Chapter 19
Principles of the Futures Market
Portfolio Construction, Management, & Protection, 4e, Robert A. Strong
Copyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.
1
As near as I can learn, and from the best information I have been able to
obtain on the Chicago Board of Trade, at least 95% of the sales of that
Board are of this fictitious character, where no property is actually
owned, no property sold or delivered, or expected to be delivered but
simply wagers or bets as to what that property may be worth at a
designated time in the future….wheat and cotton have become as much
gambling tools as chips on the farobank table. The property of the
wheat grower and the cotton grower is treated as though it were a
“stake” put on the gambling table at Monte Carlo. The producer of
wheat is compelled to see the stocks in his barn dealt with like the peas
of thimblerigger, or the cards of a three-card monte man. Between the
grain-producer and loaf eater, there has stepped in a “parasite”
between them rubbing them both.
Senator William D. Washburn (D–Minn), before
Congress, July 11, 1892
2
Outline
 Introduction
 Futures
Contracts
 Market Mechanics
 The Clearing Process
 Principles of Futures Contract Pricing
 Foreign Currency Futures
3
Introduction
 Futures
contracts can lessen price risk for:
• Businesses
• Financial institutions
• Farmers
4
Introduction (cont’d)
 The
two major groups of futures market
participants are:
• Hedgers
• Speculators
5
Futures Contracts
 What
Futures Contracts Are
 Why We Have Futures Contracts
 How to Fulfill the Futures Contract Promise
6
What Futures Contracts Are
 Futures
contracts are promises:
• The futures seller promises to deliver a quantity
of a standardized commodity to a designated
delivery point during the delivery month
• The futures buyer promises to pay a
predetermined price for the goods upon
delivery
7
What Futures
Contracts Are (cont’d)
 With
futures contracts, a trade must occur if
someone holds the contract until its delivery
date
 Most
futures contracts are eliminated before
the delivery month
• The contract obligation can be satisfied by
making an offsetting trade
8
Why We Have
Futures Contracts
 If
suppliers and future buyers of a
commodity could not agree on the future
price of the commodity today:
• There would be added price risk and
• The price to the consumer would be
significantly higher
9
Why We Have
Futures Contracts (cont’d)
 The
basic function of the commodity
futures market is to transfer risk from the
hedger to the speculator
• The speculator assumes the risk because of the
opportunity for profit
10
How to Fulfill the
Futures Contract Promise
 The
futures market would not work if
people could back out of the trade without
fulfilling their promise
• Trades actually become sales to or by the
clearing corporation of the exchange
11
How to Fulfill the Futures
Contract Promise (cont’d)
 Each
exchange has a clearing corporation:
• Ensures the integrity of the futures contract
• Assumes the responsibility for open positions
when a member is in financial distress
• Requires good faith deposits to help ensure the
member’s financial capacity to meet the
obligations
12
Market Mechanics
 The
Marketplace
 Creation of a Contract
 Market Participants
13
The Marketplace
 Commodity
trades are made by open
outcry of the floor traders
• Traders shout their offers to buy or sell
• Traders use hand signals to indicate their
willingness to buy or sell and desired quantities
• Traders are located in the pit
14
The Marketplace (cont’d)
 The
pit:
• Is either octagonal or polygonal
• Contains a raised structure called the pulpit:
– Representatives of the exchange’s market report
department enter all price changes
• Is surrounded by electronic wallboards
reflecting price information
15
The Marketplace (cont’d)
 The
Chicago Board of Trade (CBOT) is the
world’s largest futures exchange:
• Has more than 3,600 members
• Has 1,402 full members
– Have the right to trade in any of the commodities at
the exchange
• Has associate members
– Allowed to trade financial instrument futures and
certain other designated markets
16
The Marketplace (cont’d)

