Futures Contracts TermDefinition

Hedging with Futures

A hedger trades futures contracts to transfer price risk. Hedgers transfer price risk by adding a futures contract position that is opposite of an existing position in the commodity or financial instrument. When the hedge is in place: -The futures contract "throws off" cash when cash is needed. -The futures contract "absorbs" cash when cash is available.

Short position

A market position where the holder benefits from price decreases and loses from price increases.

Long hedge

Adding a long futures position to a short position in the underlying asset

Short hedge

Adding a short futures position to a long position in the underlying asset.

Forward contract

Agreement between a buyer and a seller, who both commit to a transaction at a future date at a price set by negotiation today.

Initial margin

Amount required when a futures contract is first bought or sold. Initial margin varies with the type and size of the contract, but it is the same for long and short futures positions.

Stock Index Futures

Because of the difficulty of actual delivery, stock index futures are usually cash settled. That is, when the futures contract expires, there is no delivery of shares of stock. Instead, the positions are "marked-to-market" for the last time, and the contract no longer exists.

Speculating with Futures, Long

Buying a futures contract (today) is often referred to as "going long," or establishing a long position. Recall: Each futures contract has an expiration date. Every day before expiration, a new futures price is established. If this new price is higher than the previous day's price, the holder of a long futures contract position profits from this futures price increase. If this new price is lower than the previous day's price, the holder of a long futures contract position loses from this futures price decrease.

Futures contract

Contract between a seller and a buyer specifying a commodity or financial instrument to be delivered and price paid at contract maturity. Futures contracts are managed through an organized futures exchange.

Cross-Hedging

Cross-hedging refers to hedging a particular spot position with futures contracts on a related, but not identical, commodity or financial instrument. For example, you decide to protect your stock portfolio from a fall in value by selling some S&P 500 stock index futures contracts. This attempt is a "cross-hedge" if changes in your portfolio value do not move in tandem with changes in the value of the S&P 500 index.

cash-futures arbitrage

Earning risk-free profits from an unusual difference between cash and futures prices is called

Spot Futures Parity with Dividends KNOW FOR EXAM

F = S (1 + r - D)^t

Financial Futures Background pg. 2

Financial futures are also important to organized futures exchanges. Some important milestones: Currency futures trading, 1972. (Nixon closes the Gold window August of 1971—FX begins to float) Gold futures trading, 1974. Actually, on December 31, 1974. The very day that ownership of gold by U.S. citizens was legalized. U.S. Treasury bill futures, 1976. U.S. Treasury bond futures, 1977. Eurodollar futures, 1981. Stock Index futures, 1982 (Kansas City Exchange had the first) Today, financial futures are so successful that they constitute the bulk of all futures trading.

A futures contract represents a zero-sum game between a buyer and a seller.

Gains realized by the buyer are offset by losses realized by the seller (and vice-versa). The futures exchanges keep track of the gains and losses every day.

Forward Contract Basics slide 2

Important: The price at which the trade will occur is also determined when the agreement is made. -This price is known as the forward price. -Generally, no cash changes hands until the trade is made. One party faces default risk, because the other party might have an incentive to default on the contract. This is COUNTERPARTY RISK. Forward contracts are between a specific buyer and seller who remain linked throughout the life of the contract and who have negotiated an exact delivery date and terms. To cancel the contract, both parties must agree. (One side might have to make a dollar payment to the other to get the other side to agree to cancel the contract.)

Marking-to-market

In futures trading accounts, the process whereby gains and losses on outstanding futures positions are recognized on a daily basis.

Long Hedge

Long Hedge Example: A cereal maker needs a continuous supply of grains. He has a natural short position. Cereal maker has a natural short because: If the price of corn goes up the cereal maker's profits will go down (higher costs) If the price of corn goes down the cereal maker's profits will go up (lower costs) To hedge his risk, the cereal maker needs to go long in the futures market. That is, He buys futures contracts Corn now to lock in his futures costs (e.g., price of corn). Cereal Maker is: (1) Long futures on Corn, and (2) Short corn because future profits are based on futures price of corn

Cash price

Price of a commodity or financial instrument for current delivery. Also called the spot price

Underlying asset

The commodity or financial instrument on which the futures contract is based

Basis

The difference between the cash price and the futures price for a commodity, i.e., basis = cash price - futures price.

Maintenance margin

The minimum margin level required in a futures trading account at all times.

Futures Contract Basics, II.

The price at which the trade will occur is determined "in the pit" or, increasingly, "in the electronic market." -This price is known as the futures price. -There are daily "marked to market" cash flows. No one faces default risk, even if the other party has an incentive to default on the contract. That is, NO COUNTERPARTY RISK. The Futures Exchange where the contract is traded guarantees each trade—no counterparty default is possible. To cancel the contract, an offsetting trade (REVERSING TRADE) is made, either "in the pit" or "in the electronic market."

Spot-futures parity

The relationship between spot prices and futures prices that holds in the absence of arbitrage opportunities.

