Chapter 8

1. Chapter 8 Fundamentals of the Futures Market

2. Outline A. The concept of futures contracts B. Market mechanics C. Market participants D. The clearing process E. Principles of futures contract pricing F. Hedging G. Spreading with commodity futures

3. The Concept of Futures Contracts • Introduction • The futures promise • Why we have futures contracts • Ensuring the promise is kept - the role of the Clearing House

4. Introduction • A futures contract is a legally binding agreement to buy or sell something in the future • The ‘futures market’ is represented by both the exchange traded futures contract and contracts that are established in what is know as the ‘over the counter’ or OTC market.

5. 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

6. 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

7. The Futures Promise • Futures compared to options • Futures compared to forwards • Futures regulation • Trading mechanics

8. 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

9. Forward Markets • Customized or tailored to the the customer requirements - underlying product and length of contract • Unregulated - recent events such as the Enron Corporation bankrupcty and other trading ‘irregularities’ may lead to change • Private market - transaction between two parties with no details divulged to the public • larger transactions in size • Credit risk is assumed by both parties

10. 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 initially involved foreign currencies - interbank market • Forward markets have developed for many financial instruments and commodities in recent years • Futures and Forward markets co-exist

11. 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

12. Recent OTC Market Trading Events • Trading with the former Enron Corporation and other trading firms are OTC trades where the financial integrity of the trading activity rests with the trading firm - the firms need to be well capitalized and with access to reasonably priced capital • Downgrading of many trading firms debt instruments has resulted in much higher capital costs and to cutbacks in trading operations

13. Oil & Gas/Energy OTC Activity • Participants include oil & gas producers, Pipeline companies, gas processors and other mid-stream players, electricity generators refiners, etc. • Common element is exposure to forward price risk • Active OTC risk management as well as usage of futures exchanges

14. Futures Regulation • In 1974, Congress passed the Commodity Exchange Act establishing the Commodity Futures Trading Commission (CFTC) • Ensures a fair futures market • Performs much the same function with futures as the SEC does with shares of stock or the OSC and ASC in Canada.

15. 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

16. Market and Trading Mechanics • The purpose is generally not to provide a means for the transfer of goods • 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

17. 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.

18. 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.

19. Why We Have Futures Contracts • Futures contracts allow buyers and manufacturers/users to lock into prices and costs, respectively • The commodities futures market allows for the transfer of risk from one participant to another - from one hedger to another - typically a buyer/user and a seller/producer of the commodity or between a hedger and a speculator willing to accept the risk

20. Transfer of Risk Risk Transfer Futures Market Gas Producer Gas User Futures Market Gas Producer/ /Gas user Speculator

21. Hedging Using Futures • If a firm wants oil/gas, it buys contracts, promising to pay a set price in the future (long hedge) or ‘buying forward’ • A oil/gas producer sells contracts, promising to deliver the gas (short hedge) or ‘selling forward’

22. Ensuring the Promise is Kept • Each exchange has a Clearing Corporation that ensures the integrity of the futures contract • The Clearing Corporation ensures that contracts are fulfilled • Becomes party to every trade • Assumes responsibility for member’s positions when a member is in financial distress

23. Ensuring the Promise is Kept (cont’d) • Strict financial requirements are a condition of membership on the exchange • NYMEX requires deposits to a guarantee fund • Margin requirements or ‘Good faith deposits’ ( performance bonds) are required from every member on every contract to help ensure that members have the financial capacity to meet their obligations

24. Contract Size Value Initial Margin per Contract Soybeans 5,000 bushels $23,837 $700 Gold 100 troy ounces $26,640 $1,350 Treasury Bonds $100,000 par $103,188 $1,735 S&P 500 Index $250 x index $339,625 $23,438 Heating Oil 42,000 gallons $36,918 $4,050 Ensuring the Promise is Kept (cont’d) Selected Good Faith Deposit Requirements Data as of 21 January 2001

25. Market Participants • Hedgers - long and short positions • Processors • Speculators/traders • Scalpers

26. Hedgers • A hedger is someone engaged in a business activity where there is an unacceptable level of price risk • E.g., a gas producer can lock into the price he will receive for his gas production by selling futures contracts

27. Processors • A Refiner/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 refiner buys crude oil and refines this into a range of refined products, soybean processor buys soybeans and crushes them into soybean meal and oil

28. 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

29. 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 keeps a contract for weeks • A day trader closes out all his positions before trading closes for the day

30. Scalpers • Scalpers are individuals who trade for their own account in the trading pit, making a living by buying and selling contracts • Also called locals • Scalpers help keep prices continuous and accurate with their active trading

