Chapter 21 Principles of the Futures Market

1. Chapter 21Principles of the Futures Market

2. As near as I can learn, and from the best information I have been able to obtain on the Chicago Board of Trade, at least 95% of the sales of that Board are of this fictitious character, where no property is actually owned, no property sold or delivered, r expected to be delivered but simply wagers or bets as to what that property may be worth at a designated time in the future….wheat and cotton have become as much gambling tools as chips on the farobank table. - Senator William D. Washburn

3. Outline • Introduction • Futures contracts • Market mechanics • The clearing process • Principles of futures contract pricing • Foreign currency futures

4. Introduction • Futures contracts can lessen price risk for: • Businesses • Financial institutions • Farmers

5. Introduction (cont’d) • The two major groups of futures market participants are: • Hedgers • Speculators

6. Futures Contracts • What futures contracts are • Why we have futures contracts • How to fulfill the futures contract promise

7. What Futures Contracts Are • Futures contracts are promises: • The futures seller promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month • The futures buyer promises to pay a predetermined price for the goods upon delivery

8. What Futures Contracts Are (cont’d) • With futures contracts, a trade must occur if someone holds the contract until its delivery date • Most futures contracts are eliminated before the delivery month • The contract obligation can be satisfied by making an offsetting trade • Only 2% of futures contracts actually result in delivery

9. Why We Have Futures Contracts • If suppliers and future buyers of a commodity could not agree on the future price of the commodity today: • There would be added price risk and • The price to the consumer would be significantly higher

10. Why We Have Futures Contracts (cont’d) • The basic function of the commodity futures market is to transfer risk from the hedger to the speculator • The speculator assumes the risk because of the opportunity for profit

11. How to Fulfill the Futures Contract Promise • The futures market would not work if people could back out of the trade without fulfilling their promise • Trades actually become sales to or by the clearing corporation of the exchange

12. How to Fulfill the Futures Contract Promise (cont’d) • Each exchange has a clearing corporation: • Ensures the integrity of the futures contract • Assumes the responsibility for those position when a member is in financial distress • Requires good faith deposits to help ensure the member’s financial capacity to meet the obligations

13. Market Mechanics • The marketplace • Creation of a contract • Market participants

14. The Marketplace • Commodity trades are made by open outcry of the floor traders • Traders shout their offers to buy or sell • Traders use hand signals to indicate their willingness to buy or sell and desired quantities • Traders are located in the pit

15. The Marketplace (cont’d) • The pit: • Is either octagonal or polygonal • Contains a raised structure called the pulpit: • Representatives of the exchange’s market report department enter all price changes • Is surrounded by electronic wallboards reflecting price information

16. The Marketplace (cont’d) • Pit lingo: • “See through the pit” is a day with little trading activity • An “Acapulco trade” is an unusually large trade • Traders who lose all their trading capital have “busted out” (gone to “Tapioca City”) • A “fire drill” is a sudden rush of trading activity without apparent reason • A big price move is a “lights-out” move

17. The Marketplace (cont’d) • The Chicago Board of Trade (CBOT) is the world’s largest futures exchange: • Has more than 3,600 members • Has 1,402 full members • Have the right to trade in any of the commodities at the exchange • Has associate members • Allowed to trade financial instrument futures and certain other designated markets

18. Creation of A Contract • Buyers and sellers fill out cards to record their trades • One side of the card is blue (buy trades) • One side of the card is read (sell trades) • Each commodity has a symbol • E.g., “US” means Treasury bonds

19. Creation of A Contract (cont’d) • Buyers and sellers fill out cards to record their trades (cont’d) • Each delivery month has a letter code • E.g., “U” means September • Letters identify time blocks at which the trade occurred • E.g., “A” is the first thirty minutes of trading

20. Creation of A Contract (cont’d) • Example of a trading card (see next slide): • Dan Hennebry buys: • 5 September Treasury bond futures contracts • From trader ZZZ working for firm OOO • At a price of 77 31/32 of par • In the first thirty minutes of trading

21. Creation of A Contract (cont’d)

22. Market Participants • Hedgers • Speculators • Scalpers

23. Hedgers • A hedger is someone engaged in some type of business activity with an unacceptable level of price risk • E.g., a farmer’s welfare depends on the price of the crop at harvest • The farmer wants to transfer the price risk to a speculator using the futures market • The farmer cannot eliminate the risk of a poor crop through futures

24. Hedgers (cont’d) • Hedgers normally go short in agricultural futures • A short hedge • E.g., the farmer promises to deliver • Hedgers sometimes go long • A long hedge • E.g., a manufacturer of college class rings wants to lock in the price of gold

25. Speculators • Speculators: • Have no economic activity requiring the use of futures contracts • Find attractive investment opportunities in the futures market • Hope to make a profit rather than protecting one

