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Chapter 8

Chapter 8. Fundamentals of the Futures Market. Outline. The concept of futures contracts Market mechanics http://www.pbs.org/itvs/openoutcry/thepit.html Market participants The clearing process Principles of futures contract pricing http://www.cme.com/ http://www.cbot.com /

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Chapter 8

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  1. Chapter 8 Fundamentals of the Futures Market

  2. Outline • The concept of futures contracts • Market mechanics http://www.pbs.org/itvs/openoutcry/thepit.html • Market participants • The clearing process • Principles of futures contract pricing • http://www.cme.com/ • http://www.cbot.com/ • https://www.theice.com/clear_canada.jhtml

  3. Introduction • A futures contract is a legally binding agreement to buy or sell something in the future

  4. Futures Compared to Options • Both involve a predetermined price and contract duration • The person holding an option has the right, but not the obligation, to exercise the put or the call • With futures contracts, a trade must occur if the contract is held until its delivery deadline

  5. Futures Compared to Forwards • A futures contract is more similar to a forward contract than to an options contracts • A forward contract is an agreement between a business and a financial institution to exchange something at a set price in the future • Most forward contracts involve foreign currency

  6. Futures Regulation • In 1974, Congress passed the Commodity Exchange Act establishing the Commodity Futures Trading Commission (CFTC) • Ensures a fair futures market

  7. Futures Regulation (cont’d) • A self-regulatory organization, the National Futures Association was formed in 1982 • Enforces financial and membership requirements and provides customer protection and grievance procedures

  8. Trading Mechanics • Most futures contracts are eliminated before the delivery month • The speculator with a long position would sell a contract, thereby canceling the long position • The hedger with a short position would buy a contract, thereby canceling the short position

  9. Market Participants • Hedgers • Processors • Speculators • Scalpers

  10. Delivery • Delivery can occur anytime during the delivery month • Several days are of importance: • First Notice Day • Position Day • Intention Day • Several reports are associated with delivery: • Notice of Intention to Deliver • Long Position Report

  11. Principles of Futures Contract Pricing • The expectations hypothesis • Normal backwardation • A full carrying charge market

  12. The 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 • Price discovery is an important function performed by futures • There is considerable evidence that the expectations hypothesis is a good predictor

  13. Normal Backwardation • Basis is the difference between the future price of a commodity and the current cash price • Normally, the futures price exceeds the cash price (contango market) • The futures price may be less than the cash price (backwardation or inverted market)

  14. Normal Backwardation (cont’d) • John Maynard Keynes: • Locking in a future price that is acceptable eliminates price risk for the hedger • The speculator must be rewarded for taking the risk that the hedger was unwilling to bear • Thus, at delivery, the cash price will likely be somewhat higher than the price predicated by the futures market

  15. A Full Carrying Charge Market • A full carrying charge market occurs when the futures price reflects the cost of storing and financing the commodity until the delivery month • The futures price is equal to the current spot price plus the carrying charge:

  16. A Full Carrying Charge Market (cont’d) • Arbitrage exists if someone can buy a commodity, store it at a known cost, and get someone to promise to buy it later at a price that exceeds the cost of storage • In a full carrying charge market, the basis cannot weaken because that would produce an arbitrage situation

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