1. Copyright 2014 by Diane S. Docking 1 Forwards & Futures CME Futures: How it all works: http://bcove.me/w8my8dn3http://bcove.me/w8my8dn3

2. Learning Objectives Distinguish between a forward and a futures contract Understand how a futures transaction is conducted. Identify information that can be found in a futures quote Understand the mechanics of a futures margin account Copyright 2014 by Diane S. Docking 2

3. 3 Forward Contracts a commitment by 2 parties to exchange a particular good for a specific price (F) at a specific future time is an obligation; if price falls, you still pay or receive F value of contract depends on value of underlying asset (S) must put up margin money (good faith deposit) settlement made at delivery date a contingent claim a perfect hedge –sell forward contract if expect price to decrease in future –buy forward contract if expect price to increase in future traded privately; typically thin trading volume

4. Copyright 2014 by Diane S. Docking 4 Futures Contracts a legal commitment by 2 parties to exchange a particular good for a specific price (F) at a specific future time, except profits and losses are settled on a daily basis (and not at end of contract period) –Commodity futures (underlying instrument is a commodity, e.g.: cattle, pork bellies, oil) –Index futures (underlying instrument is an index, e.g.: S&P 500) –Financial futures (underlying instrument is a financial instrument, e.g.: T-Bill) –Currency futures (underlying instrument is a foreign currency) www.cmegroup.com

5. Copyright 2014 by Diane S. Docking 5 Characteristics of Futures Contract positions marked to market daily traded on an organized exchange –brings liquidity to the market –contract is with clearing house (CBT, CME etc.) standardized contracts a zero sum game; i.e., somebody wins and somebody loses requires margin dollars limits set by Exchanges on: –size of price change (If price moves the limit, then market shuts down.) –size of position that any single trader may take –these limits are an added risk as I may not be able to undo (unwind) my position –these limits vary by contract

6. Copyright 2014 by Diane S. Docking 6 Spot and Future Prices Spot Price (P) –today’s price Future Price (F) –price in future Future rate at a premium if: –F>P, expecting P to increase in future Future rate at a discount if: –F<P, expecting P to decrease in future The value of a futures contract is derived from the value of the underlying instrument

7. Copyright 2014 by Diane S. Docking 7 Potential Payoff From Speculative Futures Position aa Profit or Loss from Selling a Futures Contract Market Value of the Futures Contract as of the Settlement Date S 0 Profit or Loss from Purchasing a Futures Contract Market Value of the Futures Contract as of the Settlement Date S 0 Unlimited loss Maximum loss = purchase price Maximum gain = selling price Unlimited gain

8. Copyright 2014 by Diane S. Docking 8 Commodity Futures Agriculture Food, fiber Livestock, Meat Corn, Oats, Rice Oilseeds Wheat Ethanol Lumber Energy Electricity Petroleum Other Weather Metals Copper Gold Platinum Palladium Silver

9. Copyright 2014 by Diane S. Docking 9 Commodity Futures Quote – Corn 8/26/14 CME group/WSJ 1.How much does one Dec futures contract cost? Link: www.cmegroup.com-cornwww.cmegroup.com-corn Corn (CBT) – 5,000 bu.; cents per bu. Open HighLowSettleChangeInterest Dec 2015 408’4 410’0 404’2 408’0 -1’2 80,769 Change is from settle to settle Closing price is the settle or last price for the Dec. contract today Name of Contract Abbreviation of the Exchange Contract Size Cost per Unit Expiration Month of Contract. Contracts expire Mar, May, Jul, Sep, & Dec Open Interest The number of contracts outstanding (i.e. having an open position) Opening Price per contract for this day Highest Price and Lowest Price contract traded at for this day.

10. Copyright 2014 by Diane S. Docking 10 Commodity Futures Quote – Corn From the preceding Corn futures quote: 1.What is the dollar amount of open interest on the Dec contract? 2.What was yesterday’s closing price for the Dec contract?

11. Copyright 2014 by Diane S. Docking 11 Going Long & Short in the Commodities Futures Market LONG If an investor buys this Dec. futures contract on corn, they promise to pay $20,400 for 5,000 bu. of corn when delivered in December. They are expecting prices to increase by Dec.; therefore, lock in a buying price today. SHORT If an investor sells this Dec. futures contract on corn, they promise to deliver to the buyer 5,000 bu. of corn in December for which they will receive $20,4000. Expecting prices to decrease by Dec.; therefore, lock in a selling price today.

