AECN 235 - Quiz 2 (Module 2)

Both futures and forward contracts are highly standardized. Hedgers and speculators have no flexibility in changing some specifications of the neither of these contracts.

False

Futures markets were created to meet specific needs of cash market traders (i.e. producers, grain elevators, grain processors) and should be traded only by these traders. Speculators have no place in futures markets.

False

In a cash market all transactions are for immediate delivery.

False

Discuss the similarities and difference s between a forward contract and futures contract.

Please check the handout "comparison between forward and futures contracts" (Module 2 in Canvas).

Speculators are more likely to trade futures contracts than forward contracts. That's because futures contracts are standardized and therefore easy to trade with anybody, futures contracts can be easily offset before delivery (most speculators don't want to deliver or take delivery because they don't have any business with the physical commodity), and the financial integrity of futures contracts is guaranteed by the clearing house.

True

When a futures or a forward contract is traded, ownership of the underlying commodity changes hands only when (and if) delivery occurs.

True

Many speculators trade in futures markets, even though they have no interest in the underlying physical commodities. Do you think it is important to have speculators in futures markets? Why?

Yes, speculators are important in futures markets. They have no interest in the physical commodity and trade in the futures market trying to make a profit from buying and selling commodities ("buy low, sell high"). Since they have no interest in the physical commodity, they can buy and sell as many contracts as they like. They are not going to delivery or take delivery, so it doesn't matter if they trade 5,000 bushels or 1,000,000 bushels. No matter how many contracts they trade, they can easily get out of the futures market before delivery and get rid of any commitment to deliver or take delivery of the commodity. As speculators are always in the market and can trade as many contracts as they like, they provide liquidity to the futures markets. When hedgers (e.g. producers or food processors) want to buy or sell in the futures market, they can easily find a speculator willing to take the other side of their contracts. Similarly, when they want to get out of the futures market, they can also easily find a speculator to take the other side of their contracts and help them offset their positions.

Do you agree with the statement below? Why? Provide examples to illustrate why you agree or disagree with this statement. "Forward contracts and then futures contracts were created to help facilitate trade in commodity markets. They were developed to fulfill specific needs from buyers and sellers in the market."

Yes, I agree with this statement. Contracts for future delivery were created by commodity buyers and sellers in order to facilitate trading. Initially, commodities were traded only for immediate delivery (spot transactions). For grains, for example, that meant that producers would harvest their grain once a year and try to sell everything as fast as they could. This implied that there would be large amounts of grain being sold at harvest, which would make prices lower and reduce producers' returns. Further, grain buyers needed to buy all the grain they need for the whole year right after harvest, which created more problems: they needed to have large storage capacity to hold all that grain for several months, and they also needed large amounts to money to pay for all that grain at once. Then buyers and sellers came up with an idea that revolutionized grain trading: trading for future delivery. They created "forward contracts", which allowed buyers and sellers to trade today but only exchange ownership of the commodity at a certain date in the future (payment would also be exchanged on delivery day). Buyers and sellers would then make a commitment to each other to exchange a given commodity at a given price on a given day in the future. This made it easier for them to plan ahead, and helped solve their previous problems: producers and buyers no longer needed to sell/buy everything they needed right after harvest, storage could be better distributed between buyers and sellers, and buyers didn't need to have enough money to buy all the grain they needed at harvest. However, these forward contracts were highly customized, i.e. the specifications of the contracts (quantity traded, delivery location, delivery date, etc) could be whatever buyer and seller agreed on. As time went on, they realized that there would be many occasions in which buyers and/or sellers would like to get out of their forward contracts. Maybe they found a better deal with another trader, or a producer realized that he wouldn't have enough grain to deliver, or the buyer realized that he wouldn't need all the grain that was contracted, and son on. Since forward contracts are legally-binding agreements, they couldn't simply walk away from it. They had to find somebody else willing to take their side of the contract. But since forward contracts were so customized, it was hard to find another person who wanted a deal with the exact same specifications, which made it harder to trade and re-trade forward contracts. That's when grain traders had another idea the revolutionized commodity markets: futures contracts. Futures contracts are essentially "standardized forward contracts". They are contracts for future delivery in which all specifications are the same. Every futures contract for a given commodity calls for the same quantity being traded and has the same delivery date, same delivery location, etc. If a buyer or seller holding a futures contract decides to get rid of it, it is easy to find somebody else to take the contract because everybody is trading the exact same contract. With futures contracts, it became easier to trade and re-trade grain, which facilitate the expansion of grain trading.

