Introduction to Futures

1
Introduction to Futures

• Jim Sartwelle, III
• Extension Economist
• Texas AM University
• ANSC 437 February 27, 2003

2
What do you worry about when you own cattle?

• That the price might go down before you can get
  them sold
• You know your breakeven, but you dont really
  know if you can meet it
• How can you manage that risk?
• Forward contract
• Hedging with futures

3
Evolution of Futures and Options Trading

• Futures Industry Association traced its sources
  back to 2000 B.C. in India.
• CBOT asserts that futures trading existed in
  Greco-Roman times.
• Time dealings in fisheries existed in Holland in
  the early 1600s. Their was a famous speculative
  bubble in Dutch tulips in 1634 -37. Active
  trading occurred in Amsterdam in grains, brandy,
  whale oil and coffee.
• 17th century Feudal landowners traded commodity
  futures (rice) in Japan (1697)

4
Modern Development of Futures Market

• Chicago Board of Trade (CBOT) was formed in 1848
  by 82 merchants. Reason To improve Commerce in
  Chicago.
• Forward contracts still left a problem
• heterogeneity default.
• In 1865, the CBOT developed standardized
  contracts first futures-type contracts. October
  13th 1865 - maybe the precise date.

5
What are futures?

• A futures contract is a binding agreement between
  a seller and a buyer to make (seller) and to take
  (buyer) delivery of the underlying commodity at a
  specified future date with agreed upon payment
  terms.
• Very seldom result in the delivery of the
  commodity

6
Futures exchanges provide

• Rules of conduct which traders must follow
• Organized marketplace with established trading
  hours
• Standardized trading/rigid contract specifications

7
Futures exchanges provide

• Focal point for the collection and dissemination
  of information about the commoditys supply and
  demand
• Guaranteed settlement of contractual and
  financial obligations via the exchange
  clearinghouse

8
Contract specifications for cattleEach trades at
the Chicago Mercantile Exchange from 905 am to
100 pm CST

• FEEDER CATTLE
• Months Jan, Mar, Apr, May, Aug, Sep, Oct, Nov
• 50,000 pounds of 700-849 USDA Medium Frame 1
  and Medium and Large Frame 1 steers

• FED CATTLE
• Months Feb, Apr, Jun, Aug, Oct, Dec
• 40,000 pounds of 55 Choice/45 Select live
  steers

9
Contract specifications for cornTrades at the
Chicago Board of Trade from 930 am to 115 pm CST

• Months Dec, Mar, May, Jul, Sep
• 5,000 bushels of USDA 2 Yellow Corn, at par
• USDA 1 Yellow, 1.5 cents/bu above
• USDA 3 Yellow, 1.5 cents/bu below

10
How do you value a futures contract?

• Quantity times current price
• Quantity varies by commodity
• Corn is 5,000 bushels (CBOT)
• Feeder cattle is 50,000 pounds (CME)
• Fed cattle is 40,000 pounds (CME)
• Example, if CME May Feeder Cattle futures price
  is 0.75/lb, value of contract is 37,500
  (50000 0.75)

11
What if the price changes?

• If the next day, the CME May Feeder Cattle
  futures price is 0.76/lb
• The change in value is 500 50000 lbs (0.76 -
  0.75)
• Therefore, if the futures price changes, the
  value of the contract changes, too

12
Impact of a change in value

• The impact depends if you bought the futures
  contract or sold the futures contract
• Futures jargon
• Short position means you sold the futures
• Long position means you bought the futures

13
Impact of a change in value, contd

• If you are in a short position (you sold)
• You benefit from a decrease in value
• If you are in a long position (you bought)
• You benefit from an increase in value
• This is not rocket science. Do not become
  intimidated by futures.

14
Ensuring contract performance

• Basically, the question is If I take a position
  in the futures market and the market moves in the
  wrong direction?
• What if I buy and the market goes down?
• What if I sell and the market goes up?
• Each trader must deposit margin money to ensure
  theyll come up with the loss, usually 5 of
  contract value

15
Remember this about the futures

• Futures is a zero-sum game
• That is, for every nickel that you make, the
  person on the other side of your trade loses a
  nickel
• Accounts are marked to market each day
• Once the closing price for each contract for each
  commodity has been determined, the exchange
  revalues every single contract

16
Why should we worry about futures?

• They allow for hedging
• Hedging is a temporary substitute for a
  transaction that will occur in the future
• Think about the stocker calf breakeven example
• They are a price forecast

17
If futures and options are so popular, why dont
farmers use them?
18
Read more about it

• Exchange websites
• CME www.cme.com
• CBOT www.cbot.com
• Extension publications on futures
• http//trmep.tamu.edu/cg/list.htm
• Texas Risk Management Education Programs
  curriculum guide
• Publications and lesson plans on these topics

19
Next Thursday, March 6

• First part of lecture
• Learn about the basics of using the futures to
  hedge
• Second part of lecture
• Another paper exercise to work through some
  examples