Lecture 12 Price Management through Futures and Options

1. Lecture 12Price Management through Futures and Options Required Text: Chapter 10

2. An Introduction to Futures Contracts • Futures Contracts −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. • Futures contracts are standardized forward contracts that are traded on some organized exchange

3. 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.”

5. 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

6. 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

7. 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

8. 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.

9. 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.

10. Mechanics of Trading Futures ContractsCME Product Codes • Futures contracts are assigned symbols for faster and easier references purposes – called the product codes or “Ticker.” • Instead of writing December CME Live Cattle, traders use the code LCZ • LC – Live Cattle, Z - December

11. Mechanics of Trading Futures ContractsTypes of Futures Orders • A futures order refers to a set of instructions given to a FCM (or introducing broker) by a customer requesting that the broker take certain actions in the futures market on behalf of the customer. Most frequently used orders: • Market Order (MKT) – “BUY 1 Oct 2009 Live Cattle MKT” • An order placed to buy or sell at the market means that the order should be executed at the best possible price immediately following the time it is received by the floor broker on the trading floor. • In this case, the customer is less concerned about the price s/he will receive, and more concerned with the speed of execution.

12. Mechanics of Trading Futures ContractsTypes of Futures Orders • Limit Orders – “BUY 1 Oct 2009 Live Cattle at 86.50” “Sell 1 Oct 2009 Live Cattle at 87.10” • A limit order is used when the customer wants to buy (sell) at a specified price below (above) the current market price. • The order must be filled either at the price specified on the order or at a better price. • The advantage of a limit order is that a trader knows the worst price he will receive if his order is executed. • However, the trader is not assured of execution, as with a market order.

13. Mechanics of Trading Futures ContractsTypes of Futures Orders • Market If Touched (MIT) – “Sell 1 Oct 2009 LC 87.10 MIT” • When the market reaches the specified limit price, an MIT order becomes a market order for immediate execution. • The actual execution may or may not be at the limit price • An MIT buy order is placed at a price below the current market price • An MIT sell order is placed at a price above the current market price • Market-on-Close (MOC) – “BUY 1 Oct 2009 LC MOC” • A MOC order instructs the floor broker to buy or sell an specified contract for the customer at the market during the official closing period for that contract. • The actual execution price need not be the last sale price which occurred, but it must fall within the range of prices traded during the official closing period for that contract on the exchange that day.

14. Mechanics of Trading Futures ContractsTypes of Futures Orders • Stop Order – “Buy 1 Oct 2009 Live Cattle 86.50 Stop” “Sell 1 Oct 2009 Live Cattle 87.10 Stop” • In contrast to limit orders, a buy-stop order is placed at a price above the current market price, and a sell-stop order is placed at a price below the current market price • Stop orders become market orders when the designated price limit is reached • The execution of simple stop orders, however, is not restricted to the designated limit price • They may be executed at any price subsequent to the designated stop order price being touched • Stop orders are often used to limit losses on open futures positions.

15. Mechanics of Trading Futures ContractsTypes of Futures Orders • Stop-Limit Order – “BUY 1 Oct 2009 LC 86.50 Stop Limit” “SELL 1 Oct 2009 LC 87.10 Stop Limit” • A stop-limit order is similar to a regular stop order except that its execution is limited to the specified limit price or “better” • A broker may not be able to execute a stop-limit order in a fast market, because of the restrictions placed on the execution price. • Spread Order – “Spread BUY 1 Oct 2009 LC SELL 1 Dec 2009 LC, Oct 10 cents premium” • A spread order directs the broker to buy and sell simultaneously two different futures contracts, either at the market or at a specified spread premium. • It is necessary to specify the order as “Spread” at the beginning, and it is customary to write BUY side of each spread order first.