What is the main difference between a spot price and a forward price? At any point in time, how many spot and forward prices do we have in a given marketplace (for example, Lincoln, NE)?

A spot price is the price negotiated between a buyer and a seller for immediate delivery. Once they agree on a price, ownership of the commodity is exchanged immediately, along with payment. Since this transaction calls for delivery and payment "today", there is only one spot price. A forward price is the price negotiated between a buyer and a seller for future delivery. In this case, buyer and seller agree on a price and on a date in the future when delivery will happen. Thus, ownership of the commodity and payment are only exchanged on the delivery date in the future. Since there are many possible delivery days in the future, there will be different forward prices for different delivery dates in the future. For example, today in Lincoln, NE, there is a spot price if a buyer and a seller agree on immediate delivery of the commodity, and there are many forward prices (one for each delivery date in the future) if they agree on future delivery of the commodity.

A producer is considering selling her corn with either a forward or a futures contract. Recalling that the corn futures contract size is 5,000 bushels and delivery months are March, May, July, September and December, which statement(s) below is (are) correct?

Both contracts allow future delivery at the price traded in the contract. With the forward contract she can sell whatever quantity she negotiates with the buyer, while with the futures contract she can only sell in multiples of 5,000 bushels.

You can find below some statements about futures prices. Which one(s) is(are) correct?

Futures prices represent the expected spot price at the delivery area during the delivery period in the future. If you sell a commodity using futures contracts, the futures price that you traded is the price you will receive when you deliver your commodity against the futures market. Since futures prices reflect the 'expected' spot price in the delivery area during the delivery period in the future, they vary over time as 'expectations' change.

Today a grain producer in Nebraska wants to sell 20,000 bushels of corn for delivery in the fall. She is considering a forward contract with her local grain elevator or a futures contract. In the corn futures market, contract size is 5,000 bu; delivery months are March, May, July, September and December; and delivery location is in northern Illinois. Based on this information, which statement(s) below is(are) true?

If she chooses to use a forward contract with her local grain elevator, she can sell all 20,000 bu in one contract and deliver in whatever month they agree on. If she chooses to use a futures contract, she will need to trade 4 contracts and can only deliver in September or December (if she wants to do it in the fall). In terms of delivery, the forward contract has the advantage of "local delivery", while with the futures contract she would need to go to northern Illinois to deliver. Even if she chooses the futures contract now, she can easily offset the futures contract later (before delivery) and still sell her grain to the local elevator in the fall.

Why is it more common to see speculators trading futures contracts than forward contracts?

Speculators have no interest in the physical commodity, i.e. they don't want to deliver or take delivery of the commodity. Hence, they need to be able to get out of their contracts before delivery day. Forward contracts are highly customized, thus it is harder to find other people willing to take that contract with unique specifications. On the other hand, futures contracts are standardized, i.e. all specifications are the same. Therefore, it is easier to find people willing to take on those contracts. Since it is easier to trade and re-trade futures contracts (and therefore get in and out of futures contracts), speculators prefer to trade futures contracts instead of forward contracts.

Both forward and futures contracts were created and developed to facilitate trade in the cash market, and not as speculative financial instruments.

True

Forward and futures contracts have the same economic function.

True

On a given day there can be different forward prices for the same commodity, depending on the delivery dates being negotiated.

True