1. Futures Chapter 27 Chapter 27: Futures

2. Background • Futures traders can take either a • Long position • Entitles buyer to take delivery of the commodity • Short position • Obligates seller to make delivery of the commodity • If the short seller does not own the commodity they must • Buy back the short position, or • Buy a similar futures contract to deliver to fulfill the short position, or • Buy the underlying commodity to deliver at the appropriate date • Speculators taking a • Long (short) position expect an increase (decrease) in the price of the underlying commodity Chapter 27: Futures

3. Mechanics of Commodities Trading • Commission brokers (AKA: floor brokers) • Execute trades on the commodity exchanges for people who are not members of the exchange • Locals execute trades only for their accounts • Each commodity is traded in a pit using open outcry method • Specialists are not used to trade commodities Chapter 27: Futures

4. In The Pits • A different color trading card is used for each commodity • When a transaction occurs, trader records • Price • Delivery month • Quantity Chapter 27: Futures

5. The Commodity Board • Futures contracts exist with different delivery months • Prices of the contracts are different for each delivery month • A commodity board lists the futures prices of each delivery month Traders watch the commodity board to get a feel for the direction of the market. Chapter 27: Futures

6. Price Fluctuation Limits • Minimum price fluctuations (ticks) are set on futures contracts • Typical tick size (depends on commodity) is a fraction of one penny • For bushel of grain • Per ounce of gold • Maximum daily price fluctuations (limit moves) are set • Prevents potentially destabilizing price changes • May be several cents above (below) the day’s opening price • Reported on the commodity board Chapter 27: Futures

7. Price Fluctuation Limits • If a limit move occurs trading is halted and cannot occur at prices differing from the opening price by more than the daily limit • Some argue that limit moves distort the natural supply/demand movements • Others argue the limits enhance price stability Chapter 27: Futures

8. Example: Limit Moves • Limit moves rarely halt trading • However, in late 1979 to 1980 the Hunt brothers tried to corner the silver market • Price went from $9/ounce to $35 in 1980 but collapsed to $9/ounce in 1981 • Caused several limit up and limit down moves Chapter 27: Futures

9. Clearing House Guarantees • Every futures contract is transferred through a clearing house • Becomes the middleman in every transaction • Collect a small fee from each contract and place this money in a guarantee fund • Use this money to guarantee the performance of every transaction • The use of a clearing house allows traders the freedom of not having to check each others credit every time they trade • Makes for a liquid market Chapter 27: Futures

10. Mechanics of Trading Commodity Futures • Commodity trader opens an account with a commodities broker • Full service brokers • Examples include Merrill Lynch, Pierce, Fenner and Smith, Goldman-Sachs • Discount brokers • Examples include Jack Carl Futures, Lind-Waldlock & Company • Futures contracts are only available in standard quantities (or units) • For example, the Chicago Board of Trade specifies that 100 tons is the unit for one futures contract of soybean meal • A Treasury bond with a $100,000 face value and an 8% coupon rate is the unit for a Treasury bond contract Chapter 27: Futures

11. Mechanics of Trading Commodity Futures • The trader must specify • Type of position (long or short) • Number of units • Bid or ask price • Desired delivery month • Must either pay cash in advance or pay the initial margin requirement when placing an order • Ranges from 3% to 10% • Remainder of cash is due upon delivery • Few contracts remain open until delivery date Chapter 27: Futures

12. Mechanics of Trading Commodity Futures • Over 90% of contracts are closed prior to delivery date • Closure occurs by reversing out of the position • A long (short) position is eliminated by taking a similar short (long) position Chapter 27: Futures

13. Mechanics of Trading Commodity Futures • A trader with a short position typically has alternatives as to • Where to make delivery • Penalties arise if delivery is not made to sanctioned location • When to make delivery • Quality of delivered goods • Cash settlements are allowed for some commodities (such as S&P500 index future) Chapter 27: Futures

