1. Financial Market Theory
Tuesday, November 14, 2017
Professor Edwin T Burton

2. Futures Contract …………………not a security Has:
An amount (with quality standardized)
Example: 100 troy ounces of gold
Example: 100 barrels of ‘West Texas’ crude oil
Maturity date
Sometimes called ‘delivery date’
Date upon which underlying is actually purchased and delivered at the price paid for the futures contract
Financing by ‘posting’ collateral
Subject to daily mark-to-markets
Best thought of as ‘delayed’ purchase

3. “Spot’ Market The market for purchase and delivery today
Meaning you pay today
Delivery takes place today
A purchase of a residence can be thought of in the same way
Except, when you agree to purchase a home, you sign a contract that has a ‘closing date.’ The closing date is actually the date that you pay and take delivery
So, purchasing a home is almost never done in the ‘spot’ market
Buying vegetables at a fruit stand is a ‘spot’ market transaction

4. Example – gold futures contract
Imagine the spot price of gold is $ 1,000 per ounce today
Suppose you buy gold today and sell a six-month gold future:
How would the gold future be priced?
What happens on delivery date?
You buy gold at the futures price
Deliver the amount of gold covered by the contract
Imagine that the six-month default-free rate is 6 percent
If you buy gold and sell the six month future at $ 1,060
Then you pay $ 1,000 today and receive $ 1,060 on the delivery date when you deliver the gold that you purchase for $ 1,000 today. This gives you a return of 6 percent. That would be the same as the default-free rate
If the future today is priced at higher than 6 percent, you earn an “arbitrage profit”
This type of transaction is called a ‘forward conversion’

5. What if future is priced at $ 1,050?
Buy the six-month gold future for 1,050 and sell gold today for $ 1,000
Invest the $ 1,000 and earn 6 percent over the next six months
On the delivery date:
Buy gold for $ 1,050
Have $ 1,060 from your investment of $ 1,000 at the default-free rate
This would be a $ 10 per contract ‘arbitrage’ profit

6. Other Complications Could be storage costs: oil, gold, etc.
Could be other income: dividends, coupon payments, etc.
Underlying may not exist: September wheat (has not been planted)
Underlying may not be durable: September hogs (are babies today)

7. Cash Settlement
Some futures ‘settle’ on delivery date in cash not the underlying
Assuming mark-to-market daily of the futures contract right up to the delivery date, nothing happens on delivery date except the future no longer exists after the delivery date