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Lecture 1 An Introduction to Futures

Lecture 1 An Introduction to Futures. Primary Texts Edwards and Ma: Chapter 1 CME: Chapters 1 and 2. An Introduction to Futures Contracts. Before the 1840s – At harvest time, farmers used to converge to a market center to sell their grains - Lack of storages

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Lecture 1 An Introduction to Futures

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  1. Lecture 1An Introduction to Futures Primary Texts Edwards and Ma: Chapter 1 CME: Chapters 1 and 2

  2. An Introduction to Futures Contracts • Before the 1840s – At harvest time, farmers used to converge to a market center to sell their grains - Lack of storages • Excess Supply in the Fall – price drop • Excess demand in the Winter and Spring – price surge • 1848 – The Chicago Board of Trade (CBOT) • Organized grain exchange • Investors built huge silos to store grain for year round consumption • Smoothing grain supply and stabilize grain price • Didn’t eliminate all price risks • Demand and supply shocks due to natural disaster, pests, diseases, political unrests, etc. • Forward contracts – to cope with other causes of price uncertainty

  3. An Introduction to Futures Contracts • Forward Contracts: A forward contract or cash forward sale is a private negotiation made in the present that establishes the price of a commodity to be delivered in the future. • Two parties agree to exchange a good or service in the future at a price specified now – the forward price. • The price for immediate delivery of the item is called the spot price. • No money is paid in the present by either party to the other. • The face valueof the contract is the quantity of the item times the forward price specified in the contract. • The party who agrees to buy the specified good or service is said to take a long position, and the party who agrees to sell the item is said to take a short position.

  4. An Introduction to Futures Contracts • Problems with forward contracts • Unable to eliminate the risk of default among the parties in the contract • Solution – A neutral third party, the exchange (e.g., CBOT) • Specific to a particular seller and buyer – not standardized or interchangeable • Solution – standardization and interchangeability • Futures Contracts - standardized forward contracts that are traded on some organized exchange A futures contract is a legally binding agreement between a seller and buyer, that calls for the seller to deliver to the buyer a standardized commodity (with specified quantity and quality) at a set price on a future date at an organized exchange.

  5. An Introduction to Futures Contracts • Basic Features of Futures Contracts • Quantity, quality and delivery date are standardized – a June CME Live Cattle futures contract requires the delivery of 40,000 lb of live cattle with 55% Choice, 45% Select, Yield Grade 3 on the last business day of June at CME • Regulated by an organized exchange - CME, CBOT, NYMEX, etc. • Interchangeability - contracts may change hands many times before their specified delivery dates • Unit price of a futures contract may change on each transaction • Both buyer and seller post a performance bond (funds) with the exchange • Last Trading Day - all open positions must be closed out by this date • A clearing operation – Plays the role of third party to every futures transaction after the trade has “cleared.”

  6. An Introduction to Futures Contracts10102.D. Daily Price Limits • There shall be no trading in corn futures at a price more than $0.40 per bushel ($2,000 per contract) above or below the previous day’s settlement price. • Should two or more corn futures contract months within the first five listed non-spot contracts close at limit bid or limit offer, the daily price limits for all contract months shall increase to $0.60 per bushel the next business day. • If price limits are $0.60 per bushel and no corn futures contract month closes at limit bid or limit offer, daily price limits for all contract months shall revert back to $0.40 per bushel the next business day. • There shall be no price limits on the current month contract on or after the second business day preceding the first day of the delivery month.

  7. An Introduction to Futures ContractsEvolution of the CME • The Chicago Mercantile Exchange • 1874 – Chicago Produce Exchange • Chicago Butter and Egg Board • 1919 - Chicago Mercantile Exchange • Added futures contracts on hides, onions, & potatoes • 1950s – added turkeys and frozen eggs futures • 1961 – added frozen pork belly futures • 1972 – added financial futures, with eight currency futures • 2005 – largest futures exchange in the US – trading 1.05 billion contracts

  8. An Introduction to Futures ContractsSix Basic Types of CME Futures Contracts • CME Commodity Products: Cattle, hogs, milk, pork bellies, butter, etc. • CME Foreign Exchange Products: CME Euro FX, CME British Pound, CME Japanese Yen, CME Canadian Dollar and other FX products. • CME Interest Rate Products: CME Eurodollars, CME Eurodollar FRA, CME Swap Futures and other interest rate products. • CME Equity Products: CME S&P 500, CME E-mini S&P 500, CME E-mini NASDAQ-100, CME E-mini Russell 2000, CME S&P MidCap 400 and other equity products. • CME Alternative Investment Products: CME Weather, CME Energy, CME Economic Derivatives and CME Housing Index products. • TRAKRS (Total Return Asset Contracts): Commodity TRAKRS, Euro Currency TRAKRS, Gold TRAKRS, LMC TRAKRS, Rogers International Commodity TRAKRS.