14. Open Interest • Open interest—the amount of outstanding futures contracts • Measures public’s interest in a commodity • When first contract is sold, open interest goes from zero to one • During early months of trading volume increases • More contracts are opened than closed • Rises to a peak approximately halfway through life of contract • As delivery date approaches, those speculators not wanting to take delivery close out their contracts Chapter 27: Futures

15. Electronic Markets • Have become popular in recent years relative to the open outcry method • Exchanges using electronic markets • Deutsche Terminborse • Sydney Futures Exchange • Cantor Financial Futures Exchange • London International Financial Futures Exchange (LIFFE) Chapter 27: Futures

16. Regulating Futures • Commodity Futures Trading Commission was established in 1974 • Must approve all futures contracts and changes to existing contracts in the U.S. • To gain approval contract must provide useful economic purpose • Requires continuous availability of current futures prices • Requires disclosure of the size of a trader’s position (once certain levels are exceeded) • Licenses dealers who offer services to public • Deals with complaints Chapter 27: Futures

17. Regulating Futures • National Futures Association • Formed in 1982 • Purpose was to shift some of CFTCs regulatory responsibility to the futures industry itself • Authorized to monitor trading and take disciplinary action • Jurisdictional turf battles • Other governmental bodies have occasionally asserted jurisdictional rights over futures trading • Concerned about impact of futures trading on spot markets for different securities, including stocks, T-bills, T-bonds Chapter 27: Futures

18. Prices and Pricing Relationships • A normal market exists when • A commodity’s futures price is greater than the spot price by an amount sufficient to cover carrying charges for storage • Induces profit-seekers to buy commodities when prices are low (at harvest) and store for later sales (when prices are higher) Chapter 27: Futures

19. Prices and Pricing Relationships • Basis is the difference between the futures price and the spot price • Basist = futures pricet – spot pricet • When basis is positive (negative) futures prices are at a premium (discount) to spot prices • If basis is negative an inverted market is said to exist Chapter 27: Futures

20. Price Convergence • Convergence Principle • As a futures contract approaches its expiration date, the futures price will converge with the spot price • Arbitrage opportunities would exist if convergence did not occur • If futures prices exceed spot prices (normal market) • Arbitrage profits could be earned by • Selling a futures contract short • Buying the physical commodity in the spot market • Delivering the commodity to fulfill the maturing futures contract • Short selling would drive the futures price down Chapter 27: Futures

21. Price Convergence • If futures prices exceed spot prices (normal market) by more than the carrying charges • Arbitrage profits could be earned by • Selling a futures contract short • Buying the physical commodity in the spot market • Delivering the commodity to fulfill the maturing futures contract • Short selling would drive the futures price down • If spot prices exceed futures prices (inverted market) for a storable commodity, arbitrage may be profitable • Buy a futures contract (long) and wait for delivery Chapter 27: Futures

22. Price Convergence • Convergence occurs because a futures contract becomes a spot contract in the delivery month • Problems arise causing non-convergence • Physical delivery of a good may require shipping costs • Commodities delivered may be of a different quality level than required • Some contract holders may ‘roll-over’ their contracts instead of taking delivery Chapter 27: Futures

23. Relationship Between Spot and Futures Prices for Storable Commodities • Under normal conditions market prices for storable commodities follow this relationship • Spot pricet + Carrying Costs  Futures pricet • For grains the carrying cost is approximately 3¢ per bushel • Total carrying costs = Monthly carrying costs  number of months inventory is carried • For financial commodities the carrying cost is interest expense for financing a securities inventory Chapter 27: Futures

24. Relationship Between Spot and Futures Prices for Storable Commodities • Futures prices should not rise above spot price + carrying costs • Carrying costs explain why futures that differ only with respect to delivery dates have different prices • Also explains why prices on separate futures contracts for the same commodity differ • If they have different delivery dates • Futures pricenear future + Carrying cost  # of months difference Futures pricedistant future • If the inequality reversed arbitrageurs would quickly restore it Chapter 27: Futures

25. One-Period Returns From Futures • One-period rate of return • Ignores commissions, taxes and other transaction costs • Should be deducted to obtain net returns Chapter 27: Futures

