Chapter 8
Fundamentals of
the Futures Market
1
© 2002 South-Western Publishing
Outline
A. The concept of futures contracts
B. Market mechanics
C. Market participants
D. The clearing process
E. Principles of futures contract pricing
F. Hedging
G. Spreading with commodity futures
2
A. The Concept of Futures
Contracts

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3
Introduction
The futures promise
Why we have futures contracts
Ensuring the promise is kept - the role of
the Clearing House
Introduction


4
A futures contract is a legally binding
agreement to buy or sell something in the
future
The ‘futures market’ is represented by both
the exchange traded futures contract and
contracts that are established in what is
know as the ‘over the counter’ or OTC
market.
Introduction (cont’d)
5

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
Introduction
6

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

As with options, the two major market
participants are the hedger and the
speculator
The Futures Promise




7
Futures compared to options
Futures compared to forwards
Futures regulation
Trading mechanics
Futures Compared to Options



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
Forward Markets

Customized or tailored to the the customer
requirements - underlying product and length of
contract
Unregulated - recent events such as the Enron
Corporation bankrupcty and other trading
‘irregularities’ may lead to change
Private market - transaction between two parties
with no details divulged to the public
larger transactions in size

Credit risk is assumed by both parties



9
Futures Compared to Forwards


10

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
– Most forward contracts initially involved foreign
currencies - interbank market
– Forward markets have developed for many
financial instruments and commodities in recent
years
Futures and Forward marketsco-exist
Futures Compared to Forwards
(cont’d)

Forwards are different from futures
because:
–
Forwards are not marketable

–
Forwards are not marked to market

–
11
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
Recent OTC MarketTrading
Events


12
Trading with the former Enron Corporation and
other trading firms are OTC trades where the
financial integrity of the trading activity rests
with the trading firm - the firms need to be well
capitalized and with access to reasonably
priced capital
Downgrading of many trading firms debt
instruments has resulted in much higher capital
costs and to cutbacks in trading operations
Oil & Gas/Energy OTC Activity


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13
Participants include oil & gas producers,
Pipeline companies, gas processors and other
mid-stream players, electricity generators
refiners, etc.
Common element is exposure to forward price
risk
Active OTC risk management as well as usage
of futures exchanges
Futures Regulation

In 1974, Congress passed the Commodity
Exchange Act establishing the Commodity
Futures Trading Commission (CFTC)
–
–
14
Ensures a fair futures market
Performs much the same function with futures
as the SEC does with shares of stock or the
OSC and ASC in Canada.
Futures Regulation (cont’d)

A self-regulatory organization, the National
Futures Association was formed in 1982
–
15
Enforces financial and membership
requirements and provides customer protection
and grievance procedures
Market and Trading Mechanics


The purpose is generally not to provide a
means for the transfer of goods
Most futures contracts are eliminated
before the delivery month
–
–
16
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.
17
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.
18
Why We Have Futures
Contracts


19
Futures contracts allow buyers and
manufacturers/users to lock into prices and
costs, respectively
The commodities futures market allows for
the transfer of risk from one participant to
another - from one hedger to another typically a buyer/user and a seller/producer
of the commodity or between a hedger and
a speculator willing to accept the risk
Transfer of Risk
Risk Transfer
Gas Producer
Gas Producer/
/Gas user
20
Futures
Market
Gas User
Futures
Market
Speculator
Hedging Using Futures
–
–
21
If a firm wants oil/gas, it buys contracts,
promising to pay a set price in the future (long
hedge) or ‘buying forward’
A oil/gas producer sells contracts, promising to
deliver the gas (short hedge) or ‘selling forward’
Ensuring the Promise is Kept


Each exchange has a Clearing Corporation
that ensures the integrity of the futures
contract
The Clearing Corporation ensures that
contracts are fulfilled
–
–
22
Becomes party to every trade
Assumes responsibility for member’s positions
when a member is in financial distress
Ensuring the Promise is Kept
(cont’d)


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23
Strict financial requirements are a condition
of membership on the exchange
NYMEX requires deposits to a guarantee
fund
Margin requirements or ‘Good faith
deposits’ ( 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 21 January 2001
24
Contract
Size
Value
Initial Margin
per Contract
Soybeans
5,000 bushels
$23,837
$700
Gold
100 troy ounces
$26,640
$1,350
Treasury Bonds
$100,000 par
$103,188
$1,735
S&P 500 Index
$250 x index
$339,625
$23,438
Heating Oil
42,000 gallons
$36,918
$4,050
B. Market Mechanics


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25
Types of orders
Ambience of the marketplace
Creation of a contract
Types of Orders
26

A broker in commodity futures is a futures
commission merchant (not the individual
who places the order)

When placing an order, the client should
specify the type of order
Types of Orders (cont’d)

