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Chapter 19

Principles of the Futures Market

Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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As near as I can learn, and from the best information I have been able to obtain on the Chicago Board of Trade, at least 95% of the sales of that Board are of this fictitious character, where no property is actually owned, no property sold or

delivered, or expected to be delivered but simply wagers or bets as to what that property may be worth at a designated time in the future….wheat and cotton

have become as much gambling tools as chips on the farobank table. The property of the wheat grower and the cotton grower is treated as though it were a “stake” put on the gambling table at Monte Carlo. The producer of wheat is

compelled to see the stocks in his barn dealt with like the peas of thimblerigger, or the cards of a three-card monte man. Between the grain-producer and loaf

eater, there has stepped in a “parasite” between them rubbing them both.

Senator William D. Washburn (D–Minn), before Congress, July 11, 1892

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Outline Introduction Futures Contracts Market Mechanics The Clearing Process Principles of Futures Contract Pricing Foreign Currency Futures

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Introduction Futures contracts can lessen price risk for:

• Businesses

• Financial institutions

• Farmers

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Introduction (cont’d) The two major groups of futures market

participants are:• Hedgers

• Speculators

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Futures Contracts What Futures Contracts Are Why We Have Futures Contracts How to Fulfill the Futures Contract Promise

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What Futures Contracts Are Futures contracts are promises:

• The futures seller promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month

• The futures buyer promises to pay a predetermined price for the goods upon delivery

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What Futures Contracts Are (cont’d)

With futures contracts, a trade must occur if someone holds the contract until its delivery date

Most futures contracts are eliminated before the delivery month• The contract obligation can be satisfied by

making an offsetting trade

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Why We Have Futures Contracts

If suppliers and future buyers of a commodity could not agree on the future price of the commodity today:• There would be added price risk and

• The price to the consumer would be significantly higher

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Why We Have Futures Contracts (cont’d)

The basic function of the commodity futures market is to transfer risk from the hedger to the speculator• The speculator assumes the risk because of the

opportunity for profit

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How to Fulfill the Futures Contract Promise

The futures market would not work if people could back out of the trade without fulfilling their promise• Trades actually become sales to or by the

clearing corporation of the exchange

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How to Fulfill the Futures Contract Promise (cont’d)

Each exchange has a clearing corporation: • Ensures the integrity of the futures contract• Assumes the responsibility for open positions

when a member is in financial distress• Requires good faith deposits to help ensure the

member’s financial capacity to meet the obligations

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Market Mechanics The Marketplace Creation of a Contract Market Participants

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The Marketplace Commodity trades are made by open

outcry of the floor traders• Traders shout their offers to buy or sell

• Traders use hand signals to indicate their willingness to buy or sell and desired quantities

• Traders are located in the pit

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The Marketplace (cont’d) The pit:

• Is either octagonal or polygonal

• Contains a raised structure called the pulpit:– Representatives of the exchange’s market report

department enter all price changes

• Is surrounded by electronic wallboards reflecting price information

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The Marketplace (cont’d) The Chicago Board of Trade (CBOT) is the

world’s largest futures exchange:• Has more than 3,600 members• Has 1,402 full members

– Have the right to trade in any of the commodities at the exchange

• Has associate members– Allowed to trade financial instrument futures and

certain other designated markets

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The Marketplace (cont’d) Pit lingo:

• “See through the pit” is a day with little trading activity

• An “Acapulco trade” is an unusually large trade by someone who normally trades just a few contracts

• Traders who lose all their trading capital have “busted out” (gone to “Tapioca City”)

• A “fire drill” is a sudden rush of trading activity without apparent reason

• A big price move is a “lights-out” move

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Creation of a Contract Buyers and sellers fill out cards to record

their trades• One side of the card is blue (buy trades)

• One side of the card is read (sell trades)

• Each commodity has a symbol– e.g., “US” means Treasury bonds

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Creation of a Contract (cont’d) Buyers and sellers fill out cards to record

their trades (cont’d)• Each delivery month has a letter code

– e.g., “U” means September

• Letters identify time blocks at which the trade occurred

– e.g., “A” is the first thirty minutes of trading

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Creation of a Contract (cont’d) Example of a trading card (see next slide):

