CHAPTER 14 Futures Contracts Chapter Sections Futures Contracts

CHAPTER 14 Futures Contracts Chapter Sections: Futures Contracts Basics Why Futures? Futures Trading Accounts Cash Prices versus Futures Prices Stock Index Futures “There are two times in a man’s life when he should not speculate; when he can’t afford it and when he can. ” – Mark Twain 1

What are Futures? n 2 Futures contract w A commitment to deliver a certain amount of some specified item at some specified date in the future w A buyer and a seller specify a commodity or financial instrument to be delivered and paid when the contract matures Ÿ The futures price is guaranteed by the contract w Futures started with commodities… Ÿ a. k. a. hard assets, real assets Ÿ Examples: wheat, soybeans, cattle, pork bellies, gold, oil, etc. w But have since moved to financial assets

What is the Purpose of Futures? n Producers of commodities use futures contracts extensively w Example: A wheat farmer in Iowa plants 1, 000 acres of wheat in April. He knows that if all goes well, Lord Willing, come September he will have 500, 000 bushels of wheat. September wheat futures are currently (in April) selling for $6 per bushel w Our farmer can “sell” his wheat (via a wheat futures contract) while it is still in ground. He can guarantee a price that he is happy with and will result in a profit w The contract states he will deliver the wheat in September and receive $6 per bushel no matter what happens to wheat prices 3

What is the Purpose of Futures? (continued) n Consumers of commodities also use them w Example: Kellogg’s and General Mills and Post Cereal need tons and tons of wheat each year to make cereal and other foodstuffs w Via futures contracts, in April, they can purchase the wheat to be delivered in September and pay $6 per bushel no matter what happens to wheat prices What are the advantages and disadvantages of using futures contracts when you are the producer and when you are the consumer? 4

What is the Purpose of Futures? (continued) n Futures contracts allow producers and consumers of commodities to hedge w Hedging: Taking a futures position opposite to an existing position in the underlying commodity or financial instrument “Hedge your bet!” Have you ever heard this saying? The farmer is protecting himself from wheat prices falling. The cereal companies are protecting themselves from wheat prices rising. 5

Major Classes of Commodities 6

7 What are Financial Futures? n The financial world adopted the technique of futures contracts to financial assets, treating financial assets like commodities w Examples: currencies, interest rates, stock and bond indexes, etc. Ÿ “I will deliver $25, 000 worth of British Pounds to you next April” Ÿ “I will purchase $10, 000 worth of the S&P 500 stock index from you next August”

Purpose of Financial Futures? n For those working in the World of Finance and especially, the World of International Business, they can be very useful tools w Example: A car manufacturer knows it will need to purchase 50, 000 engines from Japan next October w The manufacturer can buy a currency future for $20, 000 worth of Japanese Yen payable in October w This protects the manufacturer from adverse currency fluctuations Ÿ Example: The dollar falls relative to the yen 8

9 Can Anyone Purchase Futures? n Lucky You! You do not have to work in either the commodities world or the finance world to buy and sell futures contracts w You can be a speculator! w You simply buy and sell the futures contracts w You never actually deliver or take delivery of the commodity nor the financial asset w You could buy the 500, 000 bushels to be delivered in September even though you live in a condo in West Los Angeles and have never even seen a farm! What do you think of this strategy? What is the limit of your losses?

10 Speculating with Futures n Speculating – Accepting the futures price risk without having a position opposite to an existing position in the underlying commodity or financial instrument w It is the opposite of hedging w “… futures speculation is risky, but it is potentially rewarding if you can accurately forecast the direction of future commodity price movements. ” – page 456, 4 edition th Can anyone accurately forecast the future? If our LA speculator sitting in her condo had purchased the futures contract for 500, 000 bushels of wheat to be delivered in September and wheat prices plummeted, she could potentially lose hundreds of thousands of dollars!

Trading Futures n Chicago Board of Trade w Largest, most active futures exchange w Many other exchanges n Long position w The buyer of the futures contract Ÿ Protected from futures price increases Ÿ Wheat Example: Kellogg’s, Post Cereal n Short position w The seller of the futures contract Ÿ Protected from futures price decreases Ÿ Wheat Example: Our farmer 11

12 Futures Seem Like Options n In fact, the two are very similar w Financial futures work very much like options w There is the potential for great rewards w But there is also much more of the likelihood of sustaining great losses Ÿ In fact, the potential losses from futures contracts are staggering! w And, just like options, they are a tremendous source of commissions for your broker By the way, you can purchase options on futures contracts. What do you think about that?

13 Final Comments on Futures? STAY AWAY FROM THEM! They are even more potentially dangerous than options.

CHAPTER 14 – REVIEW 14 Futures Contracts Chapter Sections: Futures Contracts Basics Why Futures? Futures Trading Accounts Cash Prices versus Futures Prices Stock Index Futures Next: Brokerage Accounts, Buying on Margin, and Selling Shorting