A market order instructs the broker to
execute a client’s order at the best possible
price at the earliest opportunity

With a limit order, the client specifies a time
and a price
–
27
E.g., sell five December soybeans at 540, good
until canceled or good for the day, etc.
Types of Orders (cont’d)

A stop order becomes a market order when
the stop price is touched during trading
action
–
–
–
28
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
The price may not ultimately be the stop price
given that the stop order becomes a market
order
Ambience of the Marketplace

Trades occur by open outcry of the floor
traders
–
–
–
29
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)

30
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)

Jargon
–
–
–
31
“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)

Jargon (cont’d)
–
–
–
32
“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

Two traders confirm their trade verbally and
with hand signals

Each of them fills out a card
–
–
–
33
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)

34
At the conclusion of trading, traders
submit their cards (their deck) to their
clearinghouse
C. Market Participants



Hedgers - long and short positions
Processors
Speculators/traders
–
35
Scalpers
Hedgers

A hedger is someone engaged in a
business activity where there is an
unacceptable level of price risk
–
36
E.g., a farmer can lock into the price he will
receive for his soybean crop by selling futures
contracts
Processors

A processor earns his living by
transforming certain commodities into
another form
–
–
37
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



38
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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39
Speculators may go long or short,
depending on anticipated price movements
A position trader is someone who routinely
maintains futures positions overnight and
sometimes keeps a contract for weeks
A day trader closes out all his positions
before trading closes for the day
Scalpers

Scalpers are individuals who trade for their
own account, making a living by buying and
selling contracts
–

40
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
41
D. The Clearing Process

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42
Matching trades
Accounting supervision
Intramarket settlement
Settlement prices
Delivery
Matching Trades

Every trade must be cleared by or through a
member firm of the Board of Trade Clearing
Corporation (for the CBOT) or other
clearing arms on the other exhcanges
–
43
An independent organization with its own
officers and rules
Matching Trades (cont’d)

Each trader is responsible for making sure
his deck promptly enters the clearing
process
–
–
44
Scalpers normally use only one clearinghouse
Brokers typically submit their cards periodically
while trading
Matching Trades (cont’d)

After the Clearing Corporation receives
trading cards
–
–
–
45
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)

Mismatches (out trades) result in an
Unmatched Trade Notice being sent to each
clearing member
–
–
–
46
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)

After resolving all out trades, the computer
prints a daily Trade Register
–
–
47
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

The accounting problem is formidable
because futures contracts are marked to
market every day - see table 8-5
–
48
Open interest is a measure of how many futures
contracts in a given commodity exist at a
particular time
 Increases by one every time two opening
transactions are matched
 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
49
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

Commodity prices may move so much in a
single day that good faith deposits for
many members are seriously eroded before
the day ends
–
50
The President of the Clearing Corporation may
issue a market variation call for members to
deposit more funds into their account
Settlement Prices



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
–
51
The price of a contract is not allowed to move by more
than a predetermined amount each trading day
Delivery


Delivery can occur anytime during the
delivery month
Several days are of importance:
–
–
–

Several reports are associated with
delivery:
–
52
First Notice Day
Position Day
Intention Day
–
Notice of Intention to Deliver
Long Position Report
E. Principles of Futures
Contract Pricing
Basic concepts & terms
 Spot market or price
 Futures market or price
 Relationship between the spot price and the
futures price
–

53
‘Basis’ is the difference between the spot and
futures price
Relationship between futures prices for
different delivery months –
intracommodity spread
Principles of Futures Pricing

54
Expected future price for
Futures Pricing

Three main theories of futures pricing”
–
–
–
–
55
The expectations hypothesis
A full carrying charge market
Normal backwardation & risk aversion
Reconciling the three theories
The Expectations Hypothesis

The expectations hypothesis states that the
futures price for a commodity is what the
marketplace expects the cash or spot price
to be when the delivery month arrives
–
–
56
the presence of speculators in the marketplace
ensures that the futures price approximates the
expected future cash or spot price - a
divergence creates speculative opportunities
Price discovery is an important function
performed by futures - linked to the
expectations hypothesis
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
This theory suggests the futures price is
equal to the current spot price plus the
carrying charge:
F  St  C
57
Carrying Charge

The Cost of Carry may include:
–
–
–
–
58
storage costs
transportation costs
insurance costs
financing costs
A Full Carrying Charge Market
(cont’d)


59
An Arbitrage opportunity 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 more than covers the
cost of storage
In a full carrying charge market, the basis
cannot weaken because that would produce
an arbitrage situation
Normal Backwardation & Risk
Aversion


Speculators expect to be compensated for
taking on risk
John Maynard Keynes:
–
–
–
60
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
Keynes theory is that speculators typically take
a long position in the futures market and thus
expect futures prices rising over the life of the
contract and converging to the cash price
Normal Backwardation


