Chapter 21 Commodity and Financial Futures Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Commodity and Financial Futures • A formal agreement (contract) for –the delivery (seller) or –receipt (buyer) of a commodity • Participants in futures markets are either –speculators or –hedgers Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Positions • Speculators buy or sell contracts in anticipation of price changes • The long position anticipates price increases • The short position anticipates price decreases Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Futures Contracts • Contracts establish a futures price • The current (spot) price may be –lower –higher Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Open Interest • Number of contracts in existence Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Closing a Futures Contract • Close a position in a futures contract by entering into the opposite position • A contract to sell "offsets" a contract to buy • A contract to buy "offsets" a contract to sell Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Futures and Leverage • Futures offer large profits and losses • The source of the leverage: the small margin requirement • The margin requirement is a small percentage of the value of the contract Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Margin • Margin: a good faith deposit required of both –the long position and –the short position Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Marking to the Market • Futures positions are "marked to the market" daily • Funds are transferred between accounts • Futures prices are allowed to change only by the "daily limit” Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Maintenance Margin • A second margin requirement • If funds in the account fall below the maintenance margin requirement, the investor receives a "margin call” • Failure to meet the margin call results in the position being closed Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Hedgers • Buy and sell contracts to offset existing positions • Are growers and other users of commodities • Wish to reduce the risk of loss from price fluctuations Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Hedgers • Pass the risk of loss to the speculators • Take the opposite positions of the speculators • Forego the possibility of a large return to obtain future price certainty Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Non-Commodity Futures • Financial futures –contracts for the future delivery of a financial asset • Currency futures –contracts for the future delivery of a currency Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Stock Index Futures • Based on an index of stock prices • Speculators buy and sell stock index futures in anticipation of changes in stock prices • Portfolio managers use stock index futures to hedge against movements in stock prices Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Programmed Trading • Combines – stock index futures and – computer's ability to enter large numbers of buy and sell orders • Takes advantage of small differences in – stock index futures prices and – prices of the underlying stock Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Programmed Trading • The process of programmed trading Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Futures Pricing • Futures prices generally exceed spot prices • The current futures price may reveal the consensus concerning anticipated prices in the future Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Swap Agreements • A "swap" agreement –a contract in which the two parties trade payments Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Currency Swap • In a currency swap, the two parties –agree to trade payments in different currencies –helps manage exchange rate risk Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Other Swap Agreements • In an alternative type of swap, one party trades a fixed payment for a variable payment • The “counter party” swaps the variable payment for the fixed payment • The swap helps management reduce the risk from changes in interest rates Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Equity Swap • Two parties swap payments based on an index of stock prices • Swap payments are made based on the extent that the price indices differ Copyright © 2003 South-Western/Thomson Learning. All rights reserved.