1Lec 2 Intro to Futures Markets Lec 2: Intro to Futures Markets (Hull, Ch. 2) Basic Definitions 1. “Cash Market” or “Spot” contract is an agreement (between two parties) to trade a commodity (e.g. oranges, U.S. T-Bills, Currencies,...) for cash immediately. (Translation: the cash or spot market is like a grocery store, you buy oranges with cash today). 2. “Forward contract” is an agreement (signed today) to trade at a future date (say 90 days from now). The Forward (or Futures) price, is fixed today. 3. “Futures” contract is a standardized forward contract. Risk of default with a futures contract ∼ 0.

2Lec 2 Intro to Futures Markets Example of a Forward Contract ▸ At t = 0 (now) a corn farmer plants a crop for next June ▸ At t = 1, (June) the crop yields 10,000 bushels ▸ Suppose the spot price today and at time 1 are: $10/Bu ➟ GREAT $5/Bu $1 /Bu ➟ Not so Great.Moral: there is a lot of risk here | –––––––––| 0 1 (June) To eliminate the risk, Farmer sells the 10,000 bushels of corn forward. Del Monte Foods will take the other side of this contract. forward price = $6/bu.

3Lec 2 Intro to Futures Markets ▸ At t=0, Two parties agree on a forward price = $6/bu. Delivery in June (t=1) No money changes hands now ▸ At t =1 (June) Farmer delivers 10,000 bushels. Del Monte Foods pays $60,000 → Both parties have eliminated price risk.

4Lec 2 Intro to Futures Markets Problems ▸ Suppose at time 1, Spot price = $10/bu. ▸ Farmer could get $100,000 in the spot market. ▸ CF from the forward contract = $ 60,000. What to do? Default on Forward contract. Sell corn in the spot market for $ 100,000. Alternatively, suppose at time 1 the Spot price = $ 1/bu. ▸ Del Monte Foods could buy corn in the spot market for $ 10,000 ▸ BUT Del Monte agreed to pay = $ 60,000. What to do? Default on Forward contract and buy corn in the spot market. ➟ Moral of this story: There is a great deal of credit risk in forward contracts !!!

5Lec 2 Intro to Futures Markets Financial Innovations: Futures Contracts, and daily mark to market Contract Size (fixed): 10,000 bushels Delivery Date (fixed): Mar, Jun, Sep, Dec Exchange: Chicago Mercantile Exchange (CME) Farmer shorts 1 June futures contract. Futures price = $6. Del Monte goes long 1 June futures. Futures price = $6. Contract Size = 10,000 bu. Contract will settle 3 rd week in June Basically, ▸ Farmer has agreed to sell 10,000 bushels of corn for $ 60,000 ▸ Del Monte has agreed to buy 10,000 bushels of corn for $ 60,000 ▸ Both long and short have a Margin Requirement: ▸ Initial margin = $5,000 (may vary). Maintenance Margin = $2,000 (may vary)

6Lec 2 Intro to Futures Markets Daily Settlement Process i.e., Mark to Market DaySettle Price Notional Value Daily Δ Margin for Long(DelMonte) Short(Farmer) Day 0, 9 AM$6/bu$60,000$5,000 Day 0, close$6.25 $62,500$2,500$7,500$2,500 Day 1, close ,5001,000 8,5001,500 Short Receives “Margin Call” Day 2, close6.36 $63, ,600$4, Settlement Day ,000

7Lec 2 Intro to Futures Markets What happens at Expiration? Suppose the last Settle price = $10/bushel = spot price ▸ Long (Del Monte) has a cumulative GAIN of +10,000[ ] = $40,000 in the margin account. ▸ Short (Farmer) has a cumulative LOSS of $40, ,000[ ] = - $40,000 in the margin account. Suppose the farmer defaults (sells corn in the spot market). No Problem. Del Monte (Long) buys corn in the cash market for $100,000. BUT, Long also has a gain in the futures = $40,000. Therefore, Actual CF = -100,000+40,000 = -$60,000. (Del Monte pays $60,000 for the corn. Same as original futures price) Moral of this story: Default is not a problem because gains and losses are quantified daily and paid in cash each day. This is the advantage of Futures Contracts: Daily Mark to Market

8Lec 2 Intro to Futures Markets Thank You! (a Favara)