Chapter 21 Principles of the Futures Market

1
Chapter 21Principles of the Futures Market
2

• As near as I can learn, and from the best
  information I have been able to obtain on the
  Chicago Board of Trade, at least 95 of the sales
  of that Board are of this fictitious character,
  where no property is actually owned, no property
  sold or delivered, r expected to be delivered but
  simply wagers or bets as to what that property
  may be worth at a designated time in the
  future.wheat and cotton have become as much
  gambling tools as chips on the farobank table.
• - Senator William D. Washburn

3
Outline

• Introduction
• Futures contracts
• Market mechanics
• The clearing process
• Principles of futures contract pricing
• Foreign currency futures

4
Introduction

• Futures contracts can lessen price risk for
• Businesses
• Financial institutions
• Farmers

5
Introduction (contd)

• The two major groups of futures market
  participants are
• Hedgers
• Speculators

6
Futures Contracts

• What futures contracts are
• Why we have futures contracts
• How to fulfill the futures contract promise

7
What Futures Contracts Are

• Futures contracts are promises
• The futures seller promises to deliver a quantity
  of a standardized commodity to a designated
  delivery point during the delivery month
• The futures buyer promises to pay a predetermined
  price for the goods upon delivery

8
What Futures Contracts Are (contd)

• With futures contracts, a trade must occur if
  someone holds the contract until its delivery
  date
• Most futures contracts are eliminated before the
  delivery month
• The contract obligation can be satisfied by
  making an offsetting trade
• Only 2 of futures contracts actually result in
  delivery

9
Why We Have Futures Contracts

• If suppliers and future buyers of a commodity
  could not agree on the future price of the
  commodity today
• There would be added price risk and
• The price to the consumer would be significantly
  higher

10
Why We Have Futures Contracts (contd)

• The basic function of the commodity futures
  market is to transfer risk from the hedger to the
  speculator
• The speculator assumes the risk because of the
  opportunity for profit

11
How to Fulfill the Futures Contract Promise

• The futures market would not work if people could
  back out of the trade without fulfilling their
  promise
• Trades actually become sales to or by the
  clearing corporation of the exchange

12
How to Fulfill the Futures Contract Promise
(contd)

• Each exchange has a clearing corporation
• Ensures the integrity of the futures contract
• Assumes the responsibility for those position
  when a member is in financial distress
• Requires good faith deposits to help ensure the
  members financial capacity to meet the
  obligations

13
Market Mechanics

• The marketplace
• Creation of a contract
• Market participants

14
The Marketplace

• Commodity trades are made by open outcry of the
  floor traders
• Traders shout their offers to buy or sell
• Traders use hand signals to indicate their
  willingness to buy or sell and desired quantities
• Traders are located in the pit

15
The Marketplace (contd)

• The pit
• Is either octagonal or polygonal
• Contains a raised structure called the pulpit
• Representatives of the exchanges market report
  department enter all price changes
• Is surrounded by electronic wallboards reflecting
  price information

16
The Marketplace (contd)

• Pit lingo
• See through the pit is a day with little
  trading activity
• An Acapulco trade is an unusually large trade
• Traders who lose all their trading capital have
  busted out (gone to Tapioca City)
• A fire drill is a sudden rush of trading
  activity without apparent reason
• A big price move is a lights-out move

17
The Marketplace (contd)

• The Chicago Board of Trade (CBOT) is the worlds
  largest futures exchange
• Has more than 3,600 members
• Has 1,402 full members
• Have the right to trade in any of the commodities
  at the exchange
• Has associate members
• Allowed to trade financial instrument futures and
  certain other designated markets

18
Creation of A Contract

• Buyers and sellers fill out cards to record their
  trades
• One side of the card is blue (buy trades)
• One side of the card is read (sell trades)
• Each commodity has a symbol
• E.g., US means Treasury bonds

19
Creation of A Contract (contd)

• Buyers and sellers fill out cards to record their
  trades (contd)
• Each delivery month has a letter code
• E.g., U means September
• Letters identify time blocks at which the trade
  occurred
• E.g., A is the first thirty minutes of trading

20
Creation of A Contract (contd)

• Example of a trading card (see next slide)
• Dan Hennebry buys
• 5 September Treasury bond futures contracts
• From trader ZZZ working for firm OOO
• At a price of 77 31/32 of par
• In the first thirty minutes of trading