16. Mechanics of Trading Futures ContractsThe Order Flows: Floor Trading

17. Mechanics of Trading Futures ContractsFutures Commission Merchants (FCM) • The FCM is a central institution in the futures industry, that performs functions similar to a brokerage house in the securities industry. FCMs are regulated by Commodity Futures Trading Commission (CFTC) under the Commodity Exchange Act (CEA). • Futures traders first have to open an account at a FCM • Futures traders with FCM accounts give their trading orders to an account executive employed at the FCM • The FCM executives give customer orders to floor brokers to execute the orders on the floor of an exchange • The FCM collects margin balance from the customers (traders), maintains customer money balance, and records and reports all trading activity of its customers

18. Mechanics of Trading Futures ContractsExchanges • In order to execute customer orders, FCMs must transmit such orders to an exchange (or contract market) • Exchanges perform three functions: • Provide and maintain a physical marketplace – the floor • Police and enforce financial and ethical standards • Promote the business interests of members • Exchanges are membership organizations whose members are either individuals or business organizations • Membership is limited to a specified number of seats – the seat price rises with the trading volume • Members receive the right to trade on the floor of the exchange, without having to pay FCM commissions

19. Mechanics of Trading Futures ContractsThe Clearinghouse • Every futures exchange has a clearing house associated with it which clears all transactions of that exchange. The clearing house regulates, monitors, and protects the clearing members • Exchange members provide daily reports of all futures trades to the clearing house, which matches shorts against longs and provide a daily reconciliation • For each member, the clearing house computes daily net gain and loss and transfer funds from the account in loss to the account in gain • Collects security deposits (margins or performance bonds) from the members and customers • Regulates, monitors, and protects each trader

20. Mechanics of Trading Futures ContractsElectronic Trading • CME Globex Electronic Trading Platform • Accounts for 70% of total CME volume • Open Access: No membership is required for trading • All customers who have an account with a FCM or IB (Introducing Broker) can view the book prices and directly execute transactions in CME’s electronically traded products • All trades are guaranteed by a clearing member firm and CME’s clearing house • One contract, two platforms • Find a complete list of products offered on the CME Globex platform at • www.cme.com/globexproducthours

21. Mechanics of Trading Futures ContractsLiquidating or Settling a Futures Position • Three ways to close a futures position • Physical delivery or cash settlement • Offset or reversing trade • Exchange-for-Physicals (EFP) or ex-pit transaction • Physical Delivery • Physical delivery takes place at certain locations at certain times under rules specified by a futures exchange. • Imposes certain costs to traders • Storage costs • Insurance costs • Shipping cost, and • Brokerage fees

22. Mechanics of Trading Futures ContractsLiquidating or Settling a Futures Position • Cash Settlement • Instead of making physical delivery, traders make payments at the expiration of the contract to settle any gains or losses. • At the close of trading in a futures contract, the difference between the cash price of the underlying commodity at that time and the buying/selling price is debited/credited to the account of the long/short trader, via the clearing house and FCMs. • Available only for futures contracts that specifically designate cash settlement as the settlement procedure • Most financial futures contracts allows completion through cash settlement • Cash settlement avoids the problem of temporary shortage of supply • It also makes it difficult for traders to manipulate or influence futures prices by causing an artificial shortage of the underlying commodity

23. Mechanics of Trading Futures ContractsLiquidating or Settling a Futures Position • Offsetting • The most common way of liquidating an open futures position • The initial buyer (long) liquidates his position by selling (short) an identical futures contract (same commodity and same delivery month) • The initial seller (short) liquidates his position by buying (long) an identical futures contract (same commodity and same delivery month) • The clearinghouse plays a vital role in facilitating settlement by offset • Offsetting entails only the usual brokerage costs. • Exchange-for-Physicals (EFP) • A form of physical delivery that may occur prior to contract maturity • An EFP transaction involves the sale of a commodity off the exchange by the holder of the short contracts to the holder of long contracts, if they can identify each other and strike a deal.

24. Live Cattle CME (40,000lbs; cents/lbs), Aug 27, 2009Reported by Financial Times • Settlement Price: The settlement price is usually determined by a formula using a range of prices recorded within the closing period (such as the last minute of trading) – it is not usually the last trading price of the day

25. Convention of Reporting Futures Prices • Day’s Change: The difference between today’s settlement price and yesterday’s settlement price – can be either positive or negative Day’s change = today’s settlement – yesterday’s settlement • High: The highest price of a trade recorded during the day • Low: The lowest price of a trade recorded during the day • Volume: The total number of futures contracts that are traded during the day. • Open Interest: The number of futures contracts that are open at the close of the previous day’s trading. • The actual figures for open interest and trading volume usually lag price quotations by one day

26. Contango Markets • Contango: A market condition is referred to as in contangowhen, at a particular point in time, futures prices rise progressively with the time to delivery, i.e. the futures price of a distant delivery month is higher than the futures price of a near delivery month. • Contango =>FPt, T+n > FPt, Twhere n=1,….., N • A contango is normal for a non-perishable commodity which has a positivecost-of-carry.