61
Normally, the futures price exceeds the cash price
and prices for more distant futures are higher than
for nearby futures(contango/normal market)
– futures prices are expected to rise over the life
of the contract
The futures price may be less than the cash
price/distant futures prices are lower than nearby
contracts(backwardation or inverted market)
– futures prices are expected to fall over the life
the contract
The ‘Basis’



One of the most important concepts in the futures
markets......and for the process of hedging
Basis = Spot1 (Cash) Price - Futures Price
Convergence - behaviour of the basis over time.
The basis ‘converges’ to zero at the maturity of the
futures contract (except for transportation/transaction
costs)

The Basis can fluctuate substantially before
maturity
1) cash price at a specific location
62
The ‘Basis’


Spot (Cash) Price = Futures + Basis
Natural gas futures example
Alberta spot gas = NYMEX futures + Basis
–
–
63
if a shift in price results in the same change in
both the cash market as in the futures market then the basis has not changed
however, if the cash price changes more or less
than the futures price, the basis has changed this has implications for the effectivness of a
hedge
The ‘Basis’
Factors affecting the Basis......
 In the case of a commodity like natural gas,
transportation costs to the specified
delivery point of the futures contract Alberta gas has a different basis vs Texas
gas for example
 Local supply/demand factors - e.g. Weather
related
64
Reconciling the Three Theories
65

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

Because the hedger is really obtaining price
insurance with futures, it is logical that there be
some cost to the insurance
F. Hedging - Basic Concepts



66
Hedging is a transaction designed to
reduce /eliminate risk via a transfer of risk.
Forward contracts and futures are used
extensively as part of hedging strategies
Why hedge? Should all risk be eliminated is risk not a part of business?
– Why not let shareholders determine the
level of risk and act/hedge accordingly
Hedging
Corporations enter into hedging transactions
for a number of reasons:
 to create an acceptable combination of
return and risk
 to lock in a return for a given project
 to add stability to the firm’s earnings/cash
flow
–
67
improve the firm’s ability to access capital
markets or borrow money
Hedging


Hedging reduces risk but may not eliminate
it entirely
Eliminates upside opportunties - hedging
reduces both the upside and downside risk
–

68
hedging needs to be selective - ‘indiscriminate
hedging’ does not lead to creation of
shareholder value
Hedging involves ‘taking a position’ concerned about an unfavourable
movement and its impact
Hedging
69
Short Hedge
 offsets or hedges a ‘long’ cash position in a
given commodity e.g. Gas producer
 risk with a long cash position is a decrease
in the price of the gas
 go ‘short’ in the futures market by selling
gas futures
 gains in the futures market offset losses in
the cash market
Hedging
Long hedge
 Offsets a ‘short’ position in the cash market
- e.g a gas consumer
 risk is with increasing prices
 go ‘long’ in the futures market by buying
gas futures contracts
 gains in the futures market offset losses in
the cash market
70
Hedging - How Many Contracts?
71
Hedge ratio - the number of futures contracts to
hold (short or long) for a given position in the
cash or commodity market
 Recognizes that movements in the futures
market will not be identical to movements in
the cash market - the number of futures
contracts needs to take this variance into
consideration
 It should be the one where the futures profit or
loss offsets the cash position profit or loss
Hedging - How Many Contracts
Regression analysis is used to determine the
hedge ratio i.e. The number of futures
contracts to hold to hedge the risk in the cash
market - the ideal ratio is one where the gains
and losses in the two markets exactly offset
each other
R2 = portion or % of the total variance in the cash
price changes statistically related to the futures
prices changes

72
Spreading with Commodity
Futures



73
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
–
–
–
–
74
E.g., a speculator might feel that the price of
corn is too low relative to the price of live cattle
Crack & Spark Spread, Ted Spread etc.
Speculator is anticipating changes in the price
relationship between the two related
commodities
hedger is locking in the margin
Intercommodity Spreads
(cont’d)

With an intermarket spread, a speculator
takes opposite positions in two different
markets for the same commodity
–
–
75
E.g., trades on both the Chicago Board of Trade
and on the Kansas City Board of Trade
arbitrage type activity - speculator is looking for
profit opportunities
Intracommodity Spreads

An intracommodity spread (intermonth
spread) involves taking different positions
in different delivery months, but in the
same commodity
–
76
E.g., a speculator bullish on a commodity might
buy September and sell December contracts
Why Spread in the First Place?



77
Most intracommodity spreads are basis
plays
Intercommodity spreads are close to two
separate speculative positions
(speculation) or to lock in a margin
(hedging)
Intermarket spreads are really arbitrage
plays based on discrepancies in
transportation costs or other administrative
costs