26. Margin Requirements • When trading futures most investors do not pay the full purchase price • Instead, buy on margin • Minimum margin set by exchange and serves as a • Performance bond—helps maintain financial integrity of futures contracts • Down payment for investors wishing to borrow to leverage their position • Control to prevent excessive borrowing • Initial margin requirement for futures range from 3% to 10% • Much lower than the current 50% required for stocks Chapter 27: Futures

27. Margin Requirements • Futures investor can receive a margin call • When broker demands additional money within a day or two • Restores the trader’s equity to required level when adverse price fluctuations reduce it below required minimum • If investor does not quickly meet minimum margin requirement broker will liquidate the futures contract • Clearing house requires each account be marked to market each trading day Chapter 27: Futures

28. Marking to the Market Daily • Requires traders be ready to make cash contributions to their account if the contract’s price moves in an adverse direction • However, if price moves favorably, can withdraw excess margin • Elton, Gruber & Rentzler (1989) suggest leaving excess margin in a T-bill • Reduces margin calls and it earns interest Chapter 27: Futures

29. Hedging • Hedging can reduce or eliminate losses but also reduces gains • Involves offsetting a short (long) position with a similar long (short) position • A perfect hedge occurs when identical offsetting positions exist • Will earn profits of exactly zero Chapter 27: Futures

30. Buying Hedges • A long position in a futures contract • To protect buyer from a loss due to a price increase • For instance, if a cereal manufacturer believes the price of grain will rise, they may buy a grain future to protect them from an increase in the price of their raw material • Buying the future will guarantee the price they will pay when the goods are delivered Chapter 27: Futures

31. Selling Hedges • A short position in a futures contract • To protect from a price decline on a good held in inventory • For instance a mortgage banking firm may have an excess inventory of mortgages (that it plans to eventually sell to FNMA or GNMA) • If banker believes interest rates are going to rise, then the value of the mortgage will decline • To protect bank from losses if interest rates rise, take a short position in a T-bond future Chapter 27: Futures

32. Basis Risks • Basis risk occurs when offsetting long and short positions do not converge to the same market value as delivery date approaches • Quantity risk—if the hedger does not own the same quantity as that specified in the futures contract • Quality risk—the cheapest-to-deliver contract may not be of a sufficient quality to fulfill the contract specifications Chapter 27: Futures

33. Basis Risks • Location risk—shipping costs and/or delays will be incurred if delivery is accepted at an inconvenient location • Expiration date risk—if hedger needed a commodity in a month in which a futures contract delivery date did not exist, would incur storage costs • For above reasons most hedges are not perfect • Some speculators make a living trading on the basis • Anticipate spreads Chapter 27: Futures

34. Spreading With Futures • Involves combining long and short positions that are partially offsetting • Calendar spreads • Trader seeks to profit from misaligned far-term futures prices vs. near-term futures prices • Purchase near-term future and sell distant future • If price spread narrows spread will be profitable Chapter 27: Futures

35. Spreading With Futures • Inter-Commodity Spread • Used to capitalize on mispricings between two commodities • Such as T-bills and Eurodollars • Soybean Crush spread • A relationship exists between the amount of soybean meal and oil produced from a given quantity of soybeans • May use spreads to capitalize on perceived mispricings Chapter 27: Futures

36. Economic Effects of Hedging & Spreading • Spreading tends to align prices • Maintaining the basis between spot and futures prices • Supports law of one price • Hedging and spreading can reduce risk • Thus, lower margins are required on hedged positions and spreads Chapter 27: Futures

37. Theories About Spot & Futures Price Convergence • Competing theories • Normal backwardation • Keynes (1924) and Hicks (1946) argue that futures prices for storable commodities should be slightly less than expected spot prices • Would converge to zero at contract’s delivery date • Contango (AKA: forwardation) • Hardy (1923) argued futures price should be slightly above the expected spot price • Speculators are willing to pay to gamble • Converges to zero as contract approaches delivery date Chapter 27: Futures

