Chapter 8
Fundamentals of
the Futures Market
1
© 2004 South-Western Publishing
Outline
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2
The concept of futures contracts
Market mechanics
Market participants
The clearing process
Principles of futures contract pricing
Spreading with commodity futures
The Concept of Futures
Contracts
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3
Introduction
The futures promise
Why we have futures contracts
Ensuring the promise is kept
Introduction
4
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The futures market enables various entities
to lessen price risk, the risk of loss because
of uncertainty over the future price of a
commodity or financial asset
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As with options, the two major market
participants are the hedger and the
speculator
The Futures Promise
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5
Introduction
Futures compared to options
Futures compared to forwards
Futures regulation
Trading mechanics
Introduction
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6
A futures contract is a legally binding
agreement to buy or sell something in the
future
Introduction (cont’d)
7
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The person who initially sells the contract
promises to deliver a quantity of a
standardized commodity to a designated
delivery point during the delivery month

The other party to the trade promises to pay
a predetermined price for the goods upon
delivery
Futures Compared to Options
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8
Both involve a predetermined price and
contract duration
The person holding an option has the right,
but not the obligation, to exercise the put
or the call
With futures contracts, a trade must occur
if the contract is held until its delivery
deadline
Futures Compared to Forwards
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A futures contract is more similar to a
forward contract than to an options
contracts
A forward contract is an agreement
between a business and a financial
institution to exchange something at a
set price in the future
–
9
Most forward contracts involve foreign currency
Futures Compared to Forwards
(cont’d)
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Forwards are different from futures
because:
–
Forwards are not marketable