21
Creation of A Contract (contd)
22
Market Participants

• Hedgers
• Speculators
• Scalpers

23
Hedgers

• A hedger is someone engaged in some type of
  business activity with an unacceptable level of
  price risk
• E.g., a farmers welfare depends on the price of
  the crop at harvest
• The farmer wants to transfer the price risk to a
  speculator using the futures market
• The farmer cannot eliminate the risk of a poor
  crop through futures

24
Hedgers (contd)

• Hedgers normally go short in agricultural futures
• A short hedge
• E.g., the farmer promises to deliver
• Hedgers sometimes go long
• A long hedge
• E.g., a manufacturer of college class rings wants
  to lock in the price of gold

25
Speculators

• Speculators
• Have no economic activity requiring the use of
  futures contracts
• Find attractive investment opportunities in the
  futures market
• Hope to make a profit rather than protecting one

26
Speculators (contd)

• Speculators normally go long
• Speculating on price increases
• It is possible for speculators to go short
• Speculating on price declines

27
Speculators (contd)

• Speculators are either day traders or position
  traders
• Day traders close out all their positions before
  trading closes for the day
• Position traders
• Routinely maintain futures positions overnight
• Sometimes keep a contract open for weeks

28
Scalpers

• Scalpers
• Are really speculators
• Trade for their own account
• Make a living by buying and selling contracts in
  the pit

29
Scalpers (contd)

• Scalpers (contd)
• May buy and sell the same contract many times
  during a single trading day
• Contribute to the liquidity of the futures market
• Are also called locals

30
The Clearing Process

• Introduction
• Matching trades
• Accounting supervision
• Intramarket settlement
• Settlement prices
• Delivery

31
Introduction

• The clearing process performs the following
  functions
• Matching trades
• Supervising the accounting for performance bonds
• Handling intramarket settlements
• Establishing settlement prices
• Providing for delivery

32
Matching Trades

• All traders are responsible for ensuring that
  their card decks are entered into the clearing
  process
• The clearing corporation
• Receives the members trading cards
• Edits and checks the information on the cards by
  computer
• Returns cards with missing information to the
  clearing member for correction

33
Matching Trades (contd)

• Unmatched trades are called outtrades
• Result in an Unmatched Trade Notice being sent to
  each of the clearing corporation members
• Regardless of the reason for the Notice, it is
  the traders individual responsibility to resolve
  the error
• Outtrade clerks (employed by the exchange) assist
  in the process of reconciling trades

34
Matching Trades (contd)

• Examples of outtrades
• A price out means two traders wrote down
  different prices for a given trade
• A house out means the trading card lists an
  incorrect member firm
• A quantity out occurs when the number of
  contracts is in dispute

35
Matching Trades (contd)

• Examples of outtrades (contd)
• A strike out occurs when the striking price is
  in dispute
• A time out occurs when the delivery month is in
  dispute
• A side out occurs when both parties marked
  either buy or sell

36
Accounting Supervision

• Performance bonds deposited by member firms
  remain with the clearing corporation until the
  member either
• Closes out her position by making an offsetting
  trade or
• Closes out her position by delivery of the
  commodity

37
Accounting Supervision (contd)

• When successful delivery occurs
• Good faith deposits are returned to both parties
• Payment for the commodity is received from the
  buyer and remitted to the seller
• The warehouse receipt for the goods is delivered
  to the buyer

38
Accounting Supervision (contd)

• Futures contracts are marked to market every day
• Can create accounting problems

39
Accounting Supervision (contd)

• Open interest is a measure of how many futures
  contracts in a given commodity exist at a
  particular time
• Increases by one every time two opening
  transactions are matched
• Published by the clearinghouse in the financial
  pages on a daily basis

40
Intramarket Settlement

• Commodity prices may move so much in a single day
  that good faith deposits for members are eroded
  before the day ends
• May result in a market variation call
• A call on members to deposit more funds into
  their accounts during the day

41
Settlement Prices

• Settlement prices
• Are analogous to the closing price on the stock
  exchanges
• Are normally an average of the high and low
  prices during the last minute or so of trading
• Are established by the clearing corporation

42
Settlement Prices (contd)

• Many commodity futures prices are constrained by
  a daily price limit
• The price of a contract is not allowed to move by
  more than a predetermined about each trading day
• Commodities may be up the limit or down the limit
  when big price moves occur
• Trading will stop for the day once a limit move
  has occurred

