© 2004 South-Western Publishing 1

Chapter 8

Fundamentals of the Futures

Market

22

Outline

The concept of futures contracts Market mechanics

Market participants The clearing process

Principles of futures contract pricing Spreading with commodity futures

33

The Concept of Futures Contracts

Introduction The futures promise

Why we have futures contracts Ensuring the promise is kept

44

Introduction

The futures market enables various entities to lessen price risk, the risk of

loss because of uncertainty over the future price of a commodity or financial

asset

As with options, the two major market participants are the hedger and the

speculator

55

The Futures Promise

A futures contract is a legally binding agreement to buy or sell something in the

future The person who initially sells the contract

promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month

The other party to the trade promises to pay a predetermined price for the goods upon

delivery

66

Futures Compared to Options

Both involve a predetermined price and contract duration

The person holding an option has the right, but not the obligation, to

exercise the put or the call With futures contracts, a trade must

occur if the contract is held until its delivery deadline

77

Futures Compared to Forwards

A futures contract is more similar to a forward contract than to an options contracts

A forward contract is an agreement between a business and a financial institution to exchange

something at a pre-set price in the future– Most forward contracts involve foreign currency

Forwards are different from futures because:– Forwards are not marketable

Once a firm enters into a forward contract there is no convenient way to trade out of it

– Forwards are not marked to market The two parties exchange assets at the agreed upon date

with no intervening cash flows– Futures are standardized, forwards are customized

88

Trading Mechanics

Most futures contracts are eliminated before the delivery month

– The speculator with a long position would sell a contract, thereby canceling

the long position– The hedger with a short position would

buy a contract, thereby canceling the short position

99

Trading Mechanics (cont’d)

Gain or Loss on Futures SpeculationGain or Loss on Futures Speculation

Suppose a speculator purchases a July soybean contract at a purchase price of

$6.12 per bushel. The contract is for 5,000 bushels of No. 2 yellow soybeans at an

approved delivery point by the last business day in July.

1010

Trading Mechanics (cont’d)

Gain or Loss on Futures Speculation (cont’d)

Upon delivery, the purchaser of the contract must pay $6.12(5,000) = $30,600.

1. At the delivery date, the price for soybeans is At the delivery date, the price for soybeans is $6.16,$6.16,

This equates to a profit of $6.16 - $6.12 = $0.04 per bushel, or = $200 (5,000 * $0.04).

2. If the spot price on the delivery date were only If the spot price on the delivery date were only $6.10$6.10,

The purchaser would lose $6.12 - $6.10 = $0.02 per bushel, or = $100 (5,000 * $0.02).

1111

Why We Have Futures Contracts

Futures contracts allow buyers and manufacturers to lock into prices

and costs, respectively– If a firm wants gold, it buys contracts,

promising to pay a set price in the future (long hedge)

– A gold mining company sells contracts, promising to deliver the gold (short

hedge)

1212

Ensuring the Promise is Kept

The Clearing Corporation ensures that contracts are fulfilled:

– Becomes party to every trade,– Ensures the integrity of the futures contract,

– Assumes responsibility for those positions when a member is in financial distress.

Good faith deposits (or performance bonds) are required from every member

on every contract to help ensure that members have the financial capacity to

meet their obligations.

1313

Ensuring the Promise is Kept (cont’d)

Selected Good Faith Deposit Requirements

Data as of January 2, 2004Contract Size Value Initial Margin

per Contract

Soybeans 5,000 bushels $39,700 $1,620

Gold 100 troy ounces $41,600 $2,025

Treasury Bonds $100,000 par $108,000 $2,565

S&P 500 Index $250 x index $278,500 $20,000

Heating Oil 42,000 gallons $38,346 $3,375

1414

Market Mechanics

Types of orders Ambience of the marketplace

Creation of a contract

1515

Types of Orders

A broker in commodity futures is a futures commission merchant (not the individual who places the order)

When placing an order, the client should specify the type of order

A market order instructs the broker to execute a client’s order at the best possible price at the earliest opportunity

With a limit order, the client specifies a time and a price– E.g., sell five December soybeans at 540, good until canceled

A stop order becomes a market order when the stop price is touched during trading action

