CHAPTER TWENTY

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CHAPTER TWENTY

• FUTURES

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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

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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 (SP 500, Value Line, etc.)

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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

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HEDGERS AND SPECULATORS

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

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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

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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

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THE FUTURES MARKET

• THE CLEARINGHOUSE
• INITIAL MARGIN
• the performance margin that represents a security
  deposit intended to quarantee 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

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THE FUTURES MARKET

• THE CLEARINGHOUSE
• MAINTENANCE MARGIN
• investor keeps the accounts 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

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THE FUTURES MARKET

• MARKING TO MARKET
• DEFINITION the process of adjusting the equity
  in an investors account in order to reflect the
  change in the settlement price of the futures
  contract

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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 investors equity may change
  daily

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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

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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

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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

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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

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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 Ps
• where Pf is the current purchase price of the
  futures
• Ps is the expected future spot price at
  delivery

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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

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FUTURES PRICES AND FUTURE SPOT PRICES

• NORMAL BACKWARDATION
• which can be written
• Pf lt Ps
• this relationship known as normal backwardation
• which implies Pf can be expected to rise during
  the life of the futures contract

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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 gt Ps
• this implies that Pf can be expected to fall
  during its contract life

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FUTURES PRICES AND FUTURE SPOT PRICES

• NORMAL BACKWARDATION AND CONTANGO

Pf
PS
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FUTUTES PRICES AND CURRENT SPOT PRICES

• AT WHAT PRICE SHOULD FUTURES CONTRACTS SELL?
• Pf Ps I
• where
• Pf futures contract price
• Ps current spot asset price
• I the dollar amount of interest
• corresponding to the period
• of time from present to delivery date

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FUTUTES PRICES AND CURRENT SPOT PRICES

• Benefits of ownership
• What if there are benefits that accrue to owner
  of the asset, then
• Pf Ps I - B
• where B is the benefit

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FUTUTES PRICES AND CURRENT SPOT PRICES

• COST OF OWNERSHIP
• What if there are costs that accrue due to owning
  the asset?
• Pf Ps I - B C
• where C is the cost of owning

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FUTUTES PRICES AND CURRENT SPOT PRICES

• COST OF OWNERSHIP
• The Cost of Carry (I-BC)
• 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

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• END OF CHAPTER 20