Introduction to Agricultural Futures Markets u Overview u Terms u Participants u Procedures u Examples

Types of market transactions u Cash or spot market –Establish price today –Deliver today or very soon u Forward contract for delivery –Establish price today –Deliver in the future u Futures contracts –Establish price today –Deliver in future or offset obligation

“Forward” and “Futures” contracts are alike because: u Address biological nature of production and buyer’s need for year round supply u Agree now to buy/sell commodity at some future date –Price, quality, quantity, and delivery date established now –Commodity received/delivered at future date –Payment made/received at future date

“Forward” and “Futures” contracts are different because: u Flexibility u Liquidity u Backing u Regulation

FUTURES VS. FORWARD CONTRACTS: Flexibility u Forward Contract –Often flexible size –Commodity must be delivered/received, unless counterparty agrees to re-negotiate u Futures Contract –Standardized contract –Commodity need not be delivered/received –To avoid delivery/receipt, simply offset contract by buying/selling back before maturity

FUTURES VS. FORWARD CONTRACTS: Liquidity u Forward Contracts –Illiquid Buyer 1 Seller 1 Buyer 2 Seller 2 Buyer 3 Seller 3.. Buyer N Seller N u Futures Contracts –Very liquid Buyer 1 Seller 1 Buyer 2 Seller 2 Buyer 3 Seller 3.. Buyer N Seller N EXCHANGE

FUTURES VS. FORWARD CONTRACTS: Backing u Forward Contracts –Traded “over the counter” (OTC) »No guarantor »Security deposits may be made to guarantee transaction u Futures Contracts –Traded in organized Exchanges »Transactions guaranteed by Exchange »Both buyers and sellers must make security deposits (“margins”) with the Exchange »Exchange acts as a clearinghouse

FUTURES VS. FORWARD CONTRACTS: Regulation u Forward Contracts –Traded “over the counter” (OTC) »Regulated by state or federal commerce laws u Futures Contracts –Traded in organized Exchanges »Heavily regulated: Three tiers of regulation u Commodity Futures Trading Commission u National Futures Association u Self-regulation by Exchanges

Futures markets u Modern futures market began long ago –1848 Chicago Board of Trade –1919 Chicago Mercantile Exchange u Organized and centralized market u Today’s price for products to be delivered in the future. u A mechanism of trading promises of future commodity deliveries among traders.

Futures markets u Biological nature of ag production –Excess supply at harvest –Shortage in spring and summer –Producers need price forecast because prices not known when production decision is made –Processors need year around supply

Futures Market Exchanges u Trading pits u Centralized pricing –Buyers and sellers represented by brokers in the pits –All information represented through bids and offers u Perfectly competitive market –Open out-cry trading –Beginning electronic trading

Futures are a zero sum game u For every buyer there is a seller u For every seller there is a buyer u What one gains the other looses u There is no intermediary that buys and sells to assure the market clears u There is a transaction fee paid by both

The futures contract u A legally binding contract to make or take delivery of the commodity –Trading the promise to do something in the future –You can “offset” your promise u Standardized contract –Form (wt, grade, specifications) –Time (delivery date) –Place (delivery location)

The futures contract u No physical exchange takes place when the contract is traded. u Payment is based on the price established when the contract was initially traded. u Deliveries are made when the contract expires (delivery time).

Standardized contract u Certain delivery (contract) months u Fixed size of contract –Grains 5,000 bushels »Corn, Wheat, Soybeans –Livestock in pounds »Lean Hogs 40,000 lbs carcass »Live Cattle 40,000 lbs live »Feeder Cattle 50,000 lbs live u Specified delivery points –Relatively few delivery points

FUTURES: DEFINITIONS

u Settlement price –Average of the prices that a futures contract trades for immediately before the closing of the trading day. It is used for mark-to-market calculations. u Daily trading limit –Maximum price range during one trading session permitted by the Exchange for a contract »CBOT: u Corn: $0.20/bu above or below previous day's settlement u Soybeans: $0.50/bu above or below previous day's settlement price. u Wheat: $0.30/bu above or below previous day's settlement price. »CME: u Feeder cattle: $0.03/lb above or below previous day's settlement price u Live cattle: $0.03/lb above or below previous day's settlement price u Lean Hogs: $0.02/lb above or below previous day's settlement price

FUTURES: DEFINITIONS u Volume and Open Interest: DayActivityVolumeOpen Interest 1First day of trading Mary sells 3 contracts Peter buys 3 contracts 33

FUTURES: DEFINITIONS u Volume and Open Interest: DayActivityVolumeOpen Interest 1First day of trading Mary sells 3 contracts Peter buys 3 contracts 33 2Mary buys back 1 contract Peter sells back 1 contract 12

FUTURES: DEFINITIONS u Volume and Open Interest: DayActivityVolumeOpen Interest 1First day of trading Mary sells 3 contracts Peter buys 3 contracts 33 2Mary buys back 1 contract Peter sells back 1 contract 12 3Mary buys back 2 contracts Peter sells back 1 contract Joe sells 1 contract 21

