The Futures Market

1. Jim Chatterton The Futures Market

2. An agreement between two parties • Seller of underlying (short) • Buyer of underlying (long) • Quantity of underlying, price per unit, date and method of delivery all determined • Profit and loss is determined by daily movement of price of contract • Increase: seller looses and buyer profits • Decrease: seller profits and buyer looses What’s a Futures Contract?

3. If the contract is carried to expiry, the underlying must be delivered • This is not usually the case • Contracts are usually settled prior to expiry • Long will sell, Short will buy • When a futures contract expires the cash and futures prices converge Futures Contracts (cont.)

4. Hedger • Sells to secure current price to protect against price decline • Buys to secure current price to protect against price increase • Speculating • Sells to secure current price in anticipation of declining price • Buys to secure current price in anticipation of increasing price Hedging vs. Speculating

5. Soybean Farmer Sell Hedge – Declining Price Current Futures Price: 980 Cash Price at T: 850 Futures Price at T: 870 Sale Price: 850 Profit on Futures: 110 Relative Sale Price: 960 Hedging

6. Soy Product Manufacturer Buy Hedge – Declining Price Current Futures Price:980Cash Price at T: 850 Futures Price at T: 870 Purchase Price: 850 Loss on Futures: 110 Relative Purchase Price: 960 Hedging

7. Sell Hedge – Rising Price Current Futures Price:980Cash Price at T: 1210 Futures Price at T: 1225 Sale Price: 1210 Loss on Futures: 245 Relative Sale Price: 965 Hedging

8. Buy Hedge – Rising Price Current Futures Price:980 Cash Price at T: 1210 Futures Price at T: 1225 Purchase Price: 1210 Profit on Futures: 245 Relative Purchase Price: 965 Hedging

9. Price when asset is in plentiful supply • F(t) = S(t)er(T-t) (Rational Pricing) • The underlying price discounted at risk free rate • Expectation Pricing • F(t) = Et {S(T)} (unbiased expectation) • Determined by supply and demand Pricing Futures

10. Acts as collateral Margin rates: 5-10 % (can vary) Used to pay for loss over the time of the contract Maintenance - adverse change in position results in additional margin At expiry all margin is returned Margin

11. Controlling large cash amounts with small capital • Initial margin small compared to dollar value of the asset being traded • Example • Soybeans at 980 cents per bushel for 5000 bushels • Controlling $49,000 with a margin of $4900 • An increase to 1210 brings the dollar amount to $60,500 • That is $11,500 profit while only investing $4900 Leverage

12. Buyers and Sellers • Standardized contracts • Broker • Execute the trade through the exchange • Clearing Houses • Third Party to the buyers and sellers • Require margin • Take on defaults to control risk How is a Contract Traded?

13. Forwards are not standardized • No cost to enter into a forward contract • Payoffs • Long: fT= ST – K • Short: fT= K – ST • K is price of asset agreed on at the start • ST is the forward price • This payoff is only realized at expiry • It could be a huge loss or gain • Creates much larger credit risk Futures vs. Forwards

14. Forward Payoffs

15. Financials • Indexes (S&P 500) • Government debt (Treasury Bonds) • Currencies • Short term interest Rates (Eurodollars) • Commodities • Agriculture (soybeans, wheat, meats) • Energy (oil, power) • Metal (gold, copper) Frequently Traded Futures

16. Schwager, Jack D. A Complete Guide to the Futures Market. New York: John Wiley & Sons, 1984. Kaufman, Perry J. Handbook of Futures Markets. New York: John Wiley & Sons, 1984. http://en.wikipedia.org/wiki/Futures_contract http://en.wikipedia.org/wiki/Forward_contract http://www.cmegroup.com/ http://www.investopedia.com/university/futures/default.asp Sources