Chapter 26 – Futures Markets Forward Contracts A contract that two parties agree to today such that both parties are obligated to complete a transaction in the future Price set for transaction Delivery Date set for transaction Commodity set for transaction Delivery Location set for transaction Examples Hotel Reservation, Airplane Ticket, Book Order

Chapter 26 – Futures Markets Futures Contracts Just like forward contract except Traded on an Organized Exchange No money changes hands between the two parties today Terms Matching Commodity to be delivered or received is the UNDERLYING Price for transaction is the FUTURES PRICE Delivery Date is the SETTLEMENT DATE

Chapter 26 – Futures Markets Parties in the Futures Contract Buyer of the Futures Contract is “buying or taking delivery of the commodity” in the future and is said to be LONG in the contract Seller of the Futures Contract is “selling or making delivery of the commodity” in the future and is said to be SHORT in the contract The Exchange where the futures contracts are bought and sold Clearing House guarantees performance

Chapter 26 – Futures Markets Example of a Forward Contract and the Parties Economic Incentives Order a Book for Future Delivery Parties Buyer of the Book Bookstore Contract Commodity Book Delivery Date (Three Weeks) Price $15.00

Chapter 26 – Futures Markets Example Continued During the 3 Week period Buyer sees “ordered” book at Borders for $12.50 Buyer “skips” out of contract (fails to perform) and buys book at Borders saving $2.50 Bookstore has book and no buyer During the 3 Week period Bookstore sees book selling on eBay for $19.00 Bookstore “skips” out of contract and sells book on eBay for $19.00 making an extra $4 Buyer of contract still waiting for book

Chapter 26 – Futures Markets Closer Look at the Contracts Futures Price and Spot Price and Settle Price Futures price is the contract agreed to price and varies through out the life of the contract as different parties “reach” different agreements Spot price is the current market price for delivery and exchange of the commodity Settle Price is the consensus price of the contract at the end of the trading day Difference between YOUR contract futures price and the consensus end of day price each day reflects profit or loss on the contract

Chapter 26 – Futures Markets An example of an Actual Contract Wheat Futures at the Kansas City Board of Trade Size of Contract is 5,000 bushels Commodity is Hard Red Winter Wheat Delivery is at Grain Storage Facility on the Missouri River near the Railroad Shipping Yards Price stated in cents per bushel, 280 What does this mean? Buyer Position and Seller Position of one contract

Chapter 26 – Futures Markets Who are the traders involved in the contracts? Originator of the contract Hedgers and Speculators  Hedgers for Insurance (against future price movements)  Speculators betting on a price movement in their favor Market Makers  Dealers trading for customers  Locals

Chapter 26 – Futures Markets Profits and Losses Zero Sum Game For every dollar one party makes the party on the opposite side of the contract loses a dollar Rising prices profit to buyer of the contract Falling prices profit to seller of the contract Hedgers always break even when considering their inventory position Diagrams of Payoffs for Futures

Chapter 26 – Futures Markets Getting In and Out of Contracts Complete the contract (make or take delivery and pay or receive futures price) Sell or Buy opposite position before delivery date How can new buyer/seller be matched? How can Clearing House guaranteeing the Performance of the buyer and seller? MARGINS and Marking to Market

Chapter 26 – Futures Markets Financial Futures Settlement in Cash Contracts traded against “fictitious” underlying Questions on the Soundness of Trading Financial Futures – GAO Study Governing the Futures Markets Self Regulating Organizations CFTC – Commodity Futures Trading Commission

Chapter 26 – Futures Markets What happens to the Hedger when the inventories are short of the required delivery of the contract Buying in the Spot Delivery in the Spot and Close Futures Position Gains or Losses from the different strategies Forward Rate Agreements Special Futures – i.e. a Forward Contract