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FUTURES

Learn the basics of futures contracts, their differences from forward contracts, and how they can be used for hedging and speculation. Explore examples and strategies to manage risk in the commodities market.

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FUTURES

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  1. FUTURES DEFINITION Futures (forward) contracts are agreements between two agents where one agrees to purchase and the other to sell (deliver) a given amount of a specific commodity at a specific price at a future (prompt) date. Like an order for furniture, house, car, etc. at fixed price.

  2. BASIC FEATURES • Both parties are "obliged" -> not optional • Buy (long) - sell (short) • Like options - zero sum - derivative security • No money changes hands initially - Margin put up • Mark to market daily - money moves between • margin accounts • Delivery is seldom taken - only 2% (like options) • 70% of traders lose money - some win big (Hillary).

  3. FUTURES VS. FORWARD CONTRACTS • FUTURES CONTRACTS ARE STANDARDIZED • sold on exchanges - Chicago Board of Trade (1848) • involve clearing house • trading in pit - no specialist - different prices • FORWARD CONTRACTS ARE NOT STANDARDIZED • sold over the phone (over the counter) • no clearing house • common for currency trading - banks • 24 hour market • no mark to market - end day settlement • allow contingent delivery - sale of house etc.

  4. Look at Futures Quotes – www.futuresource.com • QUESTION: Which commodities are likely to have • futures traded? • commodity that can be graded - standardized • - widely used - volatile price • HOW USED - HELPS BUSINESSES PLAN • hedging - farmer - short hedge -grain processor - • long hedge • speculating - traders • virtual company - trade crude against gas to earn • change in refiner profit

  5. EXAMPLE: Calculating returns on futures -speculator ASSUME: - It is January - July wheat futures sell for 4.84/bushel - Each contract covers 3000 bushels - Margin rate is 15% - Trading commission is $30/roundtrip Buy 5 contracts Figure your investment = 5 x 3000 x 4.84 x .15 + (30 x 5) = 11,040

  6. A. Sell your futures in April when price is 4.96 / bushel = .149/4 months or 44.8% annual B. Sell your futures in March when price is 4.75/bushel = -.136/3 months or -54.3% annual

  7. Hedging Locks in Profit SIMPLE HEDGING EXAMPLE - CORN Farmer - is a short hedger - hedges risk by selling futures. Kelloggs - is a long hedger - hedges risk by buying futures. TimingFarmerKelloggs now sell futures 5 buy futures -5 later cost to grow -4 sell cereal 6 Net Profit 1 1

  8. Price Changes Have No Net Impact Suppose corn price is $3 at prompt date. What do the Farmer and Kelloggs do? FarmerKelloggs Sell corn in Iowa 3 Buy corn in Michigan -3 Buy back futures -3 Sell back futures 3 NET 0 0 What are the respective gains and losses for the Farmer and Kelloggs? FarmerKelloggs Loss on corn sale -2 Gain on corn buy 2 Gain on futures 2 Loss on futures -2 NET 0 0

  9. Futures Gain (Loss) Offsets Asset Loss (Gain) Suppose corn price is $6 at prompt date. What do they do then? FarmerKelloggs Sell corn in Iowa 6 Buy corn in Michigan -6 Buy back futures -6 Sell back futures 6 NET 0 0 What are the respective gains and losses? FarmerKelloggs Gain on corn sale 1 Loss on corn buy -1 Loss on futures -1 Gain on futures 1 NET 0 0

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