27. Contango Market Condition • On 02 February 2009, the wheat futures market was in contango.

28. Backwardation Markets • Backwardation is commonly referred to a market condition in which, at a particular point in time, futures prices fall progressively with the time to delivery, i.e. the futures price of a distant delivery month is lower than the futures price of a near delivery month. . • Backwardation =>FPt, T+n < FPt, T where n=1,….., N • Backwardation is characterized by a shortage of the physical commodity. Backwardation often occurs at times when cash prices are high and have been rising sharply, a manifestation of a shortage in the market. In such cases, the underlying commodity is said to have a positive convenience yield.

29. Backwardation Market Condition • On 02 February 2009, the soybean meal futures market was in backwardation.

30. The Relationship between Cash and Futures Prices • There are several obvious features of the cash and futures price relationship shown in Figures 1 and 2: • Futures settlement prices are higher than cash closing prices Futures Price (FPt, T) > Cash Price (CPt) • A distant-month futures price is higher than a near-month futures price FPt, Dec > FPt, NM > CPt • The difference between the cash and futures price depends on, and increases with, the time to delivery |CPt – FPt, T | increases with T−t (the time to delivery) • The futures prices slowly but inevitably converges to the cash prices as the delivery date approaches FPt, T→ CPt as t → T • These relationships exist regardless of the level of cash price.

31. The Cost-of-Carry Price Relationship • Cost-of-Carry: The cost-of-carry refers to the costs of purchasing and carrying (or holding) a commodity for a specified period of time. • Cost-of-Carry= financing costs + storage costs + insurance costs + shipping cost + other miscellaneous costs • CCT-t= CPt × Rt, T × (T-t)/365 + Gt, T + It, T + S + D Where • CPt= the cash price at time t • Rt, T= the annualized riskless interest rate at which funds can be borrowed at time t for period (T− t) • Gt, T = the cost of storing the physical commodity per unit for the time period from purchase (at t) to delivery (at T) • It, T=the cost of insuring the physical commodity per unit for the time period from purchase (at t) to delivery (at T) • S = The costs of shipping and handling the commodity • D = Other miscellaneous costs (e.g., depreciation, etc.)

32. The Cost-of-Carry Price Relationship • The cost-of-carryformula is based on simple interest financing cost. • It does not allow for continuous compounding interest costs. • The formula assumes that there are no information or transaction costs associated with buying or selling either futures or physical commodity, credit risks, taxes, and so on. • The Full-Carry Futures Price:The full-carry futures price of a commodity refers to the estimated futures price using the following formula. FP* = CPt + CCT-t • Thus, at any given time t the estimated futures price with delivery time T is equal to the cash price plus the cost of carrying the commodity for the period of T-t.

33. Calculating the Cost-of-Carry and Full-Carry Futures Price

34. The Convenience Yield • The convenience yield refers to an implied yield (or return) from simply holding a commodity. This yield need not be a directly measurable or pecuniary return. It could be the implicit return that a firm places on its ability to use its inventory. Ownership of the physical commodity enables a manufacturer to keep a production process running and perhaps profit from temporary local shortages. Yt, T = FP*−FPt, T = CPt + CCT−t − FPt, T • If we observe a relationship where the actual futures price (FPt, T) is less than the full-carry futures price (FP*), the actual futures price (FPt, T) is said to have an implicit convenience yield. Example: Yt, T = FP*−FPt, T = 617.61 − 612.75 = 4.86 cents/bushel.

