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In and Out of Futures

In and Out of Futures. Mike Knapp. Background. Dō jima Rice Exchange in Japan, 1730s First futures exchange market Samurai paid in rice Bad rice harvests affected rice conversion to coin Samurai wanted stable conversion to coin. Background. U.S. futures market in the 19 th century

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In and Out of Futures

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  1. In and Out of Futures Mike Knapp

  2. Background Dōjima Rice Exchange in Japan, 1730s First futures exchange market Samurai paid in rice Bad rice harvests affected rice conversion to coin Samurai wanted stable conversion to coin

  3. Background U.S. futures market in the 19th century Farmers & Agriculture wholesalers Hedge against seasonal price differences Lock in prices for crops prior to harvest/planting Now futures have developed for financial futures I.e. Stock indexes

  4. Futures Contract One buyer & one seller 3 Key Elements Futures price Settlement/delivery date Underlying Need an exchange/clearinghouse to be a futures

  5. Profit Long Position When does long position make profit? And loss? Buyer of futures contract Futures Price Loss

  6. Profit Short Position When does short position make profit? And loss? Seller of futures contract Futures Price Loss

  7. Clearinghouse Two functions Guarantee Function Takes opposite position of both long and short Removes default risk for buyer/seller Place for unwinding position Without Clearinghouse Futures Buyer  Futures Seller With Clearinghouse Futures Buyer  Clearinghouse Seller & Clearinghouse Buyer  Futures Seller

  8. Mark to Market Realize gains and losses daily Initial Margin Deposit for contract How clearinghouse has guarantee function Settlement Price Mark to market investor’s position Maintenance Margin Minimum level that equity position may fall Margin Call Request to bring equity position up to initial margin

  9. Futures Contract Two liquidating options Take offsetting position in same contract Long becomes short Sell same number of futures contracts Wait until settlement date Long accepts delivery Short delivers at the agreed-upon price This is undesirable in most futures contracts

  10. 2 player Hedge Example Day 1: Market Price = $10 per pound Buyer = Long position Seller = short position Contract: Long sells 100 pounds of watermelons to short at $10 per pound in 30 days Short Long

  11. 2 player Hedge Example Long Short Initial Margin: $100 Maintenance Margin: $50 Initial Margin: $100 Maintenance Margin: $50 Clearinghouse: Initial Margin: 10% of contract = $1,000 x 0.1 = $100 Maintenance Margin: $50

  12. 2 player Hedge Example Long Short Clearinghouse: Initial Margin: $100 Maintenance Margin: $50 Day 2: Settlement Price = $10.25 per pound $0.25 x 100 pounds = - $25 $0.25 x 100 pounds = + $25

  13. 2 player Hedge Example Long Short Clearinghouse: Initial Margin: $100 Maintenance Margin: $50 Day 3: Settlement Price = $10.75 per pound $0.75 x 100 pounds = - $75 $0.75 x 100 pounds = + $75 Short’s equity position is at $25, must bring equity back to $100

  14. 2 player Hedge Example Long Short Day 29: Settlement Price = $11.00 per pound $1.00 x 100 pounds = - $100 $1.00 x 100 pounds = + $100 But….Long and Short decide to take offsetting positions in the contract Contract 2: Long sells 100 pounds of watermelons to short at $11 per pound in 1 day Long Short

  15. Day 30: Settlement Price = $11.00 per pound Contract 1-Long = $10 x 100 pounds = - $1,000 2 player Hedge Example Contract 2-Short = $11 x 100 pounds = + $1,100 +$100 Contract 1-Short = $10 x 100 pounds = + $1,000 Contract 2-Long = $11 x 100 pounds = - $1,100 -$100

  16. But supposed to be zero-sum game when hedging…… Futures Contracts total = + $100 2 player Hedge Example Market purchase price of 100 pounds @ $11 per pound = - $100 Total = Futures + Market = $ 0 Futures Contracts total = - $100 Market selling price of 100 pounds @ $11 per pound = + $100 Total = Futures + Market = $ 0

  17. Questions

  18. References How a forward/futures contracts work: http://www.youtube.com/watch?v=2hp9w-gXRjM What is a clearinghouse: http://www.youtube.com/watch?v=nwR5b6E0Xo4 http://en.wikipedia.org/wiki/Clearing_house_(finance) http://www.cmegroup.com/education/files/a-traders-guide-to-futures.pdf http://books.google.com/books?id=6N7vc7skff4C&pg=PT177&lpg=PT177&dq=D%C5%8Djima+Rice+Exchange&source=bl&ots=v_bsmO6P7K&sig=ihVbjfoTZG5MCIrwils4zmQlSzk&hl=en&sa=X&ei=e4OaUfbTM46UjAK0w4HYDA&ved=0CEIQ6AEwBTgK http://www.investopedia.com/university/futures/futures2.asp http://www.investopedia.com/university/futures/futures7.asp

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