Futures Contracts (Ch 19)

Actual Margin

At the end of each trading day each investor's account is "MARKED TO THE MARKET". Initial margin [equity] is adjusted for subsequent changes in the futures price

FUTURES

both parties bound to transaction to take place at fixed date in future at a fixed price

Initial Margin

is usually 5 to 10% of the contract's value, thus an investor can control large commodity positions with modest sums of money. Minimum margin requirements are set by clearinghouse, but brokers are free to require more

DAILY PRICE LIMITS ON FUTURES EXCHANGES:

Due to the low margins, an investor's equity position can be wiped by relatively small price movements. To protect speculators and brokerage firms, exchanges have placed limits on the daily price movements of commodity and some financial futures contracts. Trading in that particular future is stopped once the price is up or down the limit.

SPOT AND FUTURES PRICES TEND TO MOVE TOGETHER

For most commodities, futures price exceeds cash price. Cash price lower because of interest and storage/insurance costs related to owning the commodity

Financial Futures

Futures contract whose underlying asset is a financial asset or an index of financial asset values. E.G., T-bills, T-notes, T-bonds, municipal bond index, stock index, foreign currencies, Eurodollars, etc

Settlement

Futures contracts are settled either by DELIVERY or by OFFSET. Less than 2% of the contracts are settled by delivery.

DELIVERY MONTH

Futures contracts specify a delivery month rather than a particular date for delivery. At the start of the delivery month any contracts which remain open are matched with an opposing position by the clearing house and sellers are provided with delivery instructions. Usually sellers have the option of delivering on any business date during the delivery month. Approximately 2% of all contract positions result in delivery. Most are "COVERED" prior to delivery month.

TWO TYPES OF MARKET PARTICIPANTS

Hedger, Speculator

Maintenance Margin

Margin level below which the investor gets a margin call and must deposit more cash or close his account by offset.

SPOT or CASH MARKET

Market where assets are bought and sold for IMMEDIATE delivery

Futures Market

Market where contract positions for the future purchase or sale of underlying assets are traded.

FUTURES PRICE

Market's expectation of what the spot price of the underlying asset will be at delivery (during delivery month). The delivery price which parties will enter futures contract at. NOTE: Market's expectation as to what future spot prices are going to be effects current spot price as well! If expectations are for much better future prices, sellers will store and wait thereby driving up spot prices as supply decreases.

Futures Contract

Negotiable or marketable forward contract. A forward contract which is standardized and can be traded on an organized exchange. Ultimate liability is with clearinghouse of the exchange therefor parties need not know who has opposing position or whether they are trustworthy. Exchange must bear those concerns!

Futures Options

Option on a futures contract gives the holder the right ( but not the obligation) to assume the long (call) or short position (put) on an underlying futures contract If option is exercised, the option's strike price is the futures price at which the futures position is assumed. I.e., if the call is exercised, the holder has "purchased" the underlying futures contract at the call's strike price. If a put is exercised, the holder has "sold" the underlying futures contract at the put's strike price.

Short Hedger

Owns the underlying asset and wants to be protected from potential price declines. Sell futures. E.G., grain farmer. In so doing, the short hedger trades away any potential gains from future price increases to avoid losses on future declines

Speculator

Someone who wants to bear the price risk because he believes the price is likely to move in a direction favorable to his futures position: i.e., Sell if he expects the price to fall. Buy if he expects price to rise. BUY LOW SELL HIGH! !!

SPOT PRICE SPECULATION

Speculator tries to earn a rate of return based on his ability to predict FUTURE SPOT PRICES. Rather than going long or short in the commodity itself, he buys or sells a future because of the LEVERAGE potential which it offer. Like the hedger, he too is subject to basis risk.

Basis

The basis of a futures contract at a particular point in time is the difference between the futures and spot prices at that point in time. [BASIS = FUTURES PRICE SPOT PRICE]

Open Interest

The number of futures contracts outstanding at a particular point in time

commodity futures

Typically commodity futures prices exceed spot prices, resulting in a positive basis [Time value of money, storage costs].