31. 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

32. Accounting Supervision • The accounting problem is formidable because futures contracts are marked to market every day - see table 8-5 • 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 • Different from trading volume since a single futures contract might be traded often during its life

33. Delivery Open High Low Settle Change Volume Open Jul 2000 5144 5144 5040 5046 -52 32004 46746 Aug 2000 5070 5074 5004 5012 4 7889 19480 Sep 2000 4980 4994 4950 4960 44 3960 15487 Nov 2000 5020 5042 4994 5006 56 22629 62655 Jan 2001 5110 5130 5084 5100 54 1005 6305 Mar 2001 5204 5204 5160 5180 54 1015 4987 May 2001 5240 5270 5230 5230 44 15 6202 July 2001 5290 5330 5280 5290 40 53 4187 Nov 2001 5380 5400 5330 5330 30 37 1371 Account Supervision (cont’d) Volume vs Open Interest for Soybean Futures June 16, 2000

34. 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

35. Principles of Futures Contract Pricing Basic concepts & terms • Spot market or price • Futures market or price • Relationship between the spot price and the futures price • ‘Basis’ is the difference between the spot and futures price • Relationship between futures prices for different delivery months - • Intra-commodity spread

36. Futures Prices & Commodity Prices • Commodity prices impacted by: • Supply/demand • Weather forecasts • Availability of substitute commodities • Fuel switching capability • Changes in storage costs/insurance costs • other

37. Futures Pricing • Three main theories of futures pricing” • The expectations hypothesis • A full carrying charge market • Normal backwardation & risk aversion

38. The Expectations Hypothesis • The expectations hypothesis states that the futures price for a commodity is what the marketplace expects the cash or spot price to be when the delivery month arrives • the presence of speculators in the marketplace ensures that the futures price approximates the expected future cash or spot price - a divergence creates speculative opportunities • Price discovery is an important function performed by futures - linked to the expectations hypothesis

39. 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 • This theory suggests the futures price is equal to the current spot price plus the carrying charge:

40. Carrying Charge • The Cost of Carry may include: • storage costs • transportation costs • insurance costs • financing costs

41. A Full Carrying Charge Market (cont’d) • An Arbitrage opportunity 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 more than covers the cost of carry • In a full carrying charge market, the basis cannot weaken because that would produce an arbitrage situation

42. Normal Backwardation & Risk Aversion • Speculators expect to be compensated for taking on risk • 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 • Keynes theory is that speculators typically take a long position in the futures market and thus expect futures prices rising over the life of the contract and converging to the cash price

43. Backwardation • Normally, the futures price exceeds the cash price and prices for more distant futures are higher than for nearby futures (contango/normal market) • futures prices are expected to rise over the life of the contract • The futures price may be less than the cash price/distant futures prices are lower than nearby contracts (backwardation or inverted market) • futures prices are expected to fall over the life the contract

44. The ‘Basis’ • One of the most important concepts in the futures markets......and for the process of hedging Basis = Spot1 (Cash) Price - Futures Price • Convergence - behaviour of the basis over time. • The basis ‘converges’ to zero at the maturity of the futures contract (except for transportation/transaction costs) • The Basis can fluctuate substantially before maturity 1) cash price at a specific location

45. The ‘Basis’ • Spot (Cash) Price = Futures + Basis • Natural gas futures example Alberta spot gas = NYMEX futures + Basis • if a shift in price results in the same change in both the cash market as in the futures market - then the basis has not changed • however, if the cash price changes more or less than the futures price, the basis has changed - this has implications for the effectiveness of a hedge

46. The ‘Basis’ Factors affecting the Basis...... • In the case of a commodity like natural gas, transportation costs to the specified delivery point of the futures contract - Alberta gas has a different basis vs Texas gas for example • Local supply/demand factors - e.g. Weather related - unknown factor

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

48. Hedging - Basic Concepts • Hedging is a transaction designed to reduce /eliminate risk via a transfer of risk. • Forward contracts and futures are used extensively as part of hedging strategies • Why hedge? Should all risk be eliminated - is risk not a part of business? • Why not let shareholders determine the level of risk and act/hedge accordingly • Hedging – ‘taking a position’ on the market • Not hedging – are you also ‘taking a position on the market’?

49. Hedging Corporations enter into hedging transactions for a number of reasons: • to create an acceptable combination of return and risk • to lock in a return for a given project • to add stability to the firm’s earnings/cash flow • improve the firm’s ability to access capital markets or borrow money

50. Hedging • Hedging reduces risk but may not eliminate it entirely • Eliminates upside opportunities - hedging reduces both the upside and downside risk • hedging needs to be selective - ‘indiscriminate hedging’ does not lead to creation of shareholder value • Hedging involves ‘taking a position’ - concerned about an unfavourable movement and its impact • Cash market vs futures market