FUTURES: DEFINITIONS u Volume and Open Interest: DayActivityVolumeOpen Interest 1First day of trading Mary sells 3 contracts Peter buys 3 contracts 33 2Mary buys back 1 contract Peter sells back 1 contract 12 3Mary buys back 2 contracts Peter sells back 1 contract Joe sells 1 contract 21 4Peter sells back 1 contract Joe buys back 1 contract 10

FUTURES: DEFINITIONS SPECULATORS u Have no use for physical commodity u Not willing to make or take physical delivery u Buy or sell futures in an attempt to profit from price movements u Add liquidity to the market HEDGERS u Producers or users of commodity u Willing to make or take physical delivery u Use futures to protect against unfavorable price movements

Terms and Definitions u Basis –The difference between the spot or cash price and the futures price of the same or a related commodity. u Bear or Bear Market –Someone that thinks the price will decline u Bull or Bull Market –Someone that thinks the price will increase

Terms and Definitions u Clearing House –The division of the Exchange through which all trades made must be confirmed, matched and settled each day until offset or delivered. u Closing price –The last price of a contract at the end of a trading session. u Commission –For futures contracts, the one-time fee charged by a broker to cover the trades you make to open and close each position.

Terms and Definitions u Daily trading limits –The maximum price range permitted a contract during one trading session. u Long position –A position in which the trader has bought a futures contract that does not offset a previously established short position. u Short position –A position in which the trader has sold a futures contract that does not offset a previously established long position.

Terms and Definitions u Margin –The amount of money or collateral deposited by a client with his or her broker for the purpose of insuring the broker against loss on open futures contracts. u Maturity –Period within which a futures contract can be settled by delivery of the actual commodity. u Nearby – The nearest active trading month of a futures or options on futures contract. Also referred to as the lead month.

Terms and Definitions u Spread –The price difference between two contracts. Holding a long and a short position in two related futures contracts, with the objective of profiting from a changing price relationship. u Volume –The number of contracts in futures or options on futures made during a specified period of time

Market position u Objective: Buy low, sell high u You can either buy or sell initially to open a position –“Make” a promise u Do the opposite to close the position at a later date –“Offset” the promise u Trader may also hold the position until expiration and make or take physical delivery of the commodity –Exceptions include Lean Hogs and Feeder Cattle

FUTURES: SPECULATION u Speculators: –Buy or sell in an attempt to profit from favorable price movements –Face the risk of loses from unfavorable price movements –Do not produce or consume the commodity –Benefit the market because they add liquidity

FUTURES: SPECULATION u Futures markets greatly facilitate use of superior information for speculators: –Little capital required »Initial margin, margin calls –No need to handle commodity (e.g., transportation, storage, cleaning) –As easy to speculate DOWN as UP

FUTURES: DEFINITIONS u Bullish speculator: Time Now Buy futures contractSell contract back MaturityLater “Open” a “long” futures “position” “Close” the “long” “position” “Long” futures “position” No futures “position” “Make” a promise“Offset” the promise

Long Market position: Speculator u Hope to profit from price rise u Buy a December corn contract Buy now at $3.00 Sell later at $4.00 Return +$1.00 What if the later price is $2.00

FUTURES: DEFINITIONS u Bearish speculator: Time Now Sell futures contractBuy contract back MaturityLater “Open” a “short” futures “position” “Close” the “short” “position” “Short” futures “position” No futures “position” “Make” a promise“Offset” the promise

Short Market position: Speculator u Hope to profit from a price fall u Sell a December Corn contract Sell now at $3.00 Buy later at $5.00 Return -$2.00 What if the later price is $2.00

FUTURES: SPECULATION

u Types of speculators: –Short term »Scalpers »Day traders –Long term

FUTURES: ACCOUNTING u Margin (“performance bond”) –Money deposit to ensure fulfillment of a futures contract at a future date

FUTURES: ACCOUNTING u Margins –Initial margin »Deposit that must be made when opening a position –Maintenance margin »Minimum margin that must be maintained while holding an open position –Margin call »Call to deposit additional funds into margin account to bring it up to initial margin level

MARGINS EXAMPLE u Suppose corn futures contracts have: –Contract size = 5,000 bu/contract –Initial margin = $600/contract –Maintenance margin = $400/contract u Suppose on May 10 th bearish speculator opens “short” position by selling 3 corn futures $2.10/bu –Initial margin deposit = $1800 (= $600/contract  3 contracts) –Maintenance margin = $1200 (= $400/contract  3 contracts)

MARGINS EXAMPLE Initial Margin ($/contract):600 Maintenance Margin ($/contract):400 Position Opened (long vs. short):short Number of Contracts:3 Contract Size (bu): 5000 DayTransactionSettlementDailyMargin Margin AccountCumulative Price Gain (Loss)CallBalance Gain (Loss) ($/bu) ($) 10- May

