Chapter Eight
Fundamentals of the Futures Market
Answers to Problems and Questions
1. Open interest measures the number of futures contracts that exist. One side
of the contract may change hands many times prior to the delivery month.
Each time a trade occurs, this adds to the daily volume in that contract.
Open interest, however, will not change unless the clearinghouse matches
two closing transactions.
2. A major role of the futures exchange is to enable the farmer or other hedger
to reduce price risk by promising to deliver the commodity at a specific
price. The farmer wants to deliver, and it is essential that he or she be able
to do so. It is also the prospect of having to deliver, or to take delivery, that
causes futures prices to converge on the cash price as delivery time
approaches.
3. This point has been debated for many years. The best argument in favor of
them stems from the numerous margin calls that result in a volatile market
where trading is not stopped. For instance, if a market were unregulated,
prices might advance in the morning so much that initial good faith deposits
from short sellers were completely lost. This would result in variation
margin calls that needed to be met within the hour. Yet in the afternoon,
prices might fall precipitously, and generate margin calls for those with
long futures position. It is possible under a scenario like this that the
afternoon settlement price could be the same as the opening price, yet both
sides of the market suffered severe margin calls and inconvenience during
the day.
4. An economic function of the futures exchange is to serve the need of the
hedger. Many small farmers, for instance, do not use the futures market
because of the good faith deposit requirement. A lower initial requirement
for them makes sense because it makes the market available to a greater
number of them, and does so with little risk because they fully intend to
deliver their crop when it is harvested.
5. A hedger always has the option of trading out of the futures position if it
appears advantageous to do so. A narrowing basis probably means that
relative futures prices have declined since the time the hedge was
established. Most hedgers promise to deliver, meaning they are short.
Short sellers benefit when prices decline. It might be possible for some
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Chapter Eight. Fundamentals of the Futures Market
hedger to benefit by taking a profit in the futures maker and remaining
unhedged for the time remaining until the crop is harvested.
6. Commodity spreads involve more than one futures contract, and these
contracts each have a different basis. It is not necessary that the change in
one basis be equal to the change in another. A spreader might buy one
contract and sell one in the same commodity with a more distant delivery
month. If the basis in the near month narrowed and the basis in the far
month widened, this would be to the detriment of the spreader.
7. The consequences of a bad crop price can be disastrous to farmers. One
argument in favor of this statement states that if farmers had to bear the full
risk of bad prices they would have to raise the prices of the current crop so
as to “save for a non-rainy day.” Rising prices would be inflationary, by
definition.
8. The key question is whether there is a hedgeable interest that would benefit
from the presence of the new futures contract. A secondary question is
whether the contract would be able to attract speculators, generally
essential to the success of a futures contract.
9. There would be huge capital requirements associated with a firm that acted
as a specialist in a futures market. A good argument can be made that it is
not desirable to have such responsibility (or power) in the hands of a single
firm. Trading pits spread the risk around, reduce the likelihood of “poor
pricing,” and probably are more conducive to the rapid pace of futures
trading.
10. The principal problem here is delivery. Perishable commodities would be
difficult to standardize during the delivery process. Even two or three days
can significantly alter the appearance and quality of perishable produce. If
quality cannot be guaranteed, it is unlikely such a futures contract would be
successful.
11. Fifty thousand bushels of wheat translates into ten futures contracts if the
farmer chooses to hedge 100% of the crop. Selling eight contracts is the
likely choice of the three mentioned here, because there is always the
possibility that some of the crop will not be suitable for delivery. Selling
ten contracts is a 100% hedge. Selling twelve contracts amounts to
speculation in two contracts, because the anticipated crop will only “cover”
ten of them.
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Chapter Eight. Fundamentals of the Futures Market
12. In corn, a long hedger might be a cereal manufacturer who wants the corn
to process into a breakfast food. In gold, the long hedger might be a
jeweler who needs to quote an end price for custom-made jewelry. In
soybeans, the long hedger might be a processor who makes salad oil.
13. Storage costs are the key. There is an expense associated with keeping
crops in a warehouse. For the same crop year, the current cash price will
always be less than the price for the same crop that is expected to be stored
for a few months.
14. This is a true statement. Studies have shown that speculators generally go
long and are net losers.
15. This format of the price listing reflects dollars, pennies, and eighths of a
dollar per bushel, so the price of 4912 means $4.91 2/8, or $4.9125. Each
contract covers 5,000 bushels. The settlement price shown in the paper is
$4.9600 for an increase of $0.0475 per bushel. On a long position of
20,000 bushels, this amounts to a gain of $950.00.
16. (a) You do not receive any money when you establish a commodity hedge.
Instead, the hedger must put up the good faith deposit.
(b) At delivery, the hedger would receive the agreed-upon price as
specified in the futures contract. With a settlement price of $4.96, the
hedger would receive 8 x 5000 x $4.96 = $198,400 plus the return of
the good faith deposit.
17. Individual response.
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