–
Forwards are not marked to market
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Once a firm enters into a forward contract there is no
convenient way to trade out of it
The two parties exchange assets at the agreed upon
date with no intervening cash flows
Futures are standardized, forwards are
customized
Futures Regulation
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In 1974, Congress passed the Commodity
Exchange Act establishing the Commodity
Futures Trading Commission (CFTC)
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11
Ensures a fair futures market
Futures Regulation (cont’d)
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A self-regulatory organization, the National
Futures Association was formed in 1982
–
12
Enforces financial and membership
requirements and provides customer protection
and grievance procedures
Trading Mechanics
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Most futures contracts are eliminated
before the delivery month
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13
The speculator with a long position would sell a
contract, thereby canceling the long position
The hedger with a short position would buy a
contract, thereby canceling the short position
Trading Mechanics (cont’d)
Gain or Loss on Futures Speculation
Suppose a speculator purchases a July soybean
contract at a purchase price of $6.12 per bushel.
The contract is for 5,000 bushels of No. 2 yellow
soybeans at an approved delivery point by the last
business day in July.
14
Trading Mechanics (cont’d)
Gain or Loss on Futures Speculation (cont’d)
Upon delivery, the purchaser of the contract must
pay $6.12(5,000) = $30,600. At the delivery date, the
price for soybeans is $6.16. This equates to a profit
of $6.16 - $6.12 = $0.04 per bushel, or $200.
If the spot price on the delivery date were only
$6.10, the purchaser would lose $6.12 - $6.10 =
$0.02 per bushel, or $100.
15
Why We Have Futures
Contracts
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Futures contracts allow buyers and
manufacturers to lock into prices and
costs, respectively
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If a firm wants gold, it buys contracts, promising
to pay a set price in the future (long hedge)
A gold mining company sells contracts,
promising to deliver the gold (short hedge)
Ensuring the Promise is Kept
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The Clearing Corporation ensures that
contracts are fulfilled
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Becomes party to every trade
Ensures the integrity of the futures contract
Assumes responsibility for those positions
when a member is in financial distress
Ensuring the Promise is Kept
(cont’d)
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18
Good faith deposits (or performance bonds)
are required from every member on every
contract to help ensure that members have
the financial capacity to meet their
obligations
Ensuring the Promise is Kept
(cont’d)
Selected Good Faith Deposit Requirements
Data as of January 2, 2004
19
Contract
Size
Value
Initial Margin
per Contract
Soybeans
5,000 bushels
$39,700
$1,620
Gold
100 troy ounces
$41,600
$2,025
Treasury Bonds
$100,000 par
$108,000
$2,565
S&P 500 Index
$250 x index
$278,500
$20,000
Heating Oil
42,000 gallons
$38,346
$3,375
Market Mechanics
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20
Types of orders
Ambience of the marketplace
Creation of a contract
Types of Orders
21
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A broker in commodity futures is a futures
commission merchant (not the individual
who places the order)
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When placing an order, the client should
specify the type of order
Types of Orders (cont’d)
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A market order instructs the broker to
execute a client’s order at the best possible
price at the earliest opportunity
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With a limit order, the client specifies a time
and a price
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22
E.g., sell five December soybeans at 540, good
until canceled
Types of Orders (cont’d)
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A stop order becomes a market order when
the stop price is touched during trading
action
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When executed, stop orders close out existing
commodity positions
E.g., a short seller may use a stop order to
protect himself against rising commodity prices
Ambience of the Marketplace
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Trades occur by open outcry of the floor
traders
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24
Traders stand in a sunken pit and bark their
offers to buy or sell at certain prices to others
Traders often use hand signals to signal their
wishes concerning quantity, price, etc.
On the pulpit, representatives of the exchange’s
Market Report Department enter all price
changes into the price reporting system
Ambience of the Marketplace
(cont’d)
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The perimeter of the exchange is lined with
hundreds of order desks, where
telecommunications personnel from
member firms receive orders from clients
Ambience of the Marketplace
(cont’d)
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Jargon
–
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26
“See through the pit” means little trading
activity
“Acapulco trade” is an unusually large trade by
someone who normally trades just a few
contracts
“Busted out” or “gone to Tapioca City” means
traders incorrectly assess the market and lose
all their capital
Ambience of the Marketplace
(cont’d)
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Jargon (cont’d)
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27
“Fire drill” is a sudden rush of put activity for no
apparent reason
“Lights out” is a big price move
“O’Hare Spread” refers to traders riding a
winning streak
Creation of a Contract
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Two traders confirm their trade verbally and
with hand signals
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Each of them fills out a card
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One side is blue for recording purchases
One side is red for sales
Each commodity has a symbol, and each
delivery month has a letter code
Creation of a Contract (cont’d)
29
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At the conclusion of trading, traders
submit their cards (their deck) to their
clearinghouse
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In 2003, nearly 7 million futures and options
orders were electronically sent directly to
floor brokers using special order receipts
called electronic clerks
Market Participants
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Hedgers
Processors
Speculators
Scalpers
Hedgers
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A hedger is someone engaged in a
business activity where there is an
unacceptable level of price risk
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31
E.g., a farmer can lock into the price he will
receive for his soybean crop by selling futures
contracts
Processors
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A processor earns his living by
transforming certain commodities into
another form
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Putting on a crush means the processor can
lock in an acceptable profit by appropriate
activities in the futures market
E.g., a soybean processor buys soybeans and
crushes them into soybean meal and oil
Speculators
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33
A speculator finds attractive investment
opportunities in the futures market and
takes positions in futures in the hope of
making a profit (rather than protecting one)
The speculator is willing to bear price risk
The speculator has no economic activity
requiring use of futures contracts
Speculators (cont’d)
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34
Speculators may go long or short,
depending on anticipated price movements
A position trader is someone who routinely
maintains futures positions overnight and
sometimes keep a contract for weeks
A day trader closes out all his positions
before trading closes for the day
Scalpers
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Scalpers are individuals who trade for their
own account, making a living by buying and
selling contracts
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35
Also called locals
Scalpers help keep prices continuous and
accurate
Scalpers (cont’d)
Scalping With Treasury Bond Futures
Trader Hennebry just sold 5 T-bond futures to ZZZ
for 77 31/32. Now, a sell order for 5 T-bond futures
reaches the pit and Hennebry buys them for 77
30/32. Thus, Hennebry just made 1/32 on each of
the 5 contracts, for a dollar profit of
1/32% x $100,000/contract x 5 contracts = $156.25
36
The Clearing Process
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37
Matching trades
Accounting supervision
Intramarket settlement
Settlement prices
Delivery
Matching Trades
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Every trade must be cleared by or through a
member firm of the Board of Trade Clearing
Corporation
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38
An independent organization with its own
officers and rules
Matching Trades (cont’d)
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Each trader is responsible for making sure
his deck promptly enters the clearing
process
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39
Scalpers normally use only one clearinghouse
Brokers typically submit their cards periodically
while trading
Matching Trades (cont’d)
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After the Clearing Corporation receives
trading cards
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40
The information on them is edited and checked
by computer
Cards with missing information are returned to
the clearing member
Once all cards have been edited, the computer
attempts to match cards for all trades that
occurred that day
Matching Trades (cont’d)
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Mismatches (out trades) result in an
Unmatched Trade Notice being sent to each
clearing member
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41
Traders must reconcile their out trades and
arrive at a solution
“House out” means an incorrect member firm is
listed on the trading card
“Quantity out” means the number of contracts is
in dispute
Matching Trades (cont’d)
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After resolving all out trades, the computer
prints a daily Trade Register
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42
Shows a complete record of each clearing
member’s trades for the day
Contains subsidiary accounts for each customer
clearing through the firm
Accounting Supervision
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The accounting problem is formidable
because futures contracts are marked to
market every day
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Open interest is a measure of how many futures
contracts in a given commodity exist at a
particular time
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Different from trading volume since a single futures
contract might be traded often during its life
Account Supervision (cont’d)
Volume vs Open Interest for Soybean Futures
June 16, 2000
44
Delivery
Open
High
Low
Settle
Change
-52
Volum
e
32004
Jul 2000
5144
5144
5040
5046
Aug 2000
5070
5074
5004
Sep 2000
4980
4994
Nov 2000
5020
Jan 2001
Open
46746
5012
4
7889
19480
4950
4960
44
3960
15487
5042
4994
5006
56
22629
62655
5110
5130
5084
5100
54
1005
6305
Mar 2001
5204
5204
5160
5180
54
1015
4987
May 2001
5240
5270
5230
5230
44
15
6202
July 2001
5290
5330
5280
5290
40
53
4187
Nov 2001
5380
5400
5330
5330
30
37
1371
Intramarket Settlement
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Commodity prices may move so much in a
single day that good faith deposits for
many members are seriously eroded before
the day ends
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45
The president of the Clearing Corporation may
issue a market variation call for members to
deposit more funds into their account
Settlement Prices
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The settlement price is analogous to the
closing price on the stock exchanges
The settlement price is normally an average
of the high and low prices during the last
minute of trading
Settlement prices are constrained by a daily
price limit
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46
The price of a contract is not allowed to move by more
than a predetermined amount each trading day
Delivery
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Delivery can occur anytime during the
delivery month
Several days are of importance:
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Several reports are associated with
delivery:
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First Notice Day
Position Day
Intention Day
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Notice of Intention to Deliver
Long Position Report
Principles of Futures Contract
Pricing
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The expectations hypothesis
Normal backwardation
A full carrying charge market
Reconciling the three theories
The Expectations Hypothesis
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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
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49
Price discovery is an important function
performed by futures
There is considerable evidence that the
expectations hypothesis is a good predictor
Normal Backwardation
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Basis is the difference between the future
price of a commodity and the current cash
price
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50
Normally, the futures price exceeds the cash
price (contango market)
The futures price may be less than the cash
price (backwardation or inverted market)
Normal Backwardation (cont’d)