43
Delivery

• A seller who wishes to deliver fills out a Notice
  of Intention to Deliver with the clearing
  corporation
• Indicates the intention of delivering the
  commodity on the next business day
• Delivery can occur any time during the delivery
  month

44
Delivery (contd)

• First notice day is the first business day prior
  to the first day of the delivery month
• Position day is the day prior to first notice day
• Long position members must submit a Long Position
  Report
• On intention day, the clearing corporation may
  assign delivery to the member with the oldest
  long position in the particular commodity

45
Delivery (contd)

• Speculators tend to move out of the market a few
  days prior to first notice day

46
Principles of Futures Contract Pricing

• Expectations hypothesis
• Normal backwardation
• Full carrying charge market
• Reconciling the three theories

47
Expectations Hypothesis

• The expectations hypothesis states that the
  futures price for a commodity is what the
  marketplace expects the cash price to be when the
  delivery month arrives
• One of the major functions of the futures market
  is price discovery
• The markets consensus about likely future prices
  for a commodity

48
Normal Backwardation

• Normal backwardation
• Is attributed to John Maynard Keynes
• Argues that the futures price is a
  downward-biased estimate of the future cash price
• The hedger essentially buys insurance
• The speculator must be rewarded for taking the
  risk the hedger was unwilling to bear

49
Full Carrying Charge Market

• A full carrying charge market is one where the
  prices for successive delivery months reflect the
  cost of holding the commodity
• The futures price (FP) is equal to the current
  cash price (CP) plus the carrying charges (c)
  until the delivery month
• FP CP c

50
Full Carrying Charge Market (contd)

• Basis is the difference between the futures price
  and the current cash price
• In a contango market, the futures price is
  greater than the cash price
• In an inverted market, the cash price is greater
  than the futures price

51
Full Carrying Charge Market (contd)

• Basis is the difference between the futures price
  and the current cash price (contd)
• If the gap between the futures price and the cash
  price narrows, the basis strengthens
• If the gap between the futures price and the cash
  price widens, the basis weakens

52
Full Carrying Charge Market (contd)

• The basis is often very close to the carrying
  costs between the two points in time
• Arbitrage would be possible if this were not the
  case
• Exists if someone can buy a commodity, store it
  at a known rate, and get someone to promise to
  buy it later at a price that exceeds the cost of
  storage

53
Reconciling the Three Theories

• The three theories are compatible
• The expectations hypothesis says that a futures
  price is the expected cash price at the delivery
  date
• A full carrying charge market adds costs of carry
  to the cash price to determine the futures price
• Normal backwardation says that hedgers are
  willing to take a bid less than the actual
  expected future cash price

54
Foreign Currency Futures

• Hedging and speculating with foreign currency
  futures
• Pricing of foreign exchange futures contracts

55
Hedging and Speculating With Foreign Currency
Futures

• Goods and services traded between countries must
  be valued in a currency
• Relative exchange rates fluctuate daily due to
  changes in
• The world political situation
• International interest rates
• Inflationary fears

56
Hedging and Speculating With Foreign Currency
Futures

• U.S. importers purchasing goods denominated in a
  foreign currency engage in two transactions
• Buying the foreign currency
• Paying for the imported goods

57
Hedging and Speculating With Foreign Currency
Futures

• Foreign currency futures can eliminate the price
  risk
• Go long in foreign currency futures to lock in
  the future price for the foreign currency
• If the currency appreciates, the gain in the
  futures market offsets the higher cost of the
  currency
• If the currency depreciates, the lower cost in
  the cash market is offset by a loss in the
  futures market

58
Pricing of Foreign Exchange Futures Contracts

• The cost of holding a currency is an opportunity
  cost measured by differences in the interest
  rates prevailing in the two countries
• Interest rate parity states that securities with
  similar characteristics should differ in price by
  an amount equal to (but opposite in sign from)
  the difference between national interest rates in
  the two countries

59
Pricing of Foreign Exchange Futures Contracts
(contd)

• A basic model for pricing foreign currency
  futures contracts

60
Pricing of Foreign Exchange Futures Contracts
(contd)

• Example
• Interest rates are 6 percent in Europe, and the
  prevailing eurodollar deposit rate is 7.5
  percent. The current dollar price for a euro is
  0.90.
• For how much should a 90-day futures contract on
  euros sell?

61
Pricing of Foreign Exchange Futures Contracts
(contd)

• Example (contd)
• Solution Using the pricing model for foreign
  currency futures