Futures 1 FORWARD FUTURES TRANSACTIONS LONG There are

Futures - 1

FORWARD / FUTURES TRANSACTIONS (LONG). There are three ways in which you can acquire a commodity (or currency or financial) asset in the future. Call it “the underlying asset. ” You can: a) buy now and hold it till later [at the current market price (SPOT) price] b) buy it later [at an unknown future SPOT price] c) Decide on a price today for later delivery. In a) and c) the underlying asset is acquired the same time that the price is paid. In b) the price is decided now, but paid later when the asset is delivered. Transactions (a) and (c) occur in a SPOT market, the first where cash is exchanged for an asset today, and the other where cash is exchanged for an asset at a later date. Acquiring the underlying asset via (b) is a forward/future market transaction. The price is decided NOW, but is paid LATER, regardless of what the SPOT price of the asset at that time will be.

A transaction as in b) gives the initiator a “LONG” futures The LONG is obliged to buy the underlying asset unless they close out their position before maturity. This is unlike options where call buyers have the choice of whether to exercise or not. Say long but try not to say “buy futures!” NOTHING is PAID now on the LONG futures. A margin account is opened, think of it as a “good faith deposit” against future payment. EXAMPLE: Crude Oil trades for $100 per barrel in the spot market. a) The futures price for crude in 3 months (call it March crude) is $ 102 per barrel. This means that those entering LONG futures positions in March crude are committing to paying $102 per barrel in March TO TAKE DELIVERY of crude. Each contract has a size of 1000 barrels. a) The SPOT price in March may be different from $102. The LONG futures will only pay $102 in MARCH for crude even if the SPOT price then is $80 or $120 or whatever. a) What is paid NOW? Suppose the margin is 10%. Then 10% of the $102, 000 owed later (or $10, 200) is earmarked in the margin account. For some underlying assets, collateral in the form of securities is permitted. This margin adjusts daily.

EXAMPLE: ONE WEEK LATER Suppose that the futures price for March Crude in one week is $104 per barrel. All that means is that other traders are willing to pay $104 for the same March crude that traded at $102 the previous week. This could be due to supply demand changes, weather changes etc. THE LONG POSITION initiated at $102 last week is now sitting on a paper gain of $2 per barrel, [(104 -102)*1000] = $2000. This gain goes immediately into the LONG’s margin account at the close of each day (mark-to-market). This long can a) realize the gain and book the profit or: b) let it ride as March is still some time away. Suppose the LONG decides to realize the gain, The margin account is richer by $2000, which is nearly a 20% profit on the margin deposit of $10, 200, although futures prices only went up by 2% (102 to 104). This is due to leverage. (Discuss the leverage idea more, with a housing example and bank example).

COMPARE WITH EQUITIES. Think about why someone might buy Tesla or Astra. The expectation is that the stock will go up over time, you go along for the ride and take profits along the way. People buying Tesla are also said to be LONG Tesla, just like the people above were LONG March Crude. With futures, the difference is: a) that there is a time limit, March; b) that crude is not going to the moon; c) you have to commit little in terms of funds, stocks require 50% initial margin, the futures require 10%. Terminating the purchase transaction requires you to reverse it with a sell. With publicly traded stocks, some people may have the opposite expectation, that prices may fall in the future, rather than rise. Such people can take short futures (Revisit short selling, if the class is not comfortable with it). Here again, terminating the short sale involves “buying to cover”. The single stock futures market in India is one of the biggest in the world!

SHORT FUTURES POSITIONS. VIEW A SHORT FUTURES position as a bet that: In the future, crude prices will be lower rather than higher. Continuing with the previous set of numbers for crude, suppose that the futures trader takes a short position in March crude. This is tantamount to agreeing to DELIVER crude in March at $102 per barrel. If a month later, crude prices are $95 per barrel, the short futures position profits by $7 per barrel (you buy crude in the spot market at 95 and deliver against the futures at 102) and you realize this gain by closing out the short position. You don’t have to own the oil to create the SHORT position, you don’t even have to borrow it (like you would borrow shares to short). The 10% margin funds serves as your good faith guarantee of oil delivery. Another way to think about is that when you reach March, if the spot price is even lower say $90, you can buy oil at $90 in the SPOT market and DELIVER it for $102.

