultural Mineral Financial
cattle, hogs, chickens, wheat, oats, corn
Mineral
crude oil, natural gas, gasoline, copper, zinc
Financial
interest rate, stock market index, foreign currency

9. Ingredients for Good Contract
·  Relatively competitive spot market
·  Meaningful, standardized contract (for example, a well-defined deliverable)
· Storability or its equivalence (that is, ongoing production)
· Sufficient price volatility to attract (or require) speculative and hedging interest
·  Significant business use for product

10. Characteristics of Contracts
Many contracts per commodity (e.g.,differ by delivery date)
Each contract has large dollar value

11. Clearinghouse Clearinghouse critical to futures market
Trade technically with clearinghouse, not person on other side
Clearinghouse guarantees terms of contract

12. Long and Short Transactions
Long transaction
Contract to make a purchase in the future
Going long
Short transaction
Entering into contractual agreement to deliver asset in future at specified price
Going short

13. Closing Out a Position
In options or futures trading, using an offsetting transaction to remove investor from further exposure to investment and to lock in profits or limit losses

14. Closing vs. Delivery Majority of commodity contracts are closed out
Inconvenient for shorts to make delivery and longs to take delivery
When hedging, people close out hedge and buy/sell in their local cash market

15. Round-Trip Fee
Total commission costs of executing transaction in futures market paid at time of contract’s formation

16. Large $ Value &Earnest Money
Most contracts have large $ value
Dollar price per unit usually “small”, but most contracts are for a large # of units
Margin deposit that serves as security to guarantee performance of contract by buyer and seller of a futures contract (5 – 15% of market value)
In general, money put on deposit to guarantee honoring of contract’s terms

17. Mark to the Market Recompute value of equity position on daily basis
Ensures that, as prices fluctuate, amount held in margin or escrow account remains sufficient to meet minimum requirements
Brokerage firms mark to the market to reduce risk that client might default.

18. Daily Price Limits
Rule established by futures exchanges for maximum range of price movement permitted between settle price of previous day and opening price of next day of trading for any given commodity
Once limit is reached, trading must stop until next trading session.

19. Open Outcry No specialists Traders deal directly with one another
Desired contract indicated by position on floor
Hand signals are critical for communication

20. Trading Strategies
Hedging: taking opposite positions to reduce risk exposure on one of positions
Speculating: the act of committing funds in anticipation of specific price movement
Spreading: creating a combination trade, such as both long and short position in the futures market

21. Hedging Person must take position in commodity for business reason
Example: a farmer is long the crop in his field
While crop is growing, farmer is exposed to price risk—risk spot market price of crop will fall
If farmer sells a futures contract, he replaces price risk with basis risk

22. Basis Risk Basis = cash market price – futures market price
In perfect hedge, basis does not change
Basis risk = risk that basis will change
Hedger substituting basis risk for price risk
Hedge successful as long as basis risk is less than price risk

23. Short and Long Hedges Short hedge Long hedge
Hedger is short the futures contract and long the commodity
Example: farmer is long the crop in the field, and takes short position in the futures contract
Long hedge
Hedger is long the futures contract and short the commodity
Example: builder has contracted to build home, and takes long position in a plywood futures contract

24. Short Hedge Example Farmer plants 30,000 bushels of corn
Current spot (cash) market price = $5.20/bu.
If corn harvested and sold today,
proceeds = 30,000 x $5.20 = $156,000
Farmer sells 6 futures contracts at $5/bu.
Basis = $5.20 – $5.00 = $.20
Farmer provides broker with margin
(continued)

25. Short Hedge Example (continued)
Time to harvest arrives
Cash price = $4.50/bu.
Futures price = $4.30/bu.
Basis still = $.20 (turns out to be perfect hedge)
Farmer harvests & sells corn for:
30,000 x $4.50 = $135,000
(continued)

26. Short Hedge Example (continued)
Farmer closes out futures position
($5.00 – $4.30) x 30,000 = $21,000 profit
Farmers total proceeds with hedge:
Proceeds from sale of crop: $135,000
Profit on futures hedge: ,000
Total Proceeds $156,000

27. Speculating & Spreading
Speculating: maximum risk exposure
Investor thinks he or she knows something others do not
Spreading
Offsetting positions in related contracts
Betting on change in the differential
E.G., Dec corn will rise relative to March corn

28. Differences between Markets in Commodities Futures and Stocks
Limited term
Maximum daily price moves
Margins of 5% to 15%
Long interest equal to short interest by definition
No short selling restrictions
No interest charged on unpaid margin
Market has no specialist system
Positions must be opened and closed with same brokerage firm
Stocks
Unlimited term
No limit on daily price moves
Margins of 50% or more
Short interest usually small fraction of long interest
Short sales not permitted on a downtick
Interest incurred on margin debt
Market making by specialists
No restriction on opening and closing positions with different firms 28

29. Interest Rate Futures
Futures contract calling for delivery of a debt security, such as Treasury bills or long-term government bonds
Because value of debt securities varies inversely with market interest rates, people can speculate on interest rate changes by trading futures contracts on debt securities.

30. Stock Market Index Futures
Futures contract on stock index that does not require delivery of underlying stock index but is instead settled in dollars according to difference between price agreed to in the contract and the actual closing price of the index

31. Cash Settlement Stock index futures require cash settlement because:
Awkward or impossible to deliver index bundle
Potentially expensive to deliver index
Cash settlement process:
At close of last day of contract life, open positions are treated as closed out at index price

32. Futures Options An option on a futures contract
In theory, treated like any other option contract

33. Program Trading Any large-volume, mechanical trading system
Involves the simultaneous execution of trades in a number of stocks
Allows one to hedge or arbitrage a stock index futures contract with the underlying portfolio
Leads to concept of portfolio “insurance”