– When executed, stop orders close out existing commodity positions

– E.g., a short seller may use a stop order to protect himself against rising commodity prices

1616

Ambience of the Marketplace

Trades occur by open outcry of the floor traders– Traders stand in a sunken pit and bark their offers to

buy or sell at certain prices to others– Traders often use hand signals to signal their wishes

concerning quantity, price, etc.– On the pulpit, representatives of the exchange’s Market Report Department enter all price changes

into the price reporting system

The perimeter of the exchange is lined with hundreds of order desks, where

telecommunications personnel from member firms receive orders from clients

1717

Ambience of the Marketplace (cont’d)

Jargon– “See through the pit” means little trading

activity– “Acapulco trade” is an unusually large trade by

someone who normally trades just a few contracts

– “Busted out” or “gone to Tapioca City” means traders incorrectly assess the market and lose

all their capital– “Fire drill” is a sudden rush of put activity for

no apparent reason– “Lights out” is a big price move

– “O’Hare Spread” refers to traders riding a winning streak

1818

Creation of a Contract

Two traders confirm their trade verbally and with hand signals

Each of them fills out a card– One side is blue for recording purchases

– One side is red for sales– Each commodity has a symbol, and each delivery

month has a letter code

At the conclusion of trading, traders submit their cards (their deck) to their clearinghouse

In 2003, nearly 7 million futures and options orders were electronically sent directly to floor brokers using special order receipts

called electronic clerks

1919

Market Participants

Hedgers Processors

Speculators Scalpers

2020

Hedgers

A hedger is someone engaged in a business activity where there is an

unacceptable level of price risk– E.g., a farmer can lock into the price he

will receive for his soybean crop by selling futures contracts

2121

Processors

A processor earns his living by transforming certain commodities into

another form– Putting on a crush means the processor can

lock in an acceptable profit by appropriate activities in the futures market

– E.g., a soybean processor buys soybeans and crushes them into soybean meal and oil

2222

Speculators

A speculator finds attractive investment opportunities in the futures market and takes positions in futures in the hope of

making a profit (rather than protecting one) The speculator is willing to bear price risk

The speculator has no economic activity requiring use of futures contracts

Speculators may go long or short, depending on anticipated price movements

A position trader is someone who routinely maintains futures positions overnight and

sometimes keep a contract for weeks A day trader closes out all his positions

before trading closes for the day

2323

Scalpers

Scalpers are individuals who trade for their own account, making a

living by buying and selling contracts

– Also called locals

Scalpers help keep prices continuous and accurate

2424

Scalpers (cont’d)

Scalping With Treasury Bond Futures

Trader Hennebry just sold 5 T-bond futures to ZZZ for 77 31/32. Now, a sell order for 5 T-bond futures reaches the pit and Hennebry

buys them for 77 30/32. Thus, Hennebry just made 1/32 on each of the 5 contracts, for a

dollar profit of

1/32% x $100,000/contract x 5 contracts = $156.25

2525

The Clearing Process

Matching trades Accounting supervision Intramarket settlement

Settlement prices Delivery

2626

Matching Trades

Every trade must be cleared by or through a member firm of the Board of Trade Clearing Corporation

– An independent organization with its own officers and rules

Each trader is responsible for making sure his deck promptly enters the clearing process

– Scalpers normally use only one clearinghouse– Brokers typically submit their cards periodically while trading

After the Clearing Corporation receives trading cards– The information on them is edited and checked by computer– Cards with missing information are returned to the clearing

member– Once all cards have been edited, the computer attempts to

match cards for all trades that occurred that day

2727

Matching Trades (cont’d)

Mismatches (out trades) result in an Unmatched Trade Notice being sent to each clearing member

– Traders must reconcile their out trades and arrive at a solution

– “House out” means an incorrect member firm is listed on the trading card

– “Quantity out” means the number of contracts is in dispute

After resolving all out trades, the computer prints a daily Trade Register

– Shows a complete record of each clearing member’s trades for the day

– Contains subsidiary accounts for each customer clearing through the firm

2828

Accounting Supervision

The accounting problem is formidable because futures contracts

are marked to market every day– Open interest is a measure of how many

futures contracts in a given commodity exist at a particular time

Different from trading volume since a single futures contract might be traded often during

its life

2929

Account Supervision (cont’d)

