2. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Chapter 21 Commodity and Financial Futures

3. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Commodity and Financial Futures A formal agreement (contract) for –the delivery (seller) or –receipt (buyer) of a commodity Participants in futures markets are either –speculators or –hedgers

4. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Positions Speculators buy or sell contracts in anticipation of price changes The long position anticipates price increases The short position anticipates price decreases

5. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Futures Contracts Contracts establish a futures price The current (spot) price may be –lower –higher

6. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Open Interest Number of contracts in existence

7. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Closing a Futures Contract Close a position in a futures contract by entering into the opposite position A contract to sell "offsets" a contract to buy A contract to buy "offsets" a contract to sell

8. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Futures and Leverage Futures offer large profits and losses The source of the leverage: the small margin requirement The margin requirement is a small percentage of the value of the contract

9. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Margin Margin: a good faith deposit required of both –the long position and –the short position

10. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Marking to the Market Futures positions are "marked to the market" daily Funds are transferred between accounts Futures prices are allowed to change only by the "daily limit”

11. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Maintenance Margin A second margin requirement If funds in the account fall below the maintenance margin requirement, the investor receives a "margin call” Failure to meet the margin call results in the position being closed

12. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Hedgers Buy and sell contracts to offset existing positions Are growers and other users of commodities Wish to reduce the risk of loss from price fluctuations

13. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Hedgers Pass the risk of loss to the speculators Take the opposite positions of the speculators Forego the possibility of a large return to obtain future price certainty

14. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Non-Commodity Futures Financial futures –contracts for the future delivery of a financial asset Currency futures –contracts for the future delivery of a currency

15. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Index Futures Based on an index of stock prices Speculators buy and sell stock index futures in anticipation of changes in stock prices Portfolio managers use stock index futures to hedge against movements in stock prices

16. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Programmed Trading Combines –stock index futures and –computer's ability to enter large numbers of buy and sell orders Takes advantage of small differences in –stock index futures prices and –prices of the underlying stock

17. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Programmed Trading The process of programmed trading

18. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Futures Pricing Futures prices generally exceed spot prices The current futures price may reveal the consensus concerning anticipated prices in the future

19. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Swap Agreements A "swap" agreement –a contract in which the two parties trade payments

20. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Currency Swap In a currency swap, the two parties –agree to trade payments in different currencies –helps manage exchange rate risk

21. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Other Swap Agreements In an alternative type of swap, one party trades a fixed payment for a variable payment The “counter party” swaps the variable payment for the fixed payment The swap helps management reduce the risk from changes in interest rates

22. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Equity Swap Two parties swap payments based on an index of stock prices Swap payments are made based on the extent that the price indices differ