Introduction to Futures Markets

1. Introduction to Futures Markets • Overview • Terms • Participants • Procedures • Examples

2. Cash or Spot Market • The physical commodity • “On the spot” • At a specific location • Price is established and commodity changes ownership

3. Futures markets • Organized and centralized market • Today’s price for products to be delivered in the future. • A mechanism of trading promises of future commodity deliveries among traders.

4. Futures markets • Biological nature of ag production • Excess supply at harvest • Shortage in spring and summer • Producers need price forecast because prices not known when production decision is made • Processors need year around supply

5. Futures Market Exchanges • Modern futures market began long ago • 1848 Chicago Board of Trade • 1898 Chicago Mercantile Exchange • 2007 CME Group merged CBOT and CME • Highly regulated markets • Commodity Futures Trading Commission (CFTC)

6. CME Group • http://www.cmegroup.com/ • Products • Commodities and quotes • Education • Additional resources

7. Futures Market Exchanges • Centralized pricing • Buyers and sellers represented by brokers in the pits or electronically • All information represented through bids and offers • Perfectly competitive market • Open out-cry trading • Electronic trading

8. Trading Futures Contracts • All trades through a licensed broker • Brokerage house has “seat” at the exchange and is allowed to trade • Represented “on the floor” to exercise trade • Local broker to initiate transaction and manage account with client • Full service and discount brokers

9. Electronic trading: CME Globex • Customers must have a CME Clearing Firm relationship and a CME Group-certified trading application. • Individual investors are encouraged to connect through their broker, who can provide both the Clearing Firm guarantee and trading infrastructure.

10. Futures contract • A futures contract is a commitment to make or take delivery of a specific quantity and quality of a given commodity at a specific delivery location and time in the future. • A legally binding contract • Trading the promise to do something in the future • You can “offset” your promise

11. The futures contract • All terms of the contract are standardized except for the price, which is discovered via the supply (offers) and the demand (bids). • Standardized contract • Form (wt, grade, specifications) • Time (delivery date) • Place (delivery location)

12. Standardized contract • Delivery months • Size of contract • Grains 5,000 bushels • Corn, Wheat, Soybeans • Livestock in pounds • Lean Hogs 40,000 lbs carcass • Live Cattle 40,000 lbs live • Feeder Cattle 50,000 lbs live • Specified delivery points • Relatively few delivery points

13. The futures contract • No physical exchange takes place when the contract is traded. • Payment is based on the price established when the contract was initially traded. • Deliveries are made when the contract expires (delivery time).

14. The futures contract • All contracts are ultimately settled through: • Liquidation by an offsetting transaction • Delivery of the actual physical commodity • Offset is most common • Delivery usually occurs in less than 2 percent of all agricultural contracts traded.

15. Market participants • Speculators have no use for the physical commodity. • They buy or sell in an attempt to profit from price movements. • Add liquidity to the market. • May be part of the general public, professional traders or investment managers • Short-term – “day traders” • Long-term - buy or sell and hold

16. Market participants • Hedgers are willing to make or take physical delivery because they are producers or users of commodity. • Use futures to protect against a price movement • Cash and futures prices are highly correlated • Hold counterbalancing positions in the two markets to manage the risk of price movement

17. Hedgers • Farmers, livestock producers • Merchandisers, elevators • Food processors, feed manufacturers • Exporters • Importers • What happens if futures market is restricted to only hedgers?

18. Market participants • Brokers exercise trade for traders and are paid a flat fee called a commission. • Futures are a “zero sum game” • Losers pay winners • Brokers always get paid commission

19. How futures markets work • Each trader opens an account with a licensed broker • The trader places an initial margin in the account for each contract traded • The amount of margin is set by the brokerage firm subject to minimum levels established by the exchange.

20. How futures markets work • Margin is money that buyer or seller of futures contracts must deposit with a broker and the broker in turn must deposit with a clearing house. • The margin is the performance bond that ensures that all trades are honored.

21. How futures markets work • Trades of CME Group products, will clear through CME Clearing • At the settlement time each day every contract is settled. • The gain (loss) from the previous day is added (subtracted) to the trader’s margin account • If additional money is needed to comply with the margin requirements it is known as receiving a margin call.

22. How futures markets work • The clearing operation severs the connection between the original buyer and seller. • CME Clearing assumes the opposite side of each open position and thereby ensures the financial integrity of every futures and options contract traded at CME Group. • In turn, it holds each trader accountable by settling the margin account each day.

23. Market position • Objective: Buy low, sell high • You can either buy or sell initially to open a position • “Make” a promise • Do the opposite to close the position at a later date • “Offset” the promise • Or make/take physical delivery of the commodity except for “cash settled” contracts

24. Speculator example: • You believe that Asian Soybean Rust will reduce yields and that producers may plant fewer acres of soybeans to avoid potential Asian Rust problems. • How can you profit from this scenario????

25. Speculator example: • Pork producers have lost a record amount of equity and some will go out of business. • China lifted its restrictions related to H1N1 on U.S. pork imports. • How can you profit from this scenario?

26. FUTURES: ACCOUNTING • Margin (“performance bond”) • Money deposit to ensure fulfillment of a futures contract at a future date

27. FUTURES: ACCOUNTING • Margins • Initial margin • Deposit that must be made when opening a position • Maintenance margin • Minimum margin that must be maintained while holding an open position • Margin call • Call to deposit additional funds into margin account to bring it up to initial margin level

28. FUTURES: MARGINS • Except for initial margin deposit, money not paid/received when futures are initially bought/sold. • Margins • Different across commodities • Different for speculators vs. hedgers • May change over time

29. Futures Margin per contract January 4, 2010

30. Futures Summary • Today’s price for delivery in future • Standardized contract/promise to make or take delivery • Contract/promise can be offset • Several participants for different positions • Highly leveraged trade and must maintain margin account as a performance bond