12. Copyright 2014 by Diane S. Docking 12 Open Interest Open Interest Time

13. Copyright 2014 by Diane S. Docking 13 Most Common Financial (or Interest Rate) Futures Contracts U.S. 30-yr. Treasury Bond Futures Contracts Three-month Eurodollar Time Deposit Futures Contracts One Month LIBOR Futures Contracts U.S. Treasury Bill Futures Contracts 30-day Federal Funds Futures Contracts U.S. 10-year Treasury Note Futures Contracts

14. Copyright 2014 by Diane S. Docking 14 Interest Rate Futures - T-Bond CME group/WSJ 8/26/2014 1.What is the “tick” amount? Tick = 1 bp change in interest rates = 1/32 =.03125 =.03125/100 x $100,000 = _________ Link: CMEgroup.com-T-bondsCMEgroup.com-T-bonds 30 Year U.S.Treasury Bond Futures (CBT) - $100,000; pts. 32nds of 100% Open HighLowSettleChangeInterest Mar 15 138’04 138’03 137’31 - 0’06 35 Par value or Face amount of contract Quote in 32nds, so = -1.00 / 32 = -$0.03125 Change is from settle to settle Contracts expire Mar, June, Sept, Dec Closing price is the settle price for the Sept. contract today Settlement requires minimum maturity of 15 yr, 6% coupon bond or equivalent thereof.

15. Copyright 2014 by Diane S. Docking 15 Interest Rate Futures - T-Bond 2.What is the settlement (closing) price (in $) for the contract. OR (131 x 32) + 31.0 = 4,192 + 31 = 4,223 bp 4,223 bp x $31.25 tick = $131,968.75 / contract

16. Copyright 2014 by Diane S. Docking 16 Going Long & Short in the Interest Rate Futures Market LONG If an investor buys this March futures contract on T-bonds, they promise to pay $131,968.75 for a $100,000, 15-yr. 6% T-bond (or receive the dollar equivalent) when delivered in March. They are expecting interest rates to decrease and prices to increase by March; therefore, lock in a buying price today. SHORT If an investor sells this March futures contract on T-bonds, they promise to deliver to the buyer the equivalent of a $100,000 15-year 6% T-Bond in March for which they will receive $131,968.75 They are expecting interest rates to increase and prices to decrease by March; therefore, lock in a selling price today.

17. Copyright 2014 by Diane S. Docking 17 Interest Rate Futures – Eurodollar CMEgroup/WSJ 8/26/14 1.What is the “tick” amount? Tick = 1bp change in interest rates = Face x (1 bp) x (Days to maturity/360) = $1,000,000 x.0001 x (90/360) = __________ Link: CMEgroup.com - EDCMEgroup.com - ED Eurodollar futures (CME) - $1,000,000; pts. of 100% OpenHighLowSettleChangeVolOpen Interest Dec 15 98.9650 99.000098.9650 98.9800 +.0050 192,6491,575,696 Par value or Face amount of contract Discount Rate = 100 – Settle = 1.02% Contracts expire monthly 3-month (They don’t tell you this, just know it)

18. Copyright 2014 by Diane S. Docking 18 2.What is the settlement (closing) price (in $) for the contract? Closing Price = Face – Discount where: Discount = Face x DR x (Days to maturity/360) Discount = $1 mill. x.0102 x (90/360) = $2,550** Price = $1,000,000 – 2,550 = $997,450 OR **Discount = 1.02% which is 102 bp x $25 tick = $2,550 Interest Rate Futures - Eurodollar

19. Copyright 2014 by Diane S. Docking 19 Foreign Exchange Futures Forward contracts used just as often as futures contracts Relatively informal forward market –British Pound –Euro –Canadian Dollar –Australian Dollar –Yen –Swiss Franc

