03. Futures - Introduction

8/17/2019 03. Futures - Introduction

1/38

Futures - Introduction

Ravi - IBA


2/38

Futures Contract

• A fnancial contract obligating the buyer to purchasean asset (or the seller to sell an asset), such as aphysical commodity or a fnancial instrument, at apredetermined uture date and price!

• Futures contracts detail the "uality and "uantity othe underlying asset# they are standardized tofacilitate trading on a futures exchange!

• $ome utures contracts may call or physical delivery

o the asset, %hile others are settled in cash! &heutures mar'ets are characteried by the ability touse very high leverage relative to stoc' mar'ets!


3/38

Futures Contract

Futures can be used either to hedge orto speculate on the price movement othe underlying asset!

For eample, a producer o corn coulduse utures to loc' in a certain priceand reduce ris' (hedge)! *n the other

hand, anybody could speculate on theprice movement o corn by going longor short using utures!


4/38

Futures Contract

• Futures contract+ standardized agreement betweentwo parties committing one to buy and the other tosell at a set price on or before a given date in thefuture

– argin+ perormance bonds or good-aith depositsto insure contract perormance

– Initial argin+ inimum amount re"uired toinitiate a trade

– aintenance margin+ inimum amount re"uiredat all times to sustain a mar'et position

– argin call+ %hen margin level is lo%er thanmaintenance margin


5/38

Futures characteristics

• $even maor underlying asset groups• .elivery

– physical delivery (only /0 to 10)

– cash settlement• 2ong position+ buyer o a uture contract

$hort position+ seller o a uture contract• &rading

–

open-outcry+ by voice and hand signals – 3lectronically+ by net%or'

• Floor bro'er and dual trader eecute customerorders

• Can be terminated by an o4setting transaction


6/38

Contractual 5rovisions

• 6nderlying asset+ Commodity,currency, fnancial instrument inde or

other item• Amount and "uality o the underlying

asset

• .elivery cycle+ months or %hich the

utures contracts can be traded• 3piration date

• $ettlement echanism and .elivery2ocation


7/38

Futures Daily Settlement

• Daily settlement is the process where theclosing market price is determined at the endof each trading day in order to settle the prot orloss between the long and the short.

• Yes, prots and losses are settled between thelong and the short at the end of each trading day.

• It is actually a risk control measure in force byclearinghouses and exchanges all over the world

so that losses would not accumulate, leading to problems when it comes to fullment ofobligations.


8/38

ar'-to-mar'et• .aily settlement o gains and losses

bet%een buyers and sellers! – I spot price rises, sellers pay buyers in cash

or the change in price

– I spot prices alls, buyers o%e sellers

– I a utures trader losses too much, moremoney %ill need t be put in the marginaccount!


9/38

Important di4erences bet%eenFutures 7 For%ards

/! Anonymous Counterparties

1! $tandard Contracts

8! .aily $ettlement


10/38


/! Anonymous Counterparties + 6nli'e parties to aor%ard, the buyer and seller o a uturescontract don9t 'no% each other! &he echangeta'es care o matching o buyers and sellers!

1! $tandard Contracts + 3changes also provideli"uidity by strictly defning the terms o everycontract eecuted! &he type, "uantity andgrade o underlier# its delivery price and date#even the delivery location are spelled out ingreat detail! A prospective buyer or seller mustchoose rom one o these predefned contracts!


11/38


• 8! .aily $ettlement + &his is the biggie! 5arties to aor%ard realie their payo4 on delivery# or on someearlier date i they agree to cancel or un%ind acontract!

• 5arties to uture contract ho%ever realie a payo4at the end o every trading day! &his help to reducethe ris' o party ailing to meet its obligations!

• Futures are generally more li"uid than or%ards

and a carry a smaller degree o deault ris'!• :: percent o all utures contracts are e4ectively

cancelled beore any delivery actually occurs!


12/38

Futures some ino!

• Commodity Futures (Commodity underliers)

• Financial Futures (Financial underliers)

• As %ith any securities echange, you don9t

ust call a utures echange directly andplace a order!

