© 2004 South-Western Publishing1

Chapter 8

Fundamentals of the Futures Market

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Outline

The concept of futures contracts Market mechanics Market participants The clearing process Principles of futures contract pricing Spreading with commodity futures

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The Concept of Futures Contracts

Introduction The futures promise Why we have futures contracts Ensuring the promise is kept

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Introduction

The futures market enables various entities to lessen price risk, the risk of loss because of uncertainty over the future price of a commodity or financial asset

As with options, the two major market participants are the hedger and the speculator

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The Futures Promise

Introduction Futures compared to options Futures compared to forwards Futures regulation Trading mechanics

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Introduction

A futures contract is a legally binding agreement to buy or sell something in the future

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Introduction (cont’d)

The person who initially sells the contract promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month

The other party to the trade promises to pay a predetermined price for the goods upon delivery

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Futures Compared to Options

Both involve a predetermined price and contract duration

The person holding an option has the right, but not the obligation, to exercise the put or the call

With futures contracts, a trade must occur if the contract is held until its delivery deadline

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Futures Compared to Forwards

A futures contract is more similar to a forward contract than to an options contracts

A forward contract is an agreement between a business and a financial institution to exchange something at a set price in the future– Most forward contracts involve foreign currency

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Futures Compared to Forwards (cont’d) Forwards are different from futures

because:– Forwards are not marketable

Once a firm enters into a forward contract there is no convenient way to trade out of it

– Forwards are not marked to market The two parties exchange assets at the agreed upon

date with no intervening cash flows– Futures are standardized, forwards are

customized

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Futures Regulation

In 1974, Congress passed the Commodity Exchange Act establishing the Commodity Futures Trading Commission (CFTC) – Ensures a fair futures market

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Futures Regulation (cont’d)

A self-regulatory organization, the National Futures Association was formed in 1982– Enforces financial and membership

requirements and provides customer protection and grievance procedures

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Trading Mechanics

Most futures contracts are eliminated before the delivery month– The speculator with a long position would sell a

contract, thereby canceling the long position– The hedger with a short position would buy a

contract, thereby canceling the short position

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Trading Mechanics (cont’d)

Gain or Loss on Futures Speculation

Suppose a speculator purchases a July soybean contract at a purchase price of $6.12 per bushel. The contract is for 5,000 bushels of No. 2 yellow soybeans at an approved delivery point by the last business day in July.

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Trading Mechanics (cont’d)

Gain or Loss on Futures Speculation (cont’d)

Upon delivery, the purchaser of the contract must pay $6.12(5,000) = $30,600. At the delivery date, the price for soybeans is $6.16. This equates to a profit of $6.16 - $6.12 = $0.04 per bushel, or $200.

If the spot price on the delivery date were only $6.10, the purchaser would lose $6.12 - $6.10 = $0.02 per bushel, or $100.

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Why We Have Futures Contracts

Futures contracts allow buyers and manufacturers to lock into prices and costs, respectively– If a firm wants gold, it buys contracts, promising

to pay a set price in the future (long hedge)– A gold mining company sells contracts,

promising to deliver the gold (short hedge)

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Ensuring the Promise is Kept

The Clearing Corporation ensures that contracts are fulfilled– Becomes party to every trade– Ensures the integrity of the futures contract– Assumes responsibility for those positions

when a member is in financial distress

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Ensuring the Promise is Kept (cont’d)

Good faith deposits (or performance bonds) are required from every member on every contract to help ensure that members have the financial capacity to meet their obligations

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Ensuring the Promise is Kept (cont’d)

Selected Good Faith Deposit RequirementsData as of January 2, 2004

Contract Size Value Initial Margin per Contract

Soybeans 5,000 bushels $39,700 $1,620

Gold 100 troy ounces $41,600 $2,025

Treasury Bonds $100,000 par $108,000 $2,565

S&P 500 Index $250 x index $278,500 $20,000

Heating Oil 42,000 gallons $38,346 $3,375

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Market Mechanics

Types of orders Ambience of the marketplace Creation of a contract

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Types of Orders

A broker in commodity futures is a futures commission merchant (not the individual who places the order)

When placing an order, the client should specify the type of order

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Types of Orders (cont’d)

A market order instructs the broker to execute a client’s order at the best possible price at the earliest opportunity