TERMINATING FUTURES TRANSACTIONS The notion of OPENING and CLOSING positions is important. If you OPEN a LONG position and you don’t really want to TAKE DELIVERY of crude, then you realize your profit or loss by reversing the transaction, which is CLOSE SHORT. For the March crude example, you OPEN LONG at $102 and realize your gain by CLOSING SHORT at $104. Beware that if you OPEN SHORT instead of CLOSING, you would be initiating a second futures position, i. e SHORT at $104. When opening transactions are reversed, gains/losses are calculated based upon the “settlement” price, which is typically the average of the last few trades in the futures contract on that day. The reason for such an average is to prevent participants from gaming closing prices. This settlement price is also used to calculate mark-to-market adjustments on any given day even if the transaction is not reversed. Closing short or long is only ONE way to TERMINATE a transaction, although the most common and the easiest way to illustrate how futures work. After all, most speculators don’t really want to TAKE DELIVERY or MAKE DELIVERY of crude. In fact, when the March futures start trading, people start taking positions (long or short) and the “open interest” in the contract begins to rise. As March gets closer, these positions are closed out and “open interest” begins to decline.

DELIVERY. Some market players may actually want to take delivery of the underlying oil via the futures, and keep the LONG position OPEN at maturity. The short side would then DELIVER at the futures price according to a delivery schedule that varies with the underlying asset. - Although not common with commodities, delivery is common in interest-rate futures contracts. The T bond futures contract has an extremely complicated delivery process which we will discuss later. CASH SETTLEMENT. Some futures contracts are “cash-settled. ” Think about what it would mean to deliver the S&P 500 index on an index futures contract. A share of Google, a few shares of IBM etc. makes no sense and the gain/loss is exchanged in cash. EXCHANGE FOR PHYSICALS. There is also a rare notion of “exchange for physicals” where the two parties might arrange delivery outside of the normal procedures specified by the exchange.

CONVERGENCE. T h contract. Also The Figure below represents possible paths of the hypothetical March crude futures plotted is the path of spot crude. Notice how the two are different but related. We i see that today’s s price of crude is $100, and todays price for March crude is $102. We don’t know what either of them will be in March, BUT we know that they will be the same. Ten seconds before maturity p in March, we know that the price for March crude futures should be equal to the March spot price. r. This property is CONVERGENCE. o p MAT e r 108 t y NOW 104 F=102 i s S=100 95 C O N V E 90

COST OF CARRY Recall from the first page, that someone who needs crude in March could always buy and hold it (incurring a cost, storage, insurance, spoilage etc), rather than enter the futures market. Shouldn’t today’s difference of $2 between spot crude and March crude reflect that cost. This is known as the cost of “carrying” crude for these few months. CONVENIENCE YIELDS. (for holding, dividends for stocks, contango and backwardation. MARKET PARTICIPANTS The market player in the above setting is a SPECULATOR who bets on the future price of a commodity rising (long) or falling (short). Typically, they do not take (long) or make (short) delivery. close out positions with a reversing trade. operate only in one market (futures), can do spreads and such.

HEDGERS—The more common player in these markets is a HEDGER, whose nature of business creates future spot exposure to a commodity. An oil drilling firm will have oil extracted at different points in time and will be concerned about the risk of oil prices falling. An oil refining firm purchasing crude for converting to gasoline is likewise concerned about rising crude prices. I usually tell the story of a Columbian coffee grower /Starbucks manager. These entities are not looking for speculative profits. They are looking to the futures market to hedge their future spot exposure. So they effectively operate in both spot and futures markets. A hedger who is long futures looks to profit from a possible price increase (like the speculator). But this gain, if it occurs, will offset the higher future spot price at which the commodity may have to be purchased in that spot market. A hedger who is short futures looks to profit from a possible price decrease (like a speculator). But this gain, if it occurs, will offset the lower future spot price receipts from delivery in that spot market.

