Understanding Futures Contracts: Definition, Market Participants, and Pricing Dynamics

1. CHAPTER TWENTY-FIVE FUTURES

2. FUTURES CONTRACTS • WHAT ARE FUTURES? • Definition: an agreement between two investors under which the seller promises to deliver a specific asset on a specific future date to the buyer for a predetermined price to be paid on the delivery date

3. FUTURES CONTRACTS • ASSETS INVOLVED IN FUTURES TRADING • agricultural goods (wheat, corn, etc.) • natural resources (oil, natural gas, etc.) • foreign currencies (pounds, marks, etc.) • fixed-income securities (T-bonds, etc.) • market indices (S+P 500, Value Line, etc.)

4. HEDGERS AND SPECULATORS • MARKET PARTICIPANTS • HEDGERS are traders who buy or sell to offset a risk exposure in the spot market • for example, a U.S. exporter will be paid in 30 days in a foreign currency

5. HEDGERS AND SPECULATORS • MARKET PARTICIPANTS • SPECULATORS are traders who buy or sell futures contracts for the potential of arbitrage profits

6. THE FUTURES MARKET • WHAT DISTINGUISHES IT FROM STOCK AND OPTIONS MARKETS? • there are no specialists or market-makers • members are floor traders or locals (“scalpers”) who execute orders for personal accounts • open outcry mechanism • verbal announcement of trading price in the pit

7. THE FUTURES MARKET • THE CLEARINGHOUSE • FUNCTIONS: • provide orderly and stable meeting place for buyers and sellers • prevents losses from defaults • Procedures • imposes initial and daily maintenance margins • marks to market daily

8. THE FUTURES MARKET • THE CLEARINGHOUSE • INITIAL MARGIN • the performance margin that represents a security deposit intended to guarantee the buyer and the seller will be able to fulfill their obligations • set at the amount roughly equal to the price limit times the size of the contract

9. THE FUTURES MARKET • THE CLEARINGHOUSE • MAINTENANCE MARGIN • investor keeps the account’s equity equal to or greater than a certain percentage • if not met, margin call is issued to the buyer and seller • variation margin • represents the additional deposit of cash that brings the equity up to the margin

10. THE FUTURES MARKET • MARKING TO MARKET • DEFINITION: the process of adjusting the equity in an investor’s account in order to reflect the change in the settlement price of the futures contract

11. THE FUTURES MARKET • Process • each day the clearinghouse replaces the existing contracts with new ones • the purchase price = the settlement price that day • the amount of the investor’s equity may change daily

12. THE FUTURES MARKET • MARKING TO MARKET • Price Limits • exchanges impose dollar limits on the extent to which futures prices may vary (to avoid excess volatility) • Reasoning behind limits: The Exchanges believe futures traders may overreact to major news stories

13. BASIS • WHAT IS THE BASIS? • DEFINITION: basis is the current spot price minus the current futures contract price • Current spot price is the price of the asset for immediate delivery • the current futures contract price is the purchase price of the contract in the market

14. BASIS • SPECULATING ON THE BASIS • Basis risk • the risk that the basis will narrow or widen • speculating on the basis means an investor will want to be either • short in the futures contract and long in the spot market, or • long in the futures contract and short in the spot market

15. FUTURES PRICES AND FUTURE SPOT PRICES • CERTAINTY • futures price forecasts have no certainty because if so • the purchase price would equal the spot • the purchase price would not change as delivery neared • no margin would be needed to protect against unexpected adverse price movements

16. FUTURES PRICES AND FUTURE SPOT PRICES • UNCERTAINTY • How are futures prices related to expected spot prices? • EXPECTATION HYPOTHESIS • the current futures purchase price equals the consensus expectation of the future spot price Pf = Ps where Pf is the current purchase price of the futures Ps is the expected future spot price at delivery

17. FUTURES PRICES AND FUTURE SPOT PRICES • NORMAL BACKWARDATION • KEYNES: criticized the expectation hypothesis and stated that • hedgers will want to be short futures • this entices speculators to go long in the futures markets • to do this hedgers make the expected return from a long position greater that the risk free rate

18. FUTURES PRICES AND FUTURE SPOT PRICES • NORMAL BACKWARDATION • which can be written Pf < Ps • this relationship known as normal backwardation • which implies Pfcan be expected to rise during the life of the futures contract

19. FUTURES PRICES AND FUTURE SPOT PRICES • NORMAL CONTANGO • a contrary hypothesis to Keynes’ • states that on balance hedgers want to go long in the futures and entice speculators to be short in the futures • to do this hedgers make Pf > Ps • this implies that Pfcan be expected to fall during its contract life

20. FUTURES PRICES AND FUTURE SPOT PRICES • NORMAL BACKWARDATION AND CONTANGO Pf PS

21. FUTURES PRICES AND CURRENT SPOT PRICES • AT WHAT PRICE SHOULD FUTURES CONTRACTS SELL? Pf = Ps + I where Pf = futures contract price Ps =current spot asset price I = the dollar amount of interest corresponding to the period of time from present to delivery date

22. FUTUTES PRICES AND CURRENT SPOT PRICES • Benefits of ownership • What if there are benefits that accrue to owner of the asset, then Pf = Ps + I - B where B is the benefit

23. FUTUTES PRICES AND CURRENT SPOT PRICES • COST OF OWNERSHIP • What if there are costs that accrue due to owning the asset? Pf = Ps + I - B + C where C is the cost of owning

24. FUTUTES PRICES AND CURRENT SPOT PRICES • COST OF OWNERSHIP • The Cost of Carry (I-B+C) • the total value of interest less benefits received plus cost of ownership • The Futures Price • can be greater or less than the spot price depending on whether the cost of carry is positive or negative