• Rather an echange has clearing membersentitled to actually eecute trades, %ho canta'e orders rom bro'ers %ho ta'e ordersrom commerical traders and retailers!


13/38

/;-/8

Characteristics o FuturesContracts

• &ransaction %ill not be completed until someagreed-upon date in the uture

• .elivery date and "uantity are all set %hen thefnancial uture is created

• $eller has legally binding obligation to ma'edelivery on specifed date

• Buyer7holder has legally binding obligation tota'e delivery on specifed date

•

Futures may be held until delivery date or tradedonutures mar'et

• All trading is done on a margin basis


14/38

5ayo4 or utures positions


15/38

/;-/<

Advantages o6sing Futures Contracts

• 5otential or very high returns

• argin buying allo%s use o leverage – Leverage+ the ability to obtain a given e"uity

position at a reduced capital investment,thereby magniying total return

• Allo%s producers to hedge prices – .on9t have to sell crops at harvest time %hen

prices are oten lo%

• Commodities can provide an in=ationhedge


16/38

/;-/;

.isadvantages o6sing Futures Contracts

• >igh ris' o losing more than amountoriginally invested# no limit oneposure

to loss• Involves considerable amount

o speculation

• Re"uires specialied investor s'illsand patience


17/38

Copyright ? 1@@<5earson Addison-esley!All rights reserved!

/;-/

*ptions versus FuturesContracts

*ptions

• Right to buy

• $tri'e price

specifed in optioncontract

• 2oss limited to

price paid oroption

Futures

• *bligation to buy

• .elivery price setby supply anddemand

• o limit onpotential loss


18/38

Futures 3changes

• Chicago Board o &rade (CB&) began in/DED

• 3ight 6!$! commodities echanges –

CB& is largest – Chicago ercantile and e% or' ercantilealso active

– D@0 - :@0 o 6!$! commodities trade on thesethree echanges

• 6!$! echanges use Gopen cry auctionH• 3uropean echanges are rapidly gro%ing

and using more electronic technology


19/38

5layers in the Futuresar'ets• >edgers

– 5roducers and processors – 5rotecting their interests in underlying

commodity or fnancial instrument – 5rovide the actual products being sold

• $peculators – Investors –

&rying to earn proft on epected s%ings inprices o utures contracts – 5rovide li"uidity


20/38

&rading echanics

• Contracts are easily traded on utures mar'ets• Bought and sold through bro'erage oces• $ame types o orders are use as stoc's

– ar'et –

2imit• 2ong positionJbuying a contract

– Investor %ants contract price to go up

• $hort positionJselling a contract – Investor %ants contract price to go do%n

• 2ong and short positions can be li"uidated byeecuting an o4setting transaction – About /0 o utures contracts are settled by delivery


21/38

/;-1/

argin &rading

• All utures contracts are traded on margin

• o borro%ing is re"uired

• Initial margin deposit – Amount deposited %ith bro'er at time o commodity

transactionto cover any loss in mar'et value o utures contract duetoprice movements

– argin re"uirements range rom 10 to /@0

•

aintenance deposit – inimum amount o deposit re"uired at all times – argin call occurs i value drops belo% allo%ed amount

• ar'-to-the-mar'et occurs daily


22/38


/;-11

Table 16.3 aor Classes o Commodities


23/38


/;-18

Components o CommodityContract

• &ype o product

• 3change %here contract is traded

• $ie o contract (in bushels, pounds, tons)

• ethod o valuing contract (e!g!, cents perpound, dollars per ton)

• .elivery month

• Open Interest+ the number o contractscurrently outstanding on a commodity orfnancial uture