Go back to Figure 1. The oil refining firm will be long March crude futures @ $102. If March prices are $108, they have a $6 per barrel gain on the futures and will have to pay $108 for crude in the spot market. Their out-of-pocket cost is $108 – $6 = $102. Again, if March prices are $90, they have a loss of $12 on the long futures, but they pay $90 for crude. Their out-of-pocket cost is $90 + $12 = $102. In other words, the hedger has locked in price of $102 to purchase crude in March. They are not happy with the hedge if prices fall (as they could have got the crude cheaper), but that was not their concern. The worry was that prices would rise and erode their profit margins on their core business which is refining oil. Likewise, consider the oil driller who is concerned about falling prices when they have to MAKE DELIVERY in March. They are short March crude futures at $102 as well. If March prices are $108, they can sell their crude for $108, but have a loss of $6 ($102 -$108) on the short futures (as prices went up). Their revenue per barrel is 108 -6 = $102. Again, if March prices are $90, they only get $90 from selling spot crude, but make $12 on the short futures (102 -90). Their revenue per barrel is $102. These guys are locked into $102 to deliver crude. They are not happy if crude prices went up (they could have sold it for more), but they were more worried about getting less (if crude prices fell).

ARBITRAGEURS: bet on mispricing spot and futures markets by taking positions in BOTH! An easy way to see this is to go back to Figure 1 and assume that this entity is able to carry crude till March for $1 instead of the $2 reflected in the difference between spot crude and March crude. What would this individual do? Obviously, buy spot crude for $100, hold it till March for $1, incurring a TOTAL COST of $101. But what if March prices are down to $90? She would be out $11. So, she would ADDITIONALLY also SHORT March futures at $102. If March prices are $90, she sells the crude in the spot market and makes $12 on the short futures position. Net profit ($90 + $12 - $101) = $1 per barrel. If March prices are $108, net profit is $108 – $6 - $101) = $1 per barrel. Pick any March price, the net profit will always be $1. This is a money machine. Market efficiency means that such an arbitrage will not persist. More importantly, notice the motivation of this arbitrageur. There is a mispricing of $1 in the cost-of-carry and that is what she is after. Her motivation is quite different from that of the speculator or the hedger.

TYPES OF FUTURES CONTRACTS a) Commodities, “soft” commodities are grown – corn, wheat, sugar, coffee…. “hard” commodities are extracted – gold, oil, industrial metals… In both, the basic products are often “refined” – corn + sugar to ethanol, crude oil to gasoline. “Hard” commodities dominate. Many commodities do not have futures markets, in some cases, they are emerging – water rights, pollution rights, carbon… Interest in them as an asset class extremely popular as they have historically shown negative correlations with financials. NO LONGER? CCI = Continuous Commodity Index: equal-weighted average of 17 different commodities. Softs = Coffee, cocoa, cotton, OJ, sugar. Metals: Copper, Gold, Platinum, silver. Grains: Corn, soybeans, wheat. Livestock: Hogs, Cattle. Energy: Crude, Heating Oil, Natural Gas. This is just a way of summarizing commodity prices. b) financials- currencies, interest rates, equity indexes, single-stock futures, Markets here are bigger still.

MARGINS IN FUTURES Coffee futures have a contract size of 37, 500 lbs. Say, coffee futures are 67. 00 cents per lb. AND, you are long TWO coffee futures contracts. => You agree to pay 2*0. 67*37500 = $50, 250 in 1 week for delivery If, 1 week later, coffee spot prices are 70 cents/lb. You can take delivery of the coffee at 67 cents or just close out your futures position for a gain of: (0. 70 – 0. 67) * 2 * 37500 = $2, 250 Typically, you post margin of 10%, OR 0. 10 (50250) = $5025 RATE OF RETURN IS 2250/5025 = 44. 8%, NOTE PRICE INCREASE IS (70 -67)/67 = 4. 48% SO, leveraged by a factor of 10 !! In futures markets, this gain of $ 2250 accrues in daily increments via a procedure called mark-to-market. In forward markets, this gain accrues at maturity (or when trade is closed).