With a limit order, the client specifies a time and a price– E.g., sell five December soybeans at 540, good

until canceled

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Types of Orders (cont’d)

A stop order becomes a market order when the stop price is touched during trading action– When executed, stop orders close out existing

commodity positions– E.g., a short seller may use a stop order to

protect himself against rising commodity prices

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Ambience of the Marketplace

Trades occur by open outcry of the floor traders– Traders stand in a sunken pit and bark their

offers to buy or sell at certain prices to others– Traders often use hand signals to signal their

wishes concerning quantity, price, etc.– On the pulpit, representatives of the exchange’s

Market Report Department enter all price changes into the price reporting system

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Ambience of the Marketplace (cont’d)

The perimeter of the exchange is lined with hundreds of order desks, where telecommunications personnel from member firms receive orders from clients

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Ambience of the Marketplace (cont’d)

Jargon– “See through the pit” means little trading

activity– “Acapulco trade” is an unusually large trade by

someone who normally trades just a few contracts

– “Busted out” or “gone to Tapioca City” means traders incorrectly assess the market and lose all their capital

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Ambience of the Marketplace (cont’d)

Jargon (cont’d)– “Fire drill” is a sudden rush of put activity for no

apparent reason– “Lights out” is a big price move– “O’Hare Spread” refers to traders riding a

winning streak

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Creation of a Contract

Two traders confirm their trade verbally and with hand signals

Each of them fills out a card– One side is blue for recording purchases– One side is red for sales– Each commodity has a symbol, and each

delivery month has a letter code

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Creation of a Contract (cont’d)

At the conclusion of trading, traders submit their cards (their deck) to their clearinghouse

In 2003, nearly 7 million futures and options orders were electronically sent directly to floor brokers using special order receipts called electronic clerks

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Market Participants

Hedgers Processors Speculators Scalpers

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Hedgers

A hedger is someone engaged in a business activity where there is an unacceptable level of price risk– E.g., a farmer can lock into the price he will

receive for his soybean crop by selling futures contracts

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Processors

A processor earns his living by transforming certain commodities into another form– Putting on a crush means the processor can

lock in an acceptable profit by appropriate activities in the futures market

– E.g., a soybean processor buys soybeans and crushes them into soybean meal and oil

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Speculators

A speculator finds attractive investment opportunities in the futures market and takes positions in futures in the hope of making a profit (rather than protecting one)

The speculator is willing to bear price risk The speculator has no economic activity

requiring use of futures contracts

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Speculators (cont’d)

Speculators may go long or short, depending on anticipated price movements

A position trader is someone who routinely maintains futures positions overnight and sometimes keep a contract for weeks

A day trader closes out all his positions before trading closes for the day

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Scalpers

Scalpers are individuals who trade for their own account, making a living by buying and selling contracts– Also called locals

Scalpers help keep prices continuous and accurate

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Scalpers (cont’d)

Scalping With Treasury Bond Futures

Trader Hennebry just sold 5 T-bond futures to ZZZ for 77 31/32. Now, a sell order for 5 T-bond futures reaches the pit and Hennebry buys them for 77 30/32. Thus, Hennebry just made 1/32 on each of the 5 contracts, for a dollar profit of

1/32% x $100,000/contract x 5 contracts = $156.25

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The Clearing Process

Matching trades Accounting supervision Intramarket settlement Settlement prices Delivery

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Matching Trades

Every trade must be cleared by or through a member firm of the Board of Trade Clearing Corporation– An independent organization with its own

officers and rules

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Matching Trades (cont’d)

Each trader is responsible for making sure his deck promptly enters the clearing process– Scalpers normally use only one clearinghouse– Brokers typically submit their cards periodically

while trading

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Matching Trades (cont’d)

After the Clearing Corporation receives trading cards– The information on them is edited and checked

by computer– Cards with missing information are returned to

the clearing member– Once all cards have been edited, the computer

attempts to match cards for all trades that occurred that day

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Matching Trades (cont’d) Mismatches (out trades) result in an

Unmatched Trade Notice being sent to each clearing member– Traders must reconcile their out trades and

arrive at a solution– “House out” means an incorrect member firm is

listed on the trading card– “Quantity out” means the number of contracts is

in dispute

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Matching Trades (cont’d)