• Dan Hennebry buys:– Five September Treasury bonds

– From trader ZZZ working for firm OOO

– At a price of 77 31/32 of par

– In the first thirty minutes of trading

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Creation of a Contract (cont’d)

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Market Participants Hedgers Speculators Scalpers

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Hedgers A hedger is someone engaged in some type

of business activity with an unacceptable level of price risk• E.g., a farmer’s welfare depends on the price of

the crop at harvest– The farmer wants to transfer the price risk to a

speculator using the futures market

– The farmer cannot eliminate the risk of a poor crop through futures

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Hedgers (cont’d) Hedgers normally go short in agricultural

futures• A short hedge

– e.g., the farmer promises to deliver

Hedgers sometimes go long• A long hedge

– e.g., a manufacturer of college class rings wants to lock in the price of gold

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Speculators Speculators:

• Have no economic activity requiring the use of futures contracts

• Find attractive investment opportunities in the futures market

• Hope to make a profit rather than protecting one

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Speculators (cont’d) Speculators normally go long

• Speculating on price increases

It is possible for speculators to go short• Speculating on price declines

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Speculators (cont’d) Speculators are either day traders or

position traders:• Day traders close out all their positions before

trading closes for the day

• Position traders:– Routinely maintain futures positions overnight

– Sometimes keep a contract open for weeks

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Scalpers Scalpers:

• Are really speculators

• Trade for their own account

• Make a living by buying and selling contracts in the pit

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Scalpers (cont’d) Scalpers (cont’d):

• May buy and sell the same contract many times during a single trading day

• Contribute to the liquidity of the futures market

• Are also called locals

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The Clearing Process Introduction Matching Trades Accounting Supervision Intramarket Settlement Settlement Prices Delivery

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Introduction The clearing process performs the following

functions:• Matching trades• Supervising the accounting for performance

bonds• Handling intramarket settlements• Establishing settlement prices• Providing for delivery

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Matching Trades All traders are responsible for ensuring that their

card decks are entered into the clearing process

The clearing corporation:• Receives the members’ trading cards

• Edits and checks the information on the cards by computer

• Returns cards with missing information to the clearing member for correction

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Matching Trades (cont’d) Unmatched trades are called outtrades:

• Result in an Unmatched Trade Notice being sent to the affected members

• Regardless of the reason for the Notice, it is the trader’s individual responsibility to resolve the error

• Outtrade clerks (employed by the exchange) assist in the process of reconciling trades

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Matching Trades (cont’d) Examples of outtrades:

• A price out means two traders wrote down different prices for a given trade

• A house out means the trading card lists an incorrect member firm

• A quantity out occurs when the number of contracts is in dispute

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Matching Trades (cont’d) Examples of outtrades (cont’d):

• A strike out occurs when the striking price is in dispute

• A time out occurs when the delivery month is in dispute

• A side out occurs when both parties marked either buy or sell

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Accounting Supervision Performance bonds deposited by member

firms remain with the clearing corporation until the member either:• Closes out her position by making an offsetting

trade or

• Closes out her position by delivery of the commodity

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Accounting Supervision (cont’d)

When successful delivery occurs:• Good faith deposits are returned to both parties

• Payment for the commodity is received from the buyer and remitted to the seller

• The warehouse receipt for the goods is delivered to the buyer

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Accounting Supervision (cont’d)

Futures contracts are marked to market every day• Can create accounting problems

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Accounting Supervision (cont’d)

Open interest is a measure of how many futures contracts in a given commodity exist at a particular time• Increases by one every time two opening

transactions are matched

• Published by the clearinghouse in the financial pages on a daily basis

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Intramarket Settlement Commodity prices may move so much in a

single day that good faith deposits for members are eroded before the day ends• May result in a market variation call:

– A call on members to deposit more funds into their accounts during the day

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Settlement Prices Settlement prices:

• Are analogous to the closing price on the stock exchanges

• Are normally an average of the high and low prices during the last minute or so of trading

• Are established by the clearing corporation

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Settlement Prices (cont’d) Many commodity futures prices are

constrained by a daily price limit:• The price of a contract is not allowed to move

by more than a predetermined amount each trading day

• Commodities may be up the limit or down the limit when big price moves occur

– Trading will stop for the day once a limit move has occurred

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Delivery A seller who wishes to deliver fills out a