MARK-TO-MARKET (DAILY SETTLEMENT) Say, for coffee futures contract above, you see this pattern of daily futures prices 1______2_____3_____4_____5__ / / / 67. 0 67. 9 66. 0 69 70 From day 1 to day 2, price increase of $. 009 per pound (0. 009 x 2 x 37500) per trade = $675 -1425 +2250 +750 Or $ 675 was deposited in the margin account of the long. Likewise, on day 3, $ 1425 is transferred from margin account of long position to the margin account of short position. These amounts are deposited (withdrawn) from margin accounts daily. Over the entire period a NET TOTAL OF $2250 is deposited.

SOME SIMPLE HEDGING ILLUSTRATIONS 1. COFFEE GROWER IN S. AMERICA : EXPECTS BUMPER HARVEST IN 3 MONTHS RISK: COFFEE PRICES FALL (OVERSUPPLY) ACTION: SHORT COFFEE FUTURES 2. STARBUCKS -- EXPECTS TROPICAL STORMS RISK: COFFEE PRICES WILL RISE ACTION: LONG COFFEE FUTURES 3. OIL REFINING CO. AGREES TO BUY CRUDE OIL AT FIXED PRICES FOR 2 YRS RISK: CRUDE PRICES WILL FALL COULD HAVE BOUGHT CHEAPER SPOT) ACTION: SHORT CRUDE OIL FUTURES 4. US MFG CO ORDERS HIGH-PRECISION TOOLS FROM GERMANY, TO PAY IN 6 MONTHS RISK: EURO APPRECIATION ACTION: LONG EURO FORWARD

5. US FIRMS HAS YEN ACCOUNTS RECEIVABLE RISK: YEN DEPRECIATES ACTION: SHORT YEN FORWARD 6. EQUITY FUND MANAGER RISK: STOCK MARKET WILL DECLINE ACTION: SHORT INDEX FUTURES 7. MONEY-MARKET FUND WANTS FUTURE T-BILL PURCHASE RISK: RATES WILL FALL (will pay higher price later) ACTION: LONG T-BILL FUTURES 8. TREASURER WANTS TO ISSUE COMMERCIAL PAPER IN 3 MONTHS RISK: RATES WILL RISE (receive less at issue) ACTION: SHORT T-BILL FUTURES

9. US CONSTRUCTION COMPANY BIDS ON A PROJECT TO BUILD A SPORTS FACILITY IN U. K. ---- IF BID WINS, GET PAYMENT IN POUNDS ---- IF BID LOSES, GET NOTHING RISK: BID WINS AND POUND LOSES VALUE ACTION: SHORT POUND FORWARD IF BID WINS SO: OPTION ON POUNDS FORWARD (lose option premium if bid fails)

BASIS HEDGING. Hedging focuses on changing spot prices over time, with the futures price being locked in (to make or take delivery). Hedging is a response to volatility in commodity spot prices. Such hedges are clean if you can match futures contract maturities identically with the time you want the hedge to operate. IF you cannot, then you are exposed to calendar basis risk. Alternatively, suppose you operate in one location and futures contracts are for delivery at another location, then you may be exposed to locational basis risk. Still alternatively, you may want to hedge one commodity but can only find futures on a similar (but not identical) commodity. Then you are exposed to product or quality basis risk (aluminium futures versus bauxite, corporate bonds versus Treasury futures, equity portfolio with stock index futures. These are also called cross-hedges. Keeping it simple, define the basis as (spot – futures) (TEXTBOOK DOES IT THE OTHER WAY!)

