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Chapter 16

Chapter 16. Commodities and Financial Futures. Objectives. Explain how commodities and financial futures can be used for speculation or for hedging Describe the different types of commodities and financial futures contracts that are available

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Chapter 16

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  1. Chapter 16 Commodities and Financial Futures

  2. Objectives • Explain how commodities and financial futures can be used for speculation or for hedging • Describe the different types of commodities and financial futures contracts that are available • Explain how margin is used in the futures markets to magnify gains (or losses)

  3. Objectives cont. • Explain the difference between the cash and the futures markets • Describe how currency futures and interest rate futures are currently utilized in a business environment • Explain the role of interest rate swaps as an alternative to futures

  4. Commodities and Financial Futures • Types of Commodities and Exchanges • Actual Commodities Contract • Reading Market Quotes • The Cash Market and the Futures Market • The Futures Market for Financial Instruments • Currency Futures • Interest Rate Futures • Options as Well as Futures • Interest Rates Swaps

  5. Futures Contract An agreement that provides for delivery • of a specific amount of a commodity • at a designated time in the future • at a given price

  6. Futures Contract continued • Almost all commodities futures contracts closed out (reversed) before actual transaction occurs • Tremendous volume of activity but, • Few actual items ever change hands

  7. Hedge Futures markets originally set up to allow grain & livestock producers & processors to hedge(protect) their positions in a given commodity

  8. Example 1- Wheat Producer • 5 month lead from planting to harvesting • Current price of wheat: $5.50/bushel • High risk of price drop before delivery • Produce can hedgeposition by offering to SELL futures contracts for the delivery of wheat

  9. Example 1- Wheat Producer continued • If price of wheat declines, producer sells crop for less than anticipated • Producer makes up the difference in the futures market • Buys futures back for less then he sold them • If price of wheat increases, producer sells crop for more than anticipated • Extra profit is given back in the futures market • Buys futures back for more then he sold them

  10. Example 2 -Miller processing Wheat • Opposite dilemma of wheat producer • Afraid price of wheat might go up • Cut into profit margin • Hedge position by BUYING futures contracts in wheat If price of wheat goes up, extra production cost is offset by the profits on futures contracts

  11. Speculators in the Futures Market • Take purely long or short positions without intent to hedge actual ownership

  12. Types of Commodities

  13. Table 16-1 Categories of Commodities and Financial Futures

  14. Commodity Exchanges

  15. Size of Commodity Contracts

  16. Margin Requirements • Commodity trading uses • Margins • NOT actual cash dollars Typically 2% to 5% of the value of the contract • Margin requirements may vary • Over time • Among exchanges for a given commodity

  17. Margin Maintenance Requirement • 60 to 80% of the value of initial margin • If initial margin is reduced due to losses on contract • MUST deposit more money to cover margin position if not position will be closed out (resulting in loss)

  18. Example - Margin Requirements • Value of wheat contract: $27,500 (from Table 16-3) • Margin requirement:$1,000 (in 2006) • $1,000 is 3.6 percent of $27,500 • Margin maintenance requirement: 70% × $1,000 = $700

  19. Gains and Losses - Example • Buy Dec. futures contract for $5.50/bushel • Price goes up to $5.70/bushel • One contract = 5,000 bushels • $0.20 increase per bushel • Gain = $1,000 (5,000 bushels x $0.20) • Initial margin requirement = $1,000 • Percentage profit =100%

  20. Gains and Losses – Example continued • What if the price dropped? • If maintenance margin requirement is $700, how much would the price of wheat have to decline for us to get a margin call to increase our deposit? Answer: With 5,000-bushel contract:

  21. Market Conditions • Market conditions affect price of commodities • What key variables influence value of contract? • For wheat, factors could be • Weather • Crop conditions in the Midwest • Price of corn as a substitute product • Carryover of supply from last year

  22. Market Conditions • Export of wheat to other countries • Imports from other countries • Currency fluctuations • Wheat lobby in Washington? • Can you think of any other factors?

  23. Price Movement Limitations • Hi risk of gains/losses in commodities • Limit maximum daily price movements in commodity • Examples shown in Table 16–4

  24. Price Movement Limitations • Daily limits affect efficiency of the market • If market conditions indicate price of wheat should decline by $0.30 but daily limit is $0.20, then, • price of wheat not in equilibrium as it opens next morning • Desire to stop market panics tends to override desire for total market efficiency • Potential intraday trading range is still large

  25. Reading Market Quotes

  26. Price Quotes for Corn Contracts

  27. The Cash Market and the Futures Market • Many commodity futures exchanges provide areas where • Buyers and sellers negotiate cash(or spot) prices • Cash price • actual dollar paid for immediate transfer of a commodity • Must be a transfer of physical possession of goods • Prices somewhat dependent on prices in futures market

  28. The Futures Market for Financial Instruments O L in • Foreign currencies • Interest rates • Stock indexes V L Y A I I T T • Corporate treasurers • Investors • Borrowers/Lenders • Bankers Hedge position

  29. The Futures Market for Financial Instruments Ideal for speculators because of • Low margin requirements & • Wide swings in value

  30. Currency Futures Futures are available in • Euro • Japanese yen • Australian dollar • Mexican peso • Canadian dollar • Russian ruble

  31. Currency Futures The currency futures market has • Standardized contracts & • Strong secondary market • Marked-to-market daily

  32. Interest-Rate Futures • GNMA certificates • Treasury notes • Treasury bills • Municipal bonds • Federal funds • Eurodollars

  33. Hedging with Interest-Rate Futures Used by • Corporate treasurer • Awaiting new debt • Borrowing under a floating prime rate • Mortgage banker • Pension fund manager • Commercial banker for loans

  34. Options As Well As Futures • Futures contract requires initial margin • Options require payment of option premium

  35. Interest-Rate Swaps • A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans • One company may have access to lower fixed rates and another company may have access to lower floating rates ... so they trade

  36. Examples of futures • Example 1 (click here) • Example 2 (click here)

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