Hedger

Trader who seeks to transfer price risk by taking a futures position opposite to an existing position in the underlying asset.

basis

Traditionally, the difference between the cash price and the futures price for a commodity basis = cash price - futures price

If the futures price is too high for an index: KNOW FOR EXAM

We want to buy low and sell high, so you buy the index and sell the futures contract

If you believe that gold priced will increase then you can speculate on this belief by:

buying gold futures, establishing a long position

Important Aspects of Futures Trading Accounts

1. Margin is required - initial margin as well as maintenance margin. 2. The contract values are marked to market on a daily basis, and a margin call will be issued if necessary. 3. A futures position can be closed out at any time. This is done by entering a reverse trade. In the hedging examples, Starbucks and Nestles entered reverse trades at the time they adjusted inventories. In those examples, the futures contracts had two months left before expiration.

In general, futures contracts must stipulate at least the following five terms:

1. The identity of the underlying asset (the commodity or financial instrument). 2. The futures contract size. 3. The futures maturity date, also called the expiration date. 4. The delivery or settlement procedure. 5. The futures price.

Hedging with Futures, Short Hedge

A company has a large inventory that will be sold at a future date.  So, the company will suffer losses if the value of the inventory falls. Suppose the company wants to protect the value of their inventory. Selling futures contracts today offsets potential declines in the value of the inventory. The act of selling futures contracts to protect from falling prices is called short hedging.

Hedging with Futures, Long Hedge

A company needs to buy a commodity at a future date. The company will suffer "losses" if the price of the commodity increases before then. (That is, they paid more than they could have) Suppose the company wants to "fix" the price that they will pay for the commodity. Buying futures contracts today offsets potential increases in the price of the commodity. The act of buying futures contracts to protect from rising prices is called long hedging.

Forward Contract Basics slide one

A forward contract is an agreement made today between a buyer and a seller (BOTH) who are obligated to complete a transaction with one another at a set date in the future. The buyer and the seller know each other, and they negotiate the terms of the contract. The terms of a forward contract are customized. What to trade; Where to trade; When to trade; How much to trade; What quality of good to trade—all customized under the terms of the forward contract.

Futures Contract Basics

A futures contract is an agreement made today between a buyer and a seller who are obligated to complete a transaction at a set date in the future. The buyer and the seller do not know each other. -The "negotiation" occurs in the fast-paced frenzy of a futures pit. (That is, on a FUTURES EXCHANGE) The terms of a futures contract are standardized. What to trade; Where to trade; When to trade; How much to trade; What quality of good to trade—all standardized under the terms of the futures contract. Futures contracts are fundamentally standardized, exchanged-traded forward contracts.

Futures Trading Accounts

A futures exchange, like a stock exchange, allows only exchange members to trade on the exchange. Exchange members may be firms or individuals trading for their own accounts, or they may be brokerage firms handling trades for customers.

Full hedge

A futures position that is equal, but opposite to the position in the underlying asset.

Long position

A market position where the holder benefits from price increases and loses from price decreases.

Reverse trade

A trade that closes out a previously established futures position by taking the opposite position.

Futures margin

Deposit of funds in a futures trading account dedicated to covering potential losses from an outstanding futures position.

Organized Futures Exchanges Background

Established in 1848, the Chicago Board of Trade (CBOT) was the first organized futures exchange in the United States. Other major exchanges include: New York Mercantile Exchange (1872) Chicago Mercantile Exchange, CME, (1874) During 2007, there were several important events for organized futures exchanges. -The Intercontinental Exchange (ICE) purchased the New York Board of Trade (NYBOT) -ICE also owns the NYSE The Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) merged and are now The CME Group, Inc. In 2008, the CME Group acquired the New York Mercantile Exchange (NYMEX)

carrying-charge market

For commodities with storage costs, the cash price is usually less than the futures price, i.e., basis < 0.

Cross hedge

Hedging a particular spot position with futures contracts on a related but not identical commodity or financial instrument.

Futures contracts are used for hedging and speculation.

Hedging and speculating are complementary activities. Hedgers shift price risk to speculators (e.g. sell the risk but forgo gains and losses). Speculators absorb price risk (e.g., buy the risk and receive the gains and the losses)

Speculating with Futures, Short

Selling a futures contract (today) is often called "going short," or establishing a short position. Recall: Each futures contract has an expiration date. Every day before expiration, a new futures price is established. If this new price is higher than the previous day's price, the holder of a short futures contract position loses from this futures price increase. If this new price is lower than the previous day's price, the holder of a short futures contract position profits from this futures price decrease.

Short Hedge

Short Hedge Example: The farmer who plants his soybean crop in the spring is a natural long position (farmer owns soybeans). To hedge his risk, he needs to: Go short in the futures market. He sells futures contacts in the amount of his expected crop output to transfer risk The farmer is: (1) Long the underlying asset (soybeans) and (2) Short the Futures Contract on the asset (soybeans)

index arbitrage

Strategy of monitoring the futures price on a stock index and the level of the underlying index to exploit deviations from parity.

Spot-Futures Parity

The relationship between spot prices and futures prices that must hold to prevent arbitrage opportunities is known as the spot-futures parity condition. The equation for the spot-futures parity relationship is: F = S(1+r) ^t In the equation, F is the futures price, S is the spot price, r is the risk-free rate per period, and T is the number of periods before the futures contract expires.

If you believe that the price of gold will decrease you can speculate by:

selling gold futures, or establishing a short position