The example below illustrates what happens. Consider someone who needs 50, 000 ounces of silver by July. It is now April. Silver futures (5000 troy oz, cents per oz). Spot 446. 0 July 450. 8 Buy the silver now and hold it in case prices rise? Too costly. So, enter into 10 long July futures contracts, expecting to pay about $4. 508 per ounce in July. Think of this as a long hedge. Now (Apr) July |----------------------| Spot = 4. 460 Case (a) 4. 60 July Futures = 4. 508 Case (b) 4. 30 Hedge is convenient, July contract available, spot and futures converge at maturity, or basis is zero, no basis risk.

I. LONG-HEDGER: Film maker needs silver in July. Risk of price increase. Action Now: Open long futures position 50 K oz @ 4. 508. Case (a) July spot price = $4. 60 (also July futures - convergence). July: buy spot silver @ cost of 4. 60 * 50000 = - $230, 000 Close Short futures @ 4. 60 (gain) = $4, 600 (0. 092*50000) - $225, 400 Out-of-pocket cost = - $ 225, 400/50000 = $4. 508 Notice that with the futures, the hedger effectively has obligation to pay $4. 508 at delivery (delivery is via the spot market since the short futures side usually has choice of location). Case (b) July spot price = $4. 30 (also July futures - convergence) July: buy silver @ cost of 4. 30 * 50000 = - $215, 000 Close Short futures @ 4. 30 (loss) = - $ 10, 400 (-0. 208*50000) - $225, 400 Out-of-pocket cost = - $ 225, 400/50000 = $4. 508 Again, the $4. 508 obligation results. PICK ANY JULY PRICE and the same will happen.

II. SHORT HEDGER: Silver miner who wants to deliver silver in July. Risk of price drop. Action Now: Open short futures position 50 K oz @ 4. 508. Case (a) July spot price = $4. 60 July: sell silver @ 4. 60 for 4. 60 * 50000 = + $230, 000 Close Long futures @ 4. 60 (loss) = $4, 600 Total cash flow = + $ 225, 400 unit And 225, 400/50000 = $4. 508 per Note with the futures, the short hedger effectively receives $4. 508. Case (b) July spot price = $4. 30 July: sell silver @ 4. 30 for 4. 30 * 50000 = + $215, 000 Close Long futures @ 4. 30 (gain) = + $ 10, 400 Total cash flow = + $ 225, 400 And again, 225, 400/50000 = $4. 508, per unit.

Introduce basis risk: same example except that the operative month is JUNE (before maturity). Now (Apr) June July |----------------------| Spot = 4. 460 4. 50 could be anywhere July Futures = 4. 508 5. 00 but converges BASIS = -0. 048 = - 0. 50 LONG-HEDGER: Now: Open long futures, 50 K oz @ 4. 508. June: buy silver @ cost of 4. 50 * 50000 = - $225, 000 Close Short futures @ 5. 00 (gain) = $ 24, 600 (0. 492*50000) - $200, 400 Out-of-pocket cost = - $ 200, 400/50000 = $4. 008 Notice that the long hedger effectively pays less than $4. 508 since the futures gained (0. 492) more than the loss from an increase in the spot price (0. 04). Basis was 4. 5 – 5 = 0. 5 and the cost to the hedger is original futures price + basis = 4. 508 – 0. 5 = 4. 008. The hedge was advantageous to the long hedger.

Another way to think of this is that the long hedger was “short” the basis, and the basis got more negative! The short hedger’s perspective is a mirror image. This hedger will effectively receive $4. 008 from selling silver, less than what he would have obtained without the hedge. Note that for the short hedger, the futures trade is open short and close long and this trade loses money. IMP: what started off as a hedge against price risk, ended up becoming exposure to basis risk. Still, basis risk is a lot less volatile than price risk, so hedgers are still better off. Try a case where the June spot price is 5. 00 and the futures price is 4. 80.

HEDGING COMPLICATIONS. 1. 2. 3. 4. Should you hedge at all? Should you hedge the entire amount? Should you hedge to minimize basis risk? Stack and Roll Hedges PRICING? FOR ANOTHER CLASS