John Maynard Keynes:
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–
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51
Locking in a future price that is acceptable
eliminates price risk for the hedger
The speculator must be rewarded for taking the
risk that the hedger was unwilling to bear
Thus, at delivery, the cash price will likely be
somewhat higher than the price predicated by
the futures market
A Full Carrying Charge Market

A full carrying charge market occurs when
the futures price reflects the cost of storing
and financing the commodity until the
delivery month

The futures price is equal to the current
spot price plus the carrying charge:
F  St  C
52
A Full Carrying Charge Market
(cont’d)
53

Arbitrage exists if someone can buy a
commodity, store it at a known cost, and
get someone to promise to buy it later at a
price that exceeds the cost of storage
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In a full carrying charge market, the basis
cannot weaken because that would produce
an arbitrage situation
Reconciling the Three Theories
54

The expectations hypothesis says that a
futures price is simply the expected cash
price at the delivery date of the futures
contract

People know about storage costs and other
costs of carry (insurance, interest, etc.) and
we would not expect these costs to
surprise the market
Reconciling the Three Theories
(cont’d)

55
Because the hedger is really obtaining price
insurance with futures, it is logical that
there be some cost to the insurance
Spreading with Commodity
Futures
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56
Intercommodity spreads
Intracommodity spreads
Why spread in the first place?
Intercommodity Spreads

An intercommodity spread is a long and
short position in two related commodities
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57
E.g., a speculator might feel that the price of
corn is too low relative to the price of live cattle
Risky because there is no assurance that your
hunch will be correct
Intercommodity Spreads
(cont’d)

With an intermarket spread, a speculator
takes opposite positions in two different
markets
–
58
E.g., trades on both the Chicago Board of Trade
and on the Kansas City Board of Trade
Intracommodity Spreads

An intracommodity spread (intermonth
spread) involves taking different positions
in different delivery months, but in the
same commodity
–
59
E.g., a speculator bullish on what might buy
September and sell December
Why Spread in the First Place?
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60
Most intracommodity spreads are basis
plays
Intercommodity spreads are closer to two
separate speculative positions than to a
spread in the stock option sense
Intermarket spreads are really arbitrage
plays based on discrepancies in
transportation costs or other administrative
costs