Pit lingo:
• “See through the pit” is a day with little trading activity
• An “Acapulco trade” is an unusually large trade by
someone who normally trades just a few contracts
• Traders who lose all their trading capital have “busted
out” (gone to “Tapioca City”)
• A “fire drill” is a sudden rush of trading activity
without apparent reason
• A big price move is a “lights-out” move
17
Creation of a Contract
 Buyers
and sellers fill out cards to record
their trades
• One side of the card is blue (buy trades)
• One side of the card is read (sell trades)
• Each commodity has a symbol
– e.g., “US” means Treasury bonds
18
Creation of a Contract (cont’d)
 Buyers
and sellers fill out cards to record
their trades (cont’d)
• Each delivery month has a letter code
– e.g., “U” means September
• Letters identify time blocks at which the trade
occurred
– e.g., “A” is the first thirty minutes of trading
19
Creation of a Contract (cont’d)
 Example
of a trading card (see next slide):
• Dan Hennebry buys:
– Five September Treasury bonds
– From trader ZZZ working for firm OOO
– At a price of 77 31/32 of par
– In the first thirty minutes of trading
20
Creation of a Contract (cont’d)
21
Market Participants
 Hedgers
 Speculators
 Scalpers
22
Hedgers
 A hedger
is someone engaged in some type
of business activity with an unacceptable
level of price risk
• E.g., a farmer’s welfare depends on the price of
the crop at harvest
– The farmer wants to transfer the price risk to a
speculator using the futures market
– The farmer cannot eliminate the risk of a poor crop
through futures
23
Hedgers (cont’d)
 Hedgers
normally go short in agricultural
futures
• A short hedge
– e.g., the farmer promises to deliver
 Hedgers
sometimes go long
• A long hedge
– e.g., a manufacturer of college class rings wants to
lock in the price of gold
24
Speculators
 Speculators:
• Have no economic activity requiring the use of
futures contracts
• Find attractive investment opportunities in the
futures market
• Hope to make a profit rather than protecting
one
25
Speculators (cont’d)
 Speculators
normally go long
• Speculating on price increases
 It
is possible for speculators to go short
• Speculating on price declines
26
Speculators (cont’d)
 Speculators
are either day traders or
position traders:
• Day traders close out all their positions before
trading closes for the day
• Position traders:
– Routinely maintain futures positions overnight
– Sometimes keep a contract open for weeks
27
Scalpers
 Scalpers:
• Are really speculators
• Trade for their own account
• Make a living by buying and selling contracts
in the pit
28
Scalpers (cont’d)
 Scalpers
(cont’d):
• May buy and sell the same contract many times
during a single trading day
• Contribute to the liquidity of the futures market
• Are also called locals
29
The Clearing Process
 Introduction
 Matching
Trades
 Accounting Supervision
 Intramarket Settlement
 Settlement Prices
 Delivery
30
Introduction
 The
clearing process performs the following
functions:
• Matching trades
• Supervising the accounting for performance
bonds
• Handling intramarket settlements
• Establishing settlement prices
• Providing for delivery
31
Matching Trades

All traders are responsible for ensuring that their
card decks are entered into the clearing process
 The
clearing corporation:
• Receives the members’ trading cards
• Edits and checks the information on the cards by
computer
• Returns cards with missing information to the clearing
member for correction
32
Matching Trades (cont’d)
 Unmatched
trades are called outtrades:
• Result in an Unmatched Trade Notice being
sent to the affected members
• Regardless of the reason for the Notice, it is the
trader’s individual responsibility to resolve the
error
• Outtrade clerks (employed by the exchange)
assist in the process of reconciling trades
33
Matching Trades (cont’d)
 Examples
of outtrades:
• A price out means two traders wrote down
different prices for a given trade
• A house out means the trading card lists an
incorrect member firm
• A quantity out occurs when the number of
contracts is in dispute
34
Matching Trades (cont’d)
 Examples
of outtrades (cont’d):
• A strike out occurs when the striking price is in
dispute
• A time out occurs when the delivery month is in
dispute
• A side out occurs when both parties marked
either buy or sell
35
Accounting Supervision
 Performance
bonds deposited by member
firms remain with the clearing corporation
until the member either:
• Closes out her position by making an offsetting
trade or
• Closes out her position by delivery of the
commodity
36
Accounting
Supervision (cont’d)
 When
successful delivery occurs:
• Good faith deposits are returned to both parties
• Payment for the commodity is received from
the buyer and remitted to the seller
• The warehouse receipt for the goods is
delivered to the buyer
37
Accounting
Supervision (cont’d)
 Futures
contracts are marked to market
every day
• Can create accounting problems
38
Accounting
Supervision (cont’d)
 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
• Published by the clearinghouse in the financial
pages on a daily basis
39
Intramarket Settlement
 Commodity
prices may move so much in a
single day that good faith deposits for
members are eroded before the day ends
• May result in a market variation call:
– A call on members to deposit more funds into their
accounts during the day
40
Settlement Prices
 Settlement
prices:
• Are analogous to the closing price on the stock
exchanges
• Are normally an average of the high and low
prices during the last minute or so of trading
• Are established by the clearing corporation
41
Settlement Prices (cont’d)
 Many
commodity futures prices are
constrained by a daily price limit:
• The price of a contract is not allowed to move
by more than a predetermined amount each
trading day
• Commodities may be up the limit or down the
limit when big price moves occur
– Trading will stop for the day once a limit move has
occurred
42
Delivery
 A seller
who wishes to deliver fills out a
Notice of Intention to Deliver with the
clearing corporation
• Indicates the intention of delivering the
commodity on the next business day
 Delivery
can occur any time during the
delivery month
43
Delivery (cont’d)