  9. An Introduction to Futures Contracts • Some futures contracts, such as the CME Live Cattle and CME British Pound contracts, call for physical delivery of the commodity. Other futures contracts, such as the CME S&P 500 and CME Eurodollar contracts, are cash-settled and do not have a physical delivery provision. • For a physical delivery contract like CME Live Cattle, the open positions can be closed out by making an offsetting futures trade or by making/taking physical delivery of the cattle. • For cash-settled futures contracts, positions can be closed out by making an offsetting futures trade or by leaving the position alone and having it closed out by one final mark-to-market settlement adjustment.

  10. An Introduction to Futures ContractsDifferences between Futures and Stocks • A Futures contract represents an obligation to deliver or receive a commodity at a future date, while a stock represent ownership in a corporation. • Futures contracts require an initial performance bond in an amount set by the exchange, while stock requires a partial deposit (margin) to put up with the broker while borrowing the remaining amount from the broker. • Futures contracts have time limits (fixed maturity date), while stocks don’t (no maturity date). • Futures traders can sell short as easily as they can buy long, while selling short of stocks is permitted under special circumstances. • Stock holders may receive dividends, while futures contract holders don’t.

  11. An Introduction to Futures ContractsWho Trades Futures Contracts and Why? • Speculators – Buy and sell futures contracts with the expectation of profiting from changes in the price of the underlying commodity – predominantly, individuals. • Willing to take additional risks with the profit objective • Buy (long) a futures contract if cash price is expected to rise in the future • Sell (short) a futures contract if cash price is expected to fall in the future • Hedgers – Buy and sell futures contracts to eliminate their risk exposure due to changes in the price of the underlying commodity – predominantly, businesses. • If price is expected to fall during the harvest, sell (short) futures contract now, offset (buy back) the futures position in future, and sell the harvest at the spot market

  12. An Introduction to Futures ContractsThe Economic Functions of Futures markets • Reallocation of exposure to price risk – without futures markets, the cost of risk to the society would be higher • Hedgers eliminate (or reduce) price risk • Speculators assume price risk • Price discovery – more accurate equilibrium price • Futures market provides centralized trading where information about fundamental supply and demand conditions for a commodity is efficiently assimilated and acted on, as a consequence equilibrium price is discovered • Improve economic efficiency - • By providing a means to hedge price risk associated with storing a commodity, futures market makes it possible to separate the decision of whether to physically store a commodity from the decision to have financial exposure to its price change

  13. An Introduction to Futures ContractsTerminology • Bull Market: A bull market is a market in which prices are rising. When someone is referred to as being bullish, that person has an optimistic outlook that prices will be rising. • Bear Market: A bear market is one in which prices are falling. When someone is referred to as being bearish, that person has a pessimistic outlook that prices will be falling. • Going Long: If a trader initiates a position by buying a futures contract, the trader has gone long. A trader who has purchased 10 pork belly futures contracts is long 10 pork belly contracts. • A speculator, who is long in the market expect prices to rise and make money by later selling the contracts at a higher price

  14. An Introduction to Futures ContractsTerminology • Going Short: If a trader initiates a position by selling a futures contract, the trader has gone short. A trader who has sold 10 pork belly futures contracts is short 10 pork belly contracts. • A speculator, who is short in the market expect prices to fall and make money by later buying the contracts at a lower price • Contract Maturity: Futures contracts have limited lives, known as contract maturities. • Contract maturity is expressed in terms of contract months, e.g., August, October, December. • The contract maturity designates the time at which deliveries are to be made or taken, unless the trader has offset the contract by an equal, opposite transaction prior to maturity.

  15. An Introduction to Futures ContractsTerminology • Last Day of Trading: Each futures contract has a specified last day of trading. • For CME Live Cattle futures contracts, the last business day of the contract month is the last day of trading. • For CME Canadian Dollar futures contract, the last day of trading would be the business day immediately preceding the third Wednesday of the contract month. • Last Delivery Date: Each futures contract has a specified last day of trading.

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