After resolving all out trades, the computer prints a daily Trade Register– Shows a complete record of each clearing

member’s trades for the day– Contains subsidiary accounts for each customer

clearing through the firm

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Accounting Supervision

The accounting problem is formidable because futures contracts are marked to market every day– Open interest is a measure of how many futures

contracts in a given commodity exist at a particular time

Different from trading volume since a single futures contract might be traded often during its life

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Account Supervision (cont’d)

Volume vs Open Interest for Soybean FuturesJune 16, 2000

Delivery Open High Low Settle Change Volume

Open

Jul 2000 5144 5144 5040 5046 -52 32004 46746Aug 2000 5070 5074 5004 5012 4 7889 19480Sep 2000 4980 4994 4950 4960 44 3960 15487Nov 2000 5020 5042 4994 5006 56 22629 62655Jan 2001 5110 5130 5084 5100 54 1005 6305Mar 2001 5204 5204 5160 5180 54 1015 4987May 2001 5240 5270 5230 5230 44 15 6202July 2001 5290 5330 5280 5290 40 53 4187Nov 2001 5380 5400 5330 5330 30 37 1371

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Intramarket Settlement

Commodity prices may move so much in a single day that good faith deposits for many members are seriously eroded before the day ends– The president of the Clearing Corporation may

issue a market variation call for members to deposit more funds into their account

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Settlement Prices

The settlement price is analogous to the closing price on the stock exchanges

The settlement price is normally an average of the high and low prices during the last minute of trading

Settlement 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

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Delivery Delivery can occur anytime during the

delivery month Several days are of importance:

– First Notice Day– Position Day– Intention Day

Several reports are associated with delivery:– Notice of Intention to Deliver– Long Position Report

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Principles of Futures Contract Pricing

The expectations hypothesis Normal backwardation A full carrying charge market Reconciling the three theories

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The 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– Price discovery is an important function

performed by futures

There is considerable evidence that the expectations hypothesis is a good predictor

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Normal Backwardation

Basis is the difference between the future price of a commodity and the current cash price– Normally, the futures price exceeds the cash

price (contango market)– The futures price may be less than the cash

price (backwardation or inverted market)

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Normal Backwardation (cont’d)

John Maynard Keynes:– Locking in a future price that is acceptable

eliminates price risk for the hedger– The speculator must be rewarded for taking the

risk that the hedger was unwilling to bear Thus, at delivery, the cash price will likely be

somewhat higher than the price predicated by the futures market

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A Full Carrying Charge Market

A full carrying charge market occurs when the futures price reflects the cost of storing and financing the commodity until the delivery month

The futures price is equal to the current spot price plus the carrying charge:

CSF t

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A Full Carrying Charge Market (cont’d)

Arbitrage exists if someone can buy a commodity, store it at a known cost, and get someone to promise to buy it later at a price that exceeds the cost of storage

In a full carrying charge market, the basis cannot weaken because that would produce an arbitrage situation

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Reconciling the Three Theories

The expectations hypothesis says that a futures price is simply the expected cash price at the delivery date of the futures contract

People know about storage costs and other costs of carry (insurance, interest, etc.) and we would not expect these costs to surprise the market

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Reconciling the Three Theories (cont’d)

Because the hedger is really obtaining price insurance with futures, it is logical that there be some cost to the insurance

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Spreading with Commodity Futures

Intercommodity spreads Intracommodity spreads Why spread in the first place?

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Intercommodity Spreads

An intercommodity spread is a long and short position in two related commodities– E.g., a speculator might feel that the price of

corn is too low relative to the price of live cattle– Risky because there is no assurance that your

hunch will be correct

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Intercommodity Spreads (cont’d)

With an intermarket spread, a speculator takes opposite positions in two different markets– E.g., trades on both the Chicago Board of Trade

and on the Kansas City Board of Trade

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Intracommodity Spreads

An intracommodity spread (intermonth spread) involves taking different positions in different delivery months, but in the same commodity– E.g., a speculator bullish on what might buy

September and sell December

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Why Spread in the First Place? Most intracommodity spreads are basis

plays Intercommodity spreads are closer to two

separate speculative positions than to a spread in the stock option sense

Intermarket spreads are really arbitrage plays based on discrepancies in transportation costs or other administrative costs