First notice day is the first business day prior to
the first day of the delivery month

Position day is the day prior to first notice day
• Long position members must submit a Long Position
Report
 On
intention day, the clearing corporation may
assign delivery to the member with the oldest long
position in the particular commodity
44
Delivery (cont’d)
 Speculators
tend to move out of the market
a few days prior to first notice day
45
Principles of
Futures Contract Pricing
 Expectations
Hypothesis
 Normal Backwardation
 Full Carrying Charge Market
 Reconciling the Three Theories
46
Expectations Hypothesis
 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
 One of the major functions of the futures
market is price discovery:
• The market’s consensus about likely future
prices for a commodity
47
Normal Backwardation
 Normal
backwardation:
• Is attributed to John Maynard Keynes
• Argues that the futures price is a downwardbiased estimate of the future cash price
– The hedger essentially buys insurance
– The speculator must be rewarded for taking the risk
the hedger was unwilling to bear
48
Full Carrying Charge Market
 A full
carrying charge market is one
where the prices for successive delivery
months reflect the cost of holding the
commodity
• The futures price (FP) is equal to the current
cash price (CP) plus the carrying charges (c)
until the delivery month:
FP = CP + c
49
Full Carrying
Charge Market (cont’d)
 Basis
is the difference between the futures
price and the current cash price:
• In a contango market, the futures price is
greater than the cash price
• In an inverted market, the cash price is greater
than the futures price
50
Full Carrying
Charge Market (cont’d)
 Basis
is the difference between the futures
price and the current cash price (cont’d):
• If the gap between the futures price and the
cash price narrows, the basis strengthens
• If the gap between the futures price and the
cash price widens, the basis weakens
51
Full Carrying
Charge Market (cont’d)
 The
basis is often very close to the carrying
costs between the two points in time
• Arbitrage would be possible if this were not the
case
– Exists if someone can buy a commodity, store it at a
known rate, and get someone to promise to buy it
later at a price that exceeds the cost of storage
52
Reconciling the Three Theories

The three theories are compatible:
• The expectations hypothesis says that a futures price is
the expected cash price at the delivery date
• A full carrying charge market adds costs of carry to the
cash price to determine the futures price
• Normal backwardation says that hedgers are willing to
take a price less than the actual expected future cash
price
53
Foreign Currency Futures
 Hedging
and Speculating with Foreign
Currency Futures
 Pricing of Foreign Exchange Futures
Contracts
54
Hedging and Speculating with
Foreign Currency Futures
 Goods
and services traded between
countries must be valued in a currency
 Relative
exchange rates fluctuate daily due
to changes in:
• The world political situation
• International interest rates
• Inflationary fears
55
Hedging and Speculating with
Foreign Currency Futures (cont’d)
 U.S.
importers purchasing goods
denominated in a foreign currency engage
in two transactions:
• Buying the foreign currency
• Paying for the imported goods
56
Hedging and Speculating with
Foreign Currency Futures (cont’d)
 If
the currency appreciates, the gain in the
futures market offsets the higher cost of the
currency
 If
the currency depreciates, the lower cost in
the cash market is offset by a loss in the
futures market
57
Pricing of Foreign
Exchange Futures Contracts
 The
cost of holding a currency is an
opportunity cost measured by differences in
the interest rates prevailing in the two
countries
• Interest rate parity states that securities with
similar characteristics should differ in price by
an amount equal to (but opposite in sign from)
the difference between national interest rates in
the two countries
58
Pricing of Foreign Exchange
Futures Contracts (cont’d)
 A basic
model for pricing foreign currency
futures contracts:
days to delivery 

Pf  spot rate  1  ( I ed  I lc ) 

365

where Pf  futures price
I ed  Eurodollar rate
I lc  local currency rate
59
Pricing of Foreign Exchange
Futures Contracts (cont’d)
Example
Interest rates are 6 percent in Europe, and the prevailing
eurodollar deposit rate is 7.5 percent. The current dollar
price for a euro is $0.90.
For how much should a 90-day futures contract on euros
sell?
60
Pricing of Foreign Exchange
Futures Contracts (cont’d)
Example (cont’d)
Solution: Using the pricing model for foreign currency
futures:
days to delivery 

Pf  spot rate  1  ( I ed  I lc ) 

365

90 

 $0.90  1  (0.075  0.06) 
365 

 $0.90 1.004
 $0.903
61