1. 1 Introduction to Futures Markets Overview Terms Participants Procedures Examples

2. 2 Cash or Spot Market The physical commodity “On the spot” At a specific location Price is established and commodity changes ownership

3. 3 Futures markets Organized and centralized market Today’s price for products to be delivered in the future. A mechanism of trading promises of future commodity deliveries among traders.

4. 4 Futures markets 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

5. 5 Futures Market Exchanges Modern futures market began long ago 1848 Chicago Board of Trade 1898 Chicago Mercantile Exchange 2007 CME Group merged CBOT and CME Highly regulated markets Commodity Futures Trading Commission (CFTC)

6. 6 CME Group http://www.cmegroup.com/ Products Commodities and quotes Education Additional resources

7. 7 Futures Market Exchanges Centralized pricing Buyers and sellers represented by brokers in the pits or electronically All information represented through bids and offers Perfectly competitive market Open out-cry trading Electronic trading

8. 8 Trading Futures Contracts All trades through a licensed broker Brokerage house has “seat” at the exchange and is allowed to trade Represented “on the floor” to exercise trade Local broker to initiate transaction and manage account with client Full service and discount brokers

9. 9 Electronic trading: CME Globex Customers must have a CME Clearing Firm relationship and a CME Group- certified trading application. Individual investors are encouraged to connect through their broker, who can provide both the Clearing Firm guarantee and trading infrastructure.

10. 10 Futures contract A futures contract is a commitment to make or take delivery of a specific quantity and quality of a given commodity at a specific delivery location and time in the future. A legally binding contract Trading the promise to do something in the future You can “offset” your promise

11. 11 The futures contract All terms of the contract are standardized except for the price, which is discovered via the supply (offers) and the demand (bids). Standardized contract Form (wt, grade, specifications) Time (delivery date) Place (delivery location)

12. 12 Standardized contract Delivery months 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 Specified delivery points Relatively few delivery points

13. 13 The futures contract No physical exchange takes place when the contract is traded. Payment is based on the price established when the contract was initially traded. Deliveries are made when the contract expires (delivery time).

14. 14 The futures contract All contracts are ultimately settled through: Liquidation by an offsetting transaction Delivery of the actual physical commodity Offset is most common Delivery usually occurs in less than 2 percent of all agricultural contracts traded.

15. 15 Market participants Speculators have no use for the physical commodity. They buy or sell in an attempt to profit from price movements. Add liquidity to the market. May be part of the general public, professional traders or investment managers Short-term – “day traders” Long-term - buy or sell and hold

16. 16 Market participants Hedgers are willing to make or take physical delivery because they are producers or users of commodity. Use futures to protect against a price movement Cash and futures prices are highly correlated Hold counterbalancing positions in the two markets to manage the risk of price movement

17. 17 Hedgers Farmers, livestock producers Merchandisers, elevators Food processors, feed manufacturers Exporters Importers What happens if futures market is restricted to only hedgers?

18. 18 Market participants Brokers exercise trade for traders and are paid a flat fee called a commission. Futures are a “zero sum game” Losers pay winners Brokers always get paid commission

19. 19 How futures markets work Each trader opens an account with a licensed broker The trader places an initial margin in the account for each contract traded The amount of margin is set by the brokerage firm subject to minimum levels established by the exchange.

20. 20 How futures markets work Margin is money that buyer or seller of futures contracts must deposit with a broker and the broker in turn must deposit with a clearing house. The margin is the performance bond that ensures that all trades are honored.

21. 21 How futures markets work Trades of CME Group products, will clear through CME Clearing At the settlement time each day every contract is settled. The gain (loss) from the previous day is added (subtracted) to the trader’s margin account If additional money is needed to comply with the margin requirements it is known as receiving a margin call.

22. 22 How futures markets work The clearing operation severs the connection between the original buyer and seller. CME Clearing assumes the opposite side of each open position and thereby ensures the financial integrity of every futures and options contract traded at CME Group. In turn, it holds each trader accountable by settling the margin account each day.

23. 23 Market position Objective: Buy low, sell high You can either buy or sell initially to open a position “Make” a promise Do the opposite to close the position at a later date “Offset” the promise Or make/take physical delivery of the commodity except for “cash settled” contracts

24. 24 Speculator example: You believe that Asian Soybean Rust will reduce yields and that producers may plant fewer acres of soybeans to avoid potential Asian Rust problems. How can you profit from this scenario????

25. 25 Speculator example: Pork producers have lost a record amount of equity and some will go out of business. China lifted its restrictions related to H1N1 on U.S. pork imports. How can you profit from this scenario?

26. 26 Terms and Definitions Basis The difference between the spot or cash price and the futures price of the same or a related commodity. Bear or Bear Market Someone that thinks the price will decline Bull or Bull Market Someone that thinks the price will increase

27. 27 Terms and Definitions Clearing House The division of the Exchange through which all trades made must be confirmed, matched and settled each day until offset or delivered. Closing price The last price of a contract at the end of a trading session. Commission For futures contracts, the one-time fee charged by a broker to cover the trades you make to open and close each position.