24/38

Factors in Commodity 5riceBehavior

• eather and crop orecasts

• 3conomic actors

•

5olitical actors• International pressures

• Settle Price+ the closing price (last

priceo the day) or commodities andfnancial utures


25/38

Commodity 5rice Behavior

• 5rices change daily

• Changes can be siable

• Because o leverage, small unit price changes can

cause large total dollar changes in contract price• &o protect investors, daily price change limits are

set+

– Daily price limit+ restriction on the day-to-day change

in price – Maximum aily price range+ the amount a commodity

price can change during the day# usually e"ual to t%icethe daily price limit


26/38


/;-1;

Componentso a Commodities Contract


27/38

Return on Invested Capital

• Commodities allo% use o leverageor potentially high returns

• Return to investors is based uponamount o money actually invested

Return on invested capital =

Selling price of

commodity contract −

Purchase price of

commodity contract

Amount of margin deposit


28/38

&rading $trategies %ithCommodities

• $peculating – Capitaliing on %ide s%ings that are characteristic o

many commodities

• $preading –

6sed by producers and processors to protect aposition in a product or commodity – 5roducer or gro%er attempts to hedge as high a price

as possible – 5rocessor or manuacturer attempts to hedge as lo%

a price as possible – o limit to the amount o loss that can occur %ith a

utures contract


29/38

Financial Futures

• Financial Futures+ uture contract in%hich the commodity is a fnancial asset,such as debt securities, oreigncurrencies or mar'et bas'ets o commonstoc's

• *ten used by large institutional investorsto hedge specifc types o ris'+ –

*4set interest rate ris' on debt instruments – inimie oreign currency rate ris' on overseasbusiness transactions

– inimie mar'et ris' on common stoc'investments


30/38

/;-8@

&ypes o Financial Futures+Foreign Currency

• &ypes o Currency Futures

– 6 $ .ollar

– British pound

– $%iss ranc

– eican peso

– Canadian dollar

–

Kapanese yen – Australian dollar

– 3uro


31/38

&ypes o Financial Futures+Interest Rates

• &ypes o Interest Rate Futures

– 6!$! &reasury bills

– 6!$! &reasury notes

– 6!$! &reasury bonds

– 6!$! agency notes (LA, FA)

– uni bond inde

–

Interest rate s%aps – Foreign government bonds


32/38

&ypes o Financial Futures+$toc'-Indees

• &ypes o $toc'-Inde Futures

– .o% Kones Industrial Average

– $M5


33/38

Financial FuturesContract $pecifcations

• $imilar to commodities contracts

• Control large sums o underlyingfnancial instruments

• >ave varying delivery dates

• $toc'-inde utures are settled incashrather than underlying stoc's o thespecifcstoc' inde!


34/38

$peculating in FinancialFutures• Allo%s large "uantities o fnancial

instruments to be controlled throughuture contract

•

2everage can provide high returns (orlosses)

• G2ongH positions are used i investorspeculates values %ill go up

• G$hortH positions are used i investorspeculates values %ill go do%n


35/38

Copyright ? 1@@<

5earson Addison-esley!All rights reserved!

/;-8<

>edging %ith FinancialFutures• 34ective %ay o protecting stoc' or other

securities holdings in a declining mar'et

• $toc'-inde utures used to hedge stoc'

portolios• Interest rate utures used to hedge bond

portolios

• Foreign currency utures used to hedgesignifcant eposure to oreign echangerate ris'


36/38

Combining Futures and*ptions• Futures Opti!ns+ options that give

the holders the right to buy or sell asingle standardied utures contract

or a specifed period o time at aspecifed stri'e price

– A signifcant advantage that a uturesoption has over a utures contract is thatthe option limits the buyer9s losseposure to the price o the option!


37/38

Sugar Futures "!ntract "!mm!ity Traing #xample"!ntract Speci$cati!ns

$ie o the Contract //1,@@@ lbsinimum 5rice Change

* one ounce /7/@@ cents7lb * one contract N//!1@Initial argin 2evel N@@aintenance argin 2evel NDay 2*pening Account Balance (rom .ay /) N;,;;E!@@5rice rises urther to close at

Day 3


38/38

Day 3*pening Account Balance (rom .ay 1) Nargin call o N1,

Documents

03. Futures - Introduction