35. The Basis • The basis is defined as the difference between cash and futures prices. The basis can either be negative, or positive, or zero. In particular, Bt, T = CPt − FPt, T = Yt, T − CCT−t • For Yt, T≥ 0 and CCt,T ≥ 0, a negative basis reflects that the convenience yield is lower than the cost-of-carry. • Bt, T < 0 => CPt < FPt, T => Yt, T < CCT−t • The basis is positive when the futures price is lower than the cash price. In this case, the conv. yield is higher than the cost-of-carry. • Bt, T > 0 => CPt > FPt, T => Yt, T > CCT−t • The basis is zero when the convenience yield and cost-of-carry are equal or when both the convenience yield and cost-of-carry are zero. • Bt, T = 0 => CPt = FPt, T => Yt, T = CCT−t or Yt, T= 0 = CCT−t

36. Hedging Fundamentals • Hedging: The activity of trading futures with the objective of reducing or controlling price risk (due to uncertainty about future price levels) is called hedging. • Output Price Risks: A farmer who is growing corn and planning to sell it in six months (after harvest) cannot be certain about what the price of corn will be in six months. • Input Price Risks: An airline career that wish to set passenger fares that remain fixed for the next six months cannot be certain about what the price of jet fuel will be in six months. • Both output and input price risks can be reduced or controlled by hedging. • However, quantity risk cannot be controlled by hedging.

37. Hedging FundamentalsThe Basic Long and Short Hedges • Hedging typically involves taking a position in futures that is opposite either to • A position that one already has in the cash market, or • A futures cash obligation that one has or will incur • There are two basic types of hedges: Short hedge and long hedge • Short Hedge: A short hedge occurs when a firm which owns or plans to purchase or produce a cash commodity sells futures to hedge the cash position. • Cash price risk is declining cash prices • Long Hedge: A long hedge occurs when a firm which plans to purchase a cash commodity in either cash or forward market purchase futures to hedge the future cash position. • Cash price risk is increasing cash prices

38. Hedging FundamentalsShort Hedge (with Zero Basis Risk) • Suppose it is June 01. A cotton farmer in Lubbock planted cotton in April, and expects to harvest 100,000 lbs of cotton in October. • On June 01, the cash price for cotton is 55 cents/lb in the local market and • October NYBOT Cotton futures settled at 57 cents/lb. • The farmer is worried that cash price of cotton at harvest (in October) may decline significantly. • The farmer may hedge against the declining price risk by short hedging. • To fully cover her expected cash position at harvest, the cotton farmer needs to short 2 NYBOT Cotton futures (because the size of NYBOT cotton futures is 50,000 lbs.)

39. Perfect Hedging Short Hedge (with Zero Basis Risk)

40. Perfect Hedging Short Hedge (with Zero Basis Risk)

41. Perfect Hedging Long Hedge (with Zero Basis Risk) • Suppose that a beef packer in Amarillo has a plant-capacity of slaughtering 1,000 fed cattle per month. Each fed cattle weight approximately 1,200 lbs. • It is Oct 19. The cash price for live cattle is 75 cents/lb in the local market, and Feb CME Live Cattle futures settled at 85 cents/lb. • The beef packer plans to purchase live cattle in February from the local market, but is worried that cash price for live cattle may increase significantly in February. • The beef packer may hedge against the increasing price risk by long hedging. • To fully cover her expected cash position in February, the beef packer needs to long 30 CME Live Cattle futures (because the size of CME Live Cattle futures is 40,000 lbs.)

42. Perfect Hedging Long Hedge (with Zero Basis Risk)

43. Perfect Hedging Long Hedge (with Zero Basis Risk)

45. Hedging with Basis Risk • When the basis remains unchanged, it is simple to construct predictable, no-risk hedge. • Unfortunately, perfect hedging is not usual in reality • Like cash and futures prices, basis may change as well • Basis may expand (absolute basis becomes larger) or shrink (absolute basis becomes smaller) • However, a change in the basis can affect the results of hedging • Short Hedge • Basis expands – net realized price is lower than the initial cash price • Basis shrinks – net realized price is higher than the initial cash price • Long Hedge • Basis expands – net price paid is lower than the initial cash price • Basis shrinks – net price paid is higher than the initial cash price

46. Short Hedge (with Basis Risk)Basis ExpandsChange in Basis = Long Basis – Short Basis

47. Short Hedge (with Basis Risk)Basis ExpandsChange in Basis = Long Basis – Short Basis

48. Short Hedge (with Basis Risk)Basis ShrinksChange in Basis = Long Basis – Short Basis

49. Short Hedge (with Basis Risk)Basis Shrinks Change in Basis = Long Basis – Short Basis

50. Long Hedge (with Basis Risk)Basis ExpandsChange in Basis = Short Basis – Long Basis