CHAPTER TWENTYFIVE FUTURES 1 FUTURES CONTRACTS WHAT ARE

CHAPTER TWENTY-FIVE FUTURES 1

FUTURES CONTRACTS • 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 2

FUTURES CONTRACTS • 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. ) 3

HEDGERS AND SPECULATORS • 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 4

HEDGERS AND SPECULATORS • MARKET PARTICIPANTS – SPECULATORS are traders who buy or sell futures contracts for the potential of arbitrage profits 5

THE FUTURES MARKET • 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 • verbal announcement of trading price in the pit 6

THE FUTURES MARKET • THE CLEARINGHOUSE – FUNCTIONS: • provide orderly and stable meeting place for buyers and sellers • prevents losses from defaults – Procedures • imposes initial and daily maintenance margins • marks to market daily 7

THE FUTURES MARKET • THE CLEARINGHOUSE – INITIAL MARGIN • the performance margin that represents a security deposit intended to guarantee the buyer and the seller will be able to fulfill their obligations • set at the amount roughly equal to the price limit times the size of the contract 8

THE FUTURES MARKET • THE CLEARINGHOUSE – MAINTENANCE MARGIN • investor keeps the account’s equity equal to or greater than a certain percentage • if not met, margin call is issued to the buyer and seller • variation margin – represents the additional deposit of cash that brings the equity up to the margin 9

THE FUTURES MARKET • 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 10

THE FUTURES MARKET – Process • each day the clearinghouse replaces the existing contracts with new ones • the purchase price = the settlement price that day • the amount of the investor’s equity may change daily 11

THE FUTURES MARKET • MARKING TO MARKET – Price Limits • exchanges impose dollar limits on the extent to which futures prices may vary (to avoid excess volatility) • Reasoning behind limits: The Exchanges believe futures traders may overreact to major news stories 12

BASIS • 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 13

BASIS • SPECULATING ON THE BASIS – Basis risk • the risk that the basis will narrow or widen – speculating on the basis means an investor will want to be either • short in the futures contract and long in the spot market, or • long in the futures contract and short in the spot market 14

FUTURES PRICES AND FUTURE SPOT PRICES • CERTAINTY – futures price forecasts have no certainty because if so • the purchase price would equal the spot • the purchase price would not change as delivery neared • no margin would be needed to protect against unexpected adverse price movements 15

FUTURES PRICES AND FUTURE SPOT PRICES • UNCERTAINTY – How are futures prices related to expected spot prices? • 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 16

FUTURES PRICES AND FUTURE SPOT PRICES • NORMAL BACKWARDATION – KEYNES: criticized the expectation hypothesis and stated that • hedgers will want to be short futures • this entices speculators to go long in the futures markets • to do this hedgers make the expected return from a long position greater that the risk free rate 17

FUTURES PRICES AND FUTURE SPOT PRICES • NORMAL BACKWARDATION – which can be written Pf < P s – this relationship known as normal backwardation P – which implies f can be expected to rise during the life of the futures contract 18

FUTURES PRICES AND FUTURE SPOT PRICES • 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 can be expected to fall during its contract life 19

FUTURES PRICES AND FUTURE SPOT PRICES • NORMAL BACKWARDATION AND CONTANGO P f PS 20

FUTURES PRICES AND CURRENT SPOT PRICES • AT WHAT PRICE SHOULD FUTURES CONTRACTS SELL? Pf = P s + I where Pf = Ps = I = futures contract price current spot asset price the dollar amount of interest corresponding to the period of time from present to delivery date 21

FUTUTES PRICES AND CURRENT SPOT PRICES – Benefits of ownership • What if there are benefits that accrue to owner of the asset, then Pf = P s + I - B where B is the benefit 22

FUTUTES PRICES AND CURRENT SPOT PRICES • 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 23

FUTUTES PRICES AND CURRENT SPOT PRICES • COST OF OWNERSHIP – The Cost of Carry (I-B+C) • the total value of interest less benefits received plus cost of ownership – The Futures Price • can be greater or less than the spot price depending on whether the cost of carry is positive or negative 24