28. 28 Terms and Definitions 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. Maturity Period within which a futures contract can be settled by delivery of the actual commodity. Nearby The nearest active trading month of a futures or options on futures contract. Also referred to as the lead month.

29. 29 Terms and Definitions Volume The number of contracts in futures or options on futures made during a specified period of time Open Interest Total number of futures contracts traded that have not been closed out or liquidated an offset on delivery.

30. 30 Terms and Definitions 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. Daily trading limit Maximum price range during one trading session permitted by the Exchange for a contract CBOT: Corn: $0.20/bu above or below previous day's settlement Soybeans: $0.50/bu above or below previous day's settlement price. Wheat: $0.30/bu above or below previous day's settlement price. CME: Feeder cattle: $0.03/lb above or below previous day's settlement price Live cattle: $0.03/lb above or below previous day's settlement price Lean Hogs: $0.02/lb above or below previous day's settlement price

31. 31 Terms and Definitions Long position A position in which the trader has bought a futures contract that does not offset a previously established short position. Short position A position in which the trader has sold a futures contract that does not offset a previously established long position.

32. 32 FUTURES: DEFINITIONS

33. 33 FUTURES: DEFINITIONS

34. 34 FUTURES: DEFINITIONS

35. 35 FUTURES: DEFINITIONS Volume and Open Interest: DayActivityVolumeOpen Interest 1First day of trading Mary sells 3 contracts Peter buys 3 contracts 33

36. 36 FUTURES: DEFINITIONS 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

37. 37 FUTURES: DEFINITIONS 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

38. 38 FUTURES: DEFINITIONS 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

39. 39 FUTURES: SPECULATION 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

40. 40 FUTURES: SPECULATION 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

41. 41 FUTURES: DEFINITIONS 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

42. Long Market position: Speculator Hope to profit from price rise 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

43. 43 FUTURES: DEFINITIONS 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

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

45. 45 FUTURES: SPECULATION

46. 46 FUTURES: ACCOUNTING Margin (“performance bond”) Money deposit to ensure fulfillment of a futures contract at a future date

47. 47 FUTURES: ACCOUNTING 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

48. 48 FUTURES: MARGINS Except for initial margin deposit, money not paid/received when futures are initially bought/sold. Margins Different across commodities Different for speculators vs. hedgers May change over time

49. 49 Futures Margin per contract InitialMaintenance CornSpeculator$1,350$1,000 CornHedger$1,000 SoybeansSpeculator$3,713$2,750 SoybeansHedger$2,750 Lean HogsSpeculator$1,418$1,050 Lean HogsHedger$1,050 Feeder CattleSpeculator$1,350$1,000 Feeder CattleHedger$1,000 Live CattleSpeculator$1,080$800 Live CattleHedger$800 January 4, 2010

50. 50 MARGINS EXAMPLE Suppose corn futures contracts have: Contract size = 5,000 bu/contract Initial margin = $600/contract Maintenance margin = $400/contract Suppose on May 10 th bearish speculator opens “short” position by selling 3 corn futures contracts @ $2.10/bu Initial margin deposit = $1800 (= $600/contract  3 contracts) Maintenance margin = $1200 (= $400/contract  3 contracts)

51. 51 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- May2.101800

52. 52 MARGINS EXAMPLE 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

53. 53 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-May2.101800 2.0830002100300

54. 54 MARGINS EXAMPLE 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]

55. 55 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-May2.101800 2.0830002100300 11-May2.12(600)01500(300)

56. 56 MARGINS EXAMPLE 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]

57. 57 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-May2.101800 2.0830002100300 11-May2.12(600)01500(300) 12-May2.15(450)7501800(750) On May 12 the margin balance dropped below the maintenance level and had to be restored to the initial level

58. 58 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-May2.101800 2.0830002100300 11-May2.12(600)01500(300) 12-May2.15(450)7501800(750) 15-May2.1415001950(600) 16-May2.17(450)01500(1050) 17-May2.19(300)01200(1350) 18-May2.21(300)9001800(1650) 19-May2.22(150)01650(1800) 22-May2.25(450)01200(2250) 23-May2.2330001500(1950) 24-May2.2130001800(1650) 25-May2.31(1500)15001800(3150) 26-May2.15240004200(750) 29-May2.06135005550600 30-May2.02600061501200 31-May1.96900070502100 1-Jun1.93450075002550

59. 59 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-May2.102400 2.08(400)02000(400) 11-May2.1280002800400 12-May2.15600034001000 15-May2.14(200)03200800 16-May2.17600038001400 17-May2.19400042001800 18-May2.21400046002200 19-May2.22200048002400 22-May2.25600054003000 23-May2.23(400)050002600 24-May2.21(400)046002200 25-May2.312000066004200 26-May2.15(3200)034001000 29-May2.06(1800)01600(800) 30-May2.02(800)16002400(1600) 31-May1.96(1200)12002400(2800) 1-Jun1.93(600)01800(3400)

60. 60 Futures Summary Today’s price for delivery in future Standardized contract/promise to make or take delivery Contract/promise can be offset Several participants for different positions Highly leveraged trade and must maintain margin account as a performance bond