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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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