CHAPTER TWENTY FUTURES FUTURES CONTRACTS n WHAT ARE

CHAPTER TWENTY FUTURES

FUTURES CONTRACTS n 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

FUTURES CONTRACTS n 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. )

HEDGERS AND SPECULATORS n 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

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

THE FUTURES MARKET n 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 3 verbal announcement of trading price in the pit

THE FUTURES MARKET n THE CLEARINGHOUSE • FUNCTIONS: 3 provide orderly and stable meeting place for buyers and sellers 3 prevents losses from defaults • Procedures 3 imposes initial and daily maintenance margins 3 marks to market daily

THE FUTURES MARKET n THE CLEARINGHOUSE • INITIAL MARGIN 3 the performance margin that represents a security deposit intended to quarantee the buyer and the seller will be able to fulfill their obligations 3 set at the amount roughly equal to the price limit times the size of the contract

THE FUTURES MARKET n THE CLEARINGHOUSE • MAINTENANCE MARGIN 3 investor keeps the account’s equity equal to or greater than a certain percentage 3 if not met, margin call is issued to the buyer and seller 3 variation margin – represents the additional deposit of cash that brings the equity up to the margin

THE FUTURES MARKET n 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

THE FUTURES MARKET • Process 3 each day the clearinghouse replaces the existing contracts with new ones 3 the purchase price = the settlement price that day 3 the amount of the investor’s equity may change daily

THE FUTURES MARKET n MARKING TO MARKET • Price Limits 3 exchanges impose dollar limits on the extent to which futures prices may vary (to avoid excess volatility) 3 Reasoning behind limits: The Exchanges believe futures traders may overreact to major news stories

BASIS n 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

BASIS n SPECULATING ON THE BASIS • Basis risk 3 the risk that the basis will narrow or widen • speculating on the basis means an investor will want to be either 3 short in the futures contract and long in the spot market, or 3 long in the futures contract and short in the spot market

FUTURES PRICES AND FUTURE SPOT PRICES n CERTAINTY • futures price forecasts have no certainty because if so 3 the purchase price would equal the spot 3 the purchase price would not change as delivery neared 3 no margin would be needed to protect against unexpected adverse price movements

FUTURES PRICES AND FUTURE SPOT PRICES n UNCERTAINTY • How are futures prices related to expected spot prices? 3 EXPECTATION HYPOTHESIS – the current futures purchase price equals the consensus expectation of the future spot price Pf = P s where Pf is the current purchase price of the futures Ps is the expected future spot price at delivery

FUTURES PRICES AND FUTURE SPOT PRICES n NORMAL BACKWARDATION • KEYNES: criticized the expectation hypothesis and stated that 3 hedgers will want to be short futures 3 this entices speculators to go long in the futures markets 3 to do this hedgers make the expected return from a long position greater that the risk free rate

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

FUTURES PRICES AND FUTURE SPOT PRICES n 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 > P s • this implies that Pf its contract life can be expected to fall during

FUTURES PRICES AND FUTURE SPOT PRICES n NORMAL BACKWARDATION AND CONTANGO Pf PS

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

FUTUTES PRICES AND CURRENT SPOT PRICES • Benefits of ownership 3 What if there are benefits that accrue to owner of the asset, then Pf = P s + I - B where B is the benefit

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

FUTUTES PRICES AND CURRENT SPOT PRICES n COST OF OWNERSHIP • The Cost of Carry (I-B+C) 3 the total value of interest less benefits received plus cost of ownership • The Futures Price 3 can be greater or less than the spot price depending on whether the cost of carry is positive or negative

END OF CHAPTER 20