BASIS RISK

Uncertainty as to what cover basis will be Basis may change between the point in time when the investor enters a futures position and the point when he covers. BASIS RISK IS ESPECIALLY A PROBLEM FOR THE HEDGER: Trying to hedge a cash position with an opposing futures position.

REASON FOR EXISTENCE OF FUTURES MARKETS

Uncertainty as to what the price of the underlying asset is going to do between now and the delivery date. The futures contract in effect shifts the risk of price changes from one party to another. Besides shifting the risk of price changes, futures contracts may be used to avoid storage costs. Futures contracts are NOT used to guaranted delivery at a future date. [remember, at most 2% ever reach delivery.]

financial futures

With financial futures, the spot price may exceed the futures price. Why? The underlying asset may bear interest, the futures contract does not!

REALIZED PRICE

= [initial spot price] + [initial basis] [cover basis] = [initial futures price] - [cover basis]

Forward Contract

A contract wherein two parties agree to buy and sell an underlying asset at a future date for a stated price. Any two parties can enter a forward contract. However, each must trust that the other will perform!

OFFSET

An investor "covers" or settles his future commitment by reversing their original position, i.e., a buyer covers by selling the same futures contract [i.e., same underlying asset, same delivery date]. Seller covers by buying. Once offset takes place the investor's future's position is eliminated. If commitment is NOT OFFSET, DELIVERY MUST TAKE PLACE!

Gain/Loss

Gain results when futures price at time you buy is lower than futures price at the time you sell. Lose of sell low and buy high

Margin

In a futures contract both parties are legally bound to their role in the transaction. Because it has ultimate liability, the clearinghouse requires a security deposit called a MARGIN from both parties to protect from default on the futures transaction

GOING SHORT

In the commodity market it is as easy to take a short position as a long position. Since delivery is in the future it is not necessary to borrow the commodity from a third party. I.E., take position of seller in futures contract when don't currently own the "something" to be sold.

Long Hedger

Intends to purchase the underlying asset at some future time and wants to be protected against price increases. Buys futures. E.G. Grain Miller. In so doing, the long hedger trades any gains he would reap from future price declines in order to be protected from price increases.

LONG HEDGE

Investor has a future need for a particular commodity. Current spot price is acceptable, but investor has concern about variation in spot prices between now and point when he would like to take delivery. Investor is short the commodity [he has future need for it], therefore can isolate himself from changes in the spot price by purchasing a future in the particular commodity.

Short Hedge

Investor is "long" in the underlying asset and expects to sell in the future. Wants to hedge against a decrease in spot prices between now and when he sells. If spot prices and futures price move together (lock step), a decrease in the spot price will give a loss in the spot market (farmer's long position) which is exactly OFFSET by a gain on his futures transaction. (i.e. no change in basis)

Contract Positions

Investors do not literally buy and sell contracts, rather they enter futures contracts making a commitment to buy or sell the underlying asset 1. "BUY" a futures contract to take a LONG POSITION: Commit to buying the underlying asset at a future date. 2. "SELL" a futures contract to take a SHORT POSITION: Commit to selling the underlying assets at a future date.

THE FUTURES MARKET

Like the options market it is a ZERO SUM GAME. Their is an investor on both sides of the contract. What one party makes the other party loses [ignoring transactions costs]

BUYER OF THE FUTURES CONTRACT

The party who has agreed to BUY the underlying asset at a future date and price specified in the contract. The buyer benefits of the price of the underlying asset increases.

SELLER OF THE FUTURES CONTRACT

The party who has agreed to SELL the underlying asset at a future date and price fixed in the contract. The seller benefits if the price of the underlying asset falls.

cover basis

basis on the day the contract is covered

initial basis

basis on the day the contract is initiated

OPTIONS

option holder has the option to enter transaction before a fixed expiration date at a fixed price. Option writer bound if option holder decides to exercise his option. Option buyer must pay a premium to option writer. With futures contract, neither party pays the other anything when the contract is entered