20. Copyright 2014 by Diane S. Docking 20 Foreign Exchange Futures – Euro CMEgroup/WSJ 8/26/2014 Euro (CME)-€125,000; $ per € Open HighLowSettleChg.Interest Jun 151.32201.32381.32001.3202 -.002043 Tick = $.0001/€ = $12.50/contract 1. What is the settlement (closing) price (in $) for the contract? LINK: CMEgroup.com - EuroCMEgroup.com - Euro Can buy 1€ for $1.3202 Contracts expire Mar, June, Sept, & Dec

21. Copyright 2014 by Diane S. Docking 21 Going Long & Short in the FX Futures Market LONG If an investor buys this June futures contract on the Euro, they promise to pay $165,025 for 125,000 Euros when delivered in June. They are expecting the $ to ____________ against the Euro by June (i.e., it will take more $ to buy 1€); therefore, lock in a buying price for the Euros today. SHORT If an investor sells this June futures contract on the Euro, they promise to receive $165,025 for 125,000 Euros that they will deliver in June. They are expecting the $ to ____________ against the Euro by June (i.e., they will get fewer $ for 1€ if sold on the spot market); therefore, lock in a selling price today.

22. Copyright 2014 by Diane S. Docking 22 Margin and Settlement –good faith amount originally put up to secure the contract (usually less than 3% of contract amount for financial futures). –minimum level to which an equity position may fall due to adverse price movements –(usually 75 - 80% of initial margin) –the daily change in the value of a contract If dollar amount in margin account goes below this maintenance margin amount, a “margin call” is made. Must bring up to ___________ Margin ____________ Margin Variance or Valuation Margin _________Margin

23. Example: Margin Account On March 1, an investor buys, on margin, 10 T-Bond futures contracts at the current price of 102. Initial margin is $6,000 per contract and the maintenance margin is $4,000 per contract. Show the transactions in the margin account, if the price of the T-Bond futures is the following at days end: –March 2100 –March 3 95 –March 4 96 On March 5, the investor sells the T-Bond futures contracts at 96-10. What is his gain/loss on this investment? Copyright 2014 by Diane S. Docking 23

24. Solution to Example: Margin Account IM = 10 Ks x $6,000 = $60,000 MM = 10 Ks x $4,000 = $40,000 Margin a/c (long) 3/1: Buy 10 Ks @ 102 IM = 10 Ks x $6,000 = __________ 3/2: Mark to Market: 100 – 102 = - $2,000/K x 10 Ks = __________ Balance 3/2 $_______ okay Copyright 2014 by Diane S. Docking 24

25. Solution to Example: Margin Account (cont.) Margin a/c (long) Balance 3/2 $40,000 3/3: Mark to Market: 95 – 100 = - $5,000/K x 10 Ks = _______ _______ margin call Margin call_______ Balance 3/3________to _____ Copyright 2014 by Diane S. Docking 25

26. Solution to Example: Margin Account (cont.) Margin a/c (long) Balance 3/3 $60,000 3/4: Mark to Mkt: 96 – 95 = $1,000/K x 10 Ks = ________ Balance 3/4________okay 3/5:Mark to Mkt: 96.3125 – 96 = $312.50/K x 10 Ks = ________ Balance 3/5________ Liquidate a/c________ -0- Copyright 2014 by Diane S. Docking 26

27. Solution to Example: Margin Account (cont.) Gain/Loss Calculation: Buy @102 Sell @ 96-10 $ 96,312.50 Loss/K x 10 Ks = ______________total loss OR Cash flows: Outflows :IM Margin calls Inflows:Liquidation $73,125 Total loss ________ Copyright 2014 by Diane S. Docking 27

28. Copyright 2014 by Diane S. Docking 28 Liquidating a Futures Position Settlement Dates –March, June, September, December; some monthly –Nearby futures contracts –Most distant futures contracts Liquidating a Futures Position –Take an offsetting position in the same contract prior to the settlement date – –Take/Make delivery of the underlying asset on the date of settlement – Functions of Clearinghouse –guarantees that both parties to futures contracts satisfy their obligations –simplifies the unwinding of futures positions prior to the settlement date _____________ _________________________

29. CME Simulation Game – Test your trading skills http://www.cmegroup.com/education/simul ated-trading-game.htmlhttp://www.cmegroup.com/education/simul ated-trading-game.html Copyright 2014 by Diane S. Docking 29