Volume vs Open Interest for Soybean FuturesJune 16, 2000

Delivery Open High Low Settle Change Volume

Open

Jul 2000 5144 5144 5040 5046 -52 32004 46746

Aug 2000 5070 5074 5004 5012 4 7889 19480

Sep 2000 4980 4994 4950 4960 44 3960 15487

Nov 2000 5020 5042 4994 5006 56 22629 62655

Jan 2001 5110 5130 5084 5100 54 1005 6305

Mar 2001 5204 5204 5160 5180 54 1015 4987

May 2001 5240 5270 5230 5230 44 15 6202

July 2001 5290 5330 5280 5290 40 53 4187

Nov 2001 5380 5400 5330 5330 30 37 1371

3030

Intramarket Settlement

Commodity prices may move so much in a single day that good faith

deposits for many members are seriously eroded before the day ends

– The president of the Clearing Corporation may issue a market

variation call for members to deposit more funds into their account

3131

Settlement Prices

The settlement price is analogous to the closing price on the stock exchanges

The settlement price is normally an average of the high and low prices

during the last minute of trading Settlement prices are constrained by a

daily price limit– The price of a contract is not allowed to move by

more than a predetermined amount each trading day

3232

Delivery

Delivery can occur anytime during the delivery month

Several days are of importance:– First Notice Day

– Position Day– Intention Day

Several reports are associated with delivery:

– Notice of Intention to Deliver– Long Position Report

3333

Principles of Futures Contract Pricing

The expectations hypothesis Normal backwardation

A full carrying charge market Reconciling the three theories

3434

The Expectations Hypothesis

The expectations hypothesis states that the futures price for a commodity is what

the marketplace expects the cash price to be when the delivery month arrives– Price discovery is an important function

performed by futures

There is considerable evidence that the expectations hypothesis is a good

predictor

3535

Normal Backwardation

Basis is the difference between the future price of a commodity and the

current cash price– Normally, the futures price exceeds the

cash price (contango market)– The futures price may be less than the

cash price (backwardation or inverted market)

3636

Normal Backwardation (cont’d)

John Maynard Keynes:– Locking in a future price that is

acceptable eliminates price risk for the hedger

– The speculator must be rewarded for taking the risk that the hedger was

unwilling to bear Thus, at delivery, the cash price will likely

be somewhat higher than the price predicated by the futures market

3737

A Full Carrying Charge Market

A full carrying charge market occurs when the futures price reflects the

cost of storing and financing the commodity until the delivery month

The futures price is equal to the current spot price plus the carrying

charge:CSF t

3838

A Full Carrying Charge Market (cont’d)

Arbitrage exists if someone can buy a commodity, store it at a known cost,

and get someone to promise to buy it later at a price that exceeds the cost of

storage

In a full carrying charge market, the basis cannot weaken because that

would produce an arbitrage situation

3939

Reconciling the Three Theories

The expectations hypothesis says that a futures price is simply the expected cash

price at the delivery date of the futures contract

People know about storage costs and other costs of carry (insurance, interest,

etc.) and we would not expect these costs to surprise the market

4040

Reconciling the Three Theories (cont’d)

Because the hedger is really obtaining price insurance with

futures, it is logical that there be some cost to the insurance

4141

Spreading with Commodity Futures

Intercommodity spreads Intracommodity spreads

Why spread in the first place?

4242

Intercommodity Spreads

An intercommodity spread is a long and short position in two related

commodities– E.g., a speculator might feel that the price of corn is too low relative to the

price of live cattle– Risky because there is no assurance that

your hunch will be correct

4343

Intercommodity Spreads (cont’d)

With an intermarket spread, a speculator takes opposite positions

in two different markets– E.g., trades on both the Chicago Board

of Trade and on the Kansas City Board of Trade

4444

Intracommodity Spreads

An intracommodity spread (intermonth spread) involves taking

different positions in different delivery months, but in the same

commodity– E.g., a speculator bullish on what might

buy September and sell December

4545

Why Spread in the First Place?

Most intracommodity spreads are basis plays

Intercommodity spreads are closer to two separate speculative positions than

to a spread in the stock option sense Intermarket spreads are really arbitrage

plays based on discrepancies in transportation costs or other

administrative costs