Notice of Intention to Deliver with the clearing corporation• Indicates the intention of delivering the

commodity on the next business day

Delivery can occur any time during the delivery month

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Delivery (cont’d) First notice day is the first business day prior to

the first day of the delivery month

Position day is the day prior to first notice day• Long position members must submit a Long Position

Report

On intention day, the clearing corporation may assign delivery to the member with the oldest long position in the particular commodity

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Delivery (cont’d) Speculators tend to move out of the market

a few days prior to first notice day

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Principles of Futures Contract Pricing

Expectations Hypothesis Normal Backwardation Full Carrying Charge Market Reconciling the Three Theories

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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

One of the major functions of the futures market is price discovery:• The market’s consensus about likely future

prices for a commodity

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Normal Backwardation Normal backwardation:

• Is attributed to John Maynard Keynes

• Argues that the futures price is a downward-biased estimate of the future cash price

– The hedger essentially buys insurance

– The speculator must be rewarded for taking the risk the hedger was unwilling to bear

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Full Carrying Charge Market A full carrying charge market is one

where the prices for successive delivery months reflect the cost of holding the commodity• The futures price (FP) is equal to the current

cash price (CP) plus the carrying charges (c) until the delivery month:

FP = CP + c

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Full Carrying Charge Market (cont’d)

Basis is the difference between the futures price and the current cash price:• In a contango market, the futures price is

greater than the cash price

• In an inverted market, the cash price is greater than the futures price

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Full Carrying Charge Market (cont’d)

Basis is the difference between the futures price and the current cash price (cont’d):• If the gap between the futures price and the

cash price narrows, the basis strengthens

• If the gap between the futures price and the cash price widens, the basis weakens

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Full Carrying Charge Market (cont’d)

The basis is often very close to the carrying costs between the two points in time• Arbitrage would be possible if this were not the

case– Exists if someone can buy a commodity, store it at a

known rate, and get someone to promise to buy it later at a price that exceeds the cost of storage

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Reconciling the Three Theories The three theories are compatible:

• The expectations hypothesis says that a futures price is the expected cash price at the delivery date

• A full carrying charge market adds costs of carry to the cash price to determine the futures price

• Normal backwardation says that hedgers are willing to take a price less than the actual expected future cash price

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Foreign Currency Futures Hedging and Speculating with Foreign

Currency Futures Pricing of Foreign Exchange Futures

Contracts

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Hedging and Speculating with Foreign Currency Futures

Goods and services traded between countries must be valued in a currency

Relative exchange rates fluctuate daily due to changes in:• The world political situation• International interest rates• Inflationary fears

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Hedging and Speculating with Foreign Currency Futures (cont’d) U.S. importers purchasing goods

denominated in a foreign currency engage in two transactions:• Buying the foreign currency

• Paying for the imported goods

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Hedging and Speculating with Foreign Currency Futures (cont’d) If the currency appreciates, the gain in the

futures market offsets the higher cost of the currency

If the currency depreciates, the lower cost in the cash market is offset by a loss in the futures market

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Pricing of Foreign Exchange Futures Contracts

The cost of holding a currency is an opportunity cost measured by differences in the interest rates prevailing in the two countries• Interest rate parity states that securities with

similar characteristics should differ in price by an amount equal to (but opposite in sign from) the difference between national interest rates in the two countries

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Pricing of Foreign Exchange Futures Contracts (cont’d)

A basic model for pricing foreign currency futures contracts:

days to delivery spot rate 1 ( )

365

where futures price

Eurodollar rate

local currency rate

f ed lc

f

ed

lc

P I I

P

I

I

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Pricing of Foreign Exchange Futures Contracts (cont’d)

Example

Interest rates are 6 percent in Europe, and the prevailing eurodollar deposit rate is 7.5 percent. The current dollar price for a euro is $0.90.

For how much should a 90-day futures contract on euros sell?

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Pricing of Foreign Exchange Futures Contracts (cont’d)

Example (cont’d)

Solution: Using the pricing model for foreign currency futures:

days to delivery spot rate 1 ( )

365

90$0.90 1 (0.075 0.06)

365

$0.90 1.004

$0.903

f ed lcP I I