26. Speculators (cont’d) • Speculators normally go long • Speculating on price increases • It is possible for speculators to go short • Speculating on price declines

27. Speculators (cont’d) • Speculators are either day traders or position traders: • Day traders close out all their positions before trading closes for the day • Position traders: • Routinely maintain futures positions overnight • Sometimes keep a contract open for weeks

28. Scalpers • Scalpers: • Are really speculators • Trade for their own account • Make a living by buying and selling contracts in the pit

29. Scalpers (cont’d) • Scalpers (cont’d): • May buy and sell the same contract many times during a single trading day • Contribute to the liquidity of the futures market • Are also called locals

30. The Clearing Process • Introduction • Matching trades • Accounting supervision • Intramarket settlement • Settlement prices • Delivery

31. Introduction • The clearing process performs the following functions: • Matching trades • Supervising the accounting for performance bonds • Handling intramarket settlements • Establishing settlement prices • Providing for delivery

32. Matching Trades • All traders are responsible for ensuring that their card decks are entered into the clearing process • The clearing corporation: • Receives the members’ trading cards • Edits and checks the information on the cards by computer • Returns cards with missing information to the clearing member for correction

33. Matching Trades (cont’d) • Unmatched trades are called outtrades: • Result in an Unmatched Trade Notice being sent to each of the clearing corporation members • Regardless of the reason for the Notice, it is the trader’s individual responsibility to resolve the error • Outtrade clerks (employed by the exchange) assist in the process of reconciling trades

34. Matching Trades (cont’d) • Examples of outtrades: • A “price out” means two traders wrote down different prices for a given trade • A “house out” means the trading card lists an incorrect member firm • A “quantity out” occurs when the number of contracts is in dispute

35. Matching Trades (cont’d) • Examples of outtrades (cont’d): • A “strike out” occurs when the striking price is in dispute • A “time out” occurs when the delivery month is in dispute • A “side out” occurs when both parties marked either buy or sell

36. Accounting Supervision • Performance bonds deposited by member firms remain with the clearing corporation until the member either: • Closes out her position by making an offsetting trade or • Closes out her position by delivery of the commodity

37. Accounting Supervision (cont’d) • When successful delivery occurs: • Good faith deposits are returned to both parties • Payment for the commodity is received from the buyer and remitted to the seller • The warehouse receipt for the goods is delivered to the buyer

38. Accounting Supervision (cont’d) • Futures contracts are marked to market every day • Can create accounting problems

39. Accounting Supervision (cont’d) • Open interest is a measure of how many futures contracts in a given commodity exist at a particular time • Increases by one every time two opening transactions are matched • Published by the clearinghouse in the financial pages on a daily basis

40. Intramarket Settlement • Commodity prices may move so much in a single day that good faith deposits for members are eroded before the day ends • May result in a market variation call: • A call on members to deposit more funds into their accounts during the day

41. Settlement Prices • Settlement prices: • Are analogous to the closing price on the stock exchanges • Are normally an average of the high and low prices during the last minute or so of trading • Are established by the clearing corporation

42. Settlement Prices (cont’d) • Many commodity futures prices are constrained by a daily price limit: • The price of a contract is not allowed to move by more than a predetermined about each trading day • Commodities may be up the limit or down the limit when big price moves occur • Trading will stop for the day once a limit move has occurred

43. Delivery • A seller who wishes to deliver fills out a Notice of Intention to Deliver with the clearing corporation • Indicates the intention of delivering the commodity on the next business day • Delivery can occur any time during the delivery month

44. Delivery (cont’d) • First notice day is the first business day prior to the first day of the delivery month • Position day is the day prior to first notice day • Long position members must submit a Long Position Report • On intention day, the clearing corporation may assign delivery to the member with the oldest long position in the particular commodity

45. Delivery (cont’d) • Speculators tend to move out of the market a few days prior to first notice day

46. Principles of Futures Contract Pricing • Expectations hypothesis • Normal backwardation • Full carrying charge market • Reconciling the three theories

47. 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 • One of the major functions of the futures market is price discovery: • The market’s consensus about likely future prices for a commodity

48. Normal Backwardation • Normal backwardation: • Is attributed to John Maynard Keynes • Argues that the futures price is a downward-biased estimate of the future cash price • The hedger essentially buys insurance • The speculator must be rewarded for taking the risk the hedger was unwilling to bear

49. Full Carrying Charge Market • A full carrying charge market is one where the prices for successive delivery months reflect the cost of holding the commodity • The futures price (FP) is equal to the current cash price (CP) plus the carrying charges (c) until the delivery month: FP = CP + c

50. Full Carrying Charge Market (cont’d) • Basis is the difference between the futures price and the current cash price: • In a contango market, the futures price is greater than the cash price • In an inverted market, the cash price is greater than the futures price