MARGINS EXAMPLE u Price falls and settlement price is $2.08/bu on May 10 th : –Daily gain (loss) = $300 –[= ($2.10/bu - $2.08/bu)  5000 bu/contract  3 contracts] –$.02 x 5000 x 3 = $300

MARGINS EXAMPLE Initial Margin ($/contract):600 Maintenance Margin ($/contract):400 Position Opened (long vs. short):short Number of Contracts:3 Contract Size (bu): 5000 DayTransactionSettlementDailyMargin Margin AccountCumulative Price Gain (Loss)CallBalance Gain (Loss) ($/bu) ($) 10-May

MARGINS EXAMPLE u Settlement price rises to $2.12/bu on May 11 th : –Daily gain (loss) = ($600) [= ($2.08/bu - $2.12/bu)  5000 bu/contract  3 contracts]

MARGINS EXAMPLE Initial Margin ($/contract): 600 Maintenance Margin ($/contract):400 Position Opened (long vs. short):short Number of Contracts:3 Contract Size (bu): 5000 DayTransactionSettlementDailyMarginMargin AccountCumulative Price Gain (Loss)CallBalanceGain (Loss) ($/bu) ($) 10-May May2.12(600)01500(300)

MARGINS EXAMPLE u Settlement price rises to $2.15/bu on May 12 th : –Daily gain (loss) = ($450) [= ($2.12/bu - $2.15/bu)  5000 bu/contract  3 contracts]

MARGINS EXAMPLE Initial Margin ($/contract): 600 Maintenance Margin ($/contract):400 Position Opened (long vs. short):short Number of Contracts:3 Contract Size (bu): 5000 DayTransactionSettlementDailyMarginMargin AccountCumulative Price Gain (Loss)CallBalanceGain (Loss) ($/bu) ($) 10-May May2.12(600)01500(300) 12-May2.15(450) (750) On May 12 the margin balance dropped below the maintenance level and had to be restored to the initial level

MARGINS EXAMPLE Initial Margin ($/contract): 600 Maintenance Margin ($/contract):400 Position Opened (long vs. short):short Number of Contracts:3 Contract Size (bu): 5000 DayTransactionSettlementDailyMarginMargin AccountCumulative Price Gain (Loss)CallBalanceGain (Loss) ($/bu) ($) 10-May May2.12(600)01500(300) 12-May2.15(450) (750) 15-May (600) 16-May2.17(450)01500(1050) 17-May2.19(300)01200(1350) 18-May2.21(300) (1650) 19-May2.22(150)01650(1800) 22-May2.25(450)01200(2250) 23-May (1950) 24-May (1650) 25-May2.31(1500) (3150) 26-May (750) 29-May May May Jun

MARGINS EXAMPLE Initial Margin ($/contract): 600 Maintenance Margin ($/contract):400 Position Opened (long vs. short):long Number of Contracts:4 Contract Size (bu): 5000 DayTransactionSettlementDailyMarginMargin AccountCumulative Price Gain (Loss)CallBalanceGain (Loss) ($/bu) ($) 10-May (400)02000(400) 11-May May May2.14(200) May May May May May May2.23(400) May2.21(400) May May2.15(3200) May2.06(1800)01600(800) 30-May2.02(800) (1600) 31-May1.96(1200) (2800) 1-Jun1.93(600)01800(3400)

FUTURES: MARGINS u Margins –Settlement Price –“Marking-to-market”

FUTURES: MARGINS u Except for initial margin deposit, money not paid/received when futures are initially bought/sold.

FUTURES: MARGINS u Margins –Different across commodities –Different for speculators vs. hedgers –May change over time

FUTURES: MARGINS

FUTURES: TRADING PROCEDURES u Transactions executed by brokers –Brokerage fee

FUTURES: TRADING PROCEDURES 1. Opening the futures position 2. Maintaining the futures position 3. Closing the futures position

FUTURES: TRADING PROCEDURES 1. Opening the futures position Step 1: You decide to open a futures position (e.g., short) Step 2: Call broker and place order to trade (e.g., sell Dec corn at the market) Step 3: Broker forwards order to the Exchange, where broker's representative runs the order to the pit and tries to fill the order Step 4: Order is filled $2.34/bu) Step 5: Broker calls you back to confirm fill Step 6: You deposit initial margin with broker on same day order is filled

FUTURES: TRADING PROCEDURES 2. Maintaining the futures position Step 7: Until position is closed, margin account balance is calculated at the close of the market each day; deposit margin calls as required to maintain the position

FUTURES: TRADING PROCEDURES 3. Closing the futures position Step 8: Decide to close the futures position Step 9: Call broker and place order to close the position (e.g., buy Dec corn at the market) Step 10: Broker forwards order to the Exchange, where broker's representative runs the order to the pit and tries to fill the order Step 11: Order is filled $2.50/bu) Step 12: Broker calculates the ending margin account balance, subtracts his commission (e.g., $40/contract), and returns the remainder to you

Futures Summary u Today’s price for delivery in future u Standardized contract/promise to make or take delivery u Contract/promise can be offset u Several participants for different positions