38. Theories About Spot & Futures Price Convergence • Unbiased expectations • Others suggest spot prices should equal futures prices • Futures prices are unbiased estimates of expected spot prices Chapter 27: Futures

39. Universal Pricing Principle For Forwards and Futures • The Net Present Value (NPV) of an asset is • NPV = Present Value – Purchase Price • A contract’s initial NPV = 0, thus we can solve for the appropriate purchase price of the forward or futures contract Chapter 27: Futures

40. Includes inventory financing costs, warehousing costs. Universal Pricing Principle For Forwards and Futures • To determine PV need a cash flow and a discount factor • If a contract has three months to maturity and a discount rate of 6%, the discount factor is Chapter 27: Futures

41. Financial Futures • Financial futures do not incur physical storage costs • Thus, the discount rate is the interest rate on a loan to finance the inventory underlying the contract • Default risk is non-existent in futures contracts (due to clearing house) • Should use risk-free rate as discount rate • The purchase price of a financial future is Chapter 27: Futures

42. Pricing Futures Contracts on U.S. Treasury Bills • We can use this model to price futures on any original issue discount bond or non-dividend paying stock • Use quasi-arbitrage to price a futures contract • Assume some cash is invested • Create a synthetic position Chapter 27: Futures

43. A T-Bill Example • An investor wishes to buy a T-bill with the following characteristics • Face value of $1 million • Matures in 180 days • Could either • Directly purchase the T-bill and hold it until it matures • Indirectly purchase a different T-bill by simultaneously • Buying a T-bill at t=0 with 90 days until expiration and a yield of RFR (for a cost of $PV) • Buying (for a cost of F90B/(1+RFR)) a forward contract at t=0 for a 90-day T-bill deliverable in 90 days • The deliverable T-bill will have a face value of $1 million Chapter 27: Futures

44. A T-Bill Example Both the strategies provide the desired $1 million in 180 days. Thus, according to law of one price, they should have the same purchase price. Chapter 27: Futures

45. A T-Bill Example • Because of the law of one price, we can equate the purchase price of the two plans • Cost of direct purchase plan  PV = F90B/(1+RFR)  Cost of indirect purchase plan • Suggests that futures price is a function of • Spot and forward prices • Rate of interest Chapter 27: Futures

46. Economic Forces That Align Prices • If the law of one price is violated economic processes will occur to restore equilibrium • Arbitrage • Buy the cheapest-to-deliver (CTD) • Switching • However, transactions costs may preclude the above • Transaction costs include • Cost of gathering information • Telephone expenses • Postal fees • Brokerage commissions • Taxes • Time and trading effort Chapter 27: Futures

47. The Cost of Marking-to-the-MarketOn T-Bill Futures • Marking-to-the-market • Forces traders to meet minimum margin requirements daily • Operating cost differences can exist between forward and futures contracts due to marking-to-the-market • Elton, Gruber & Rentzler (1989) estimate the cost of marking a T-bill futures contract to the market to be an average of $4 per contract Chapter 27: Futures

48. Using a Carrying Cost Model to Price T-Bill Futures • Carrying costs cause a difference in spot and futures prices • For financial futures the only carrying cost is interest expense for financing inventory • Thus, the model for a futures contract on an original issue discount bond is • FPt = SPt (1 + RFR)year Chapter 27: Futures

49. Example • Last month the National Bank of Dallas bought a futures contract with a 3-month maturity on a $100,000 one-year T-bill • FP = $98,000—delivery price upon maturity of contract with a current price on the underlying T-bill of $96,000 Chapter 27: Futures

50. Example • What profit can the bank earn by holding the contract to maturity? • $98,000 - $96,000 (1.06)0.25 = $98,000 - $97,408.69 = $591.31 profit in three months • What profit can be earned by selling a forward contract today? • $98,000/1.060.25 - $96,000 = $96,582.76 - $96,000 = $582.76 profit today • Profits are identical because 591.31/1.060.25 = $582.76 Chapter 27: Futures