Chapter 8
Fundamentals of
the Futures Market
1
© 2004 South-Western Publishing
Outline


The concept of futures contracts
Market mechanics
http://www.pbs.org/itvs/openoutcry/thepit.html

Market participants
The clearing process
Principles of futures contract pricing

http://www.cme.com/

http://www.cbot.com

https://www.theice.com/clear_canada.jhtml


2
/
Introduction

3
A futures contract is a legally binding
agreement to buy or sell something in the
future
Futures Compared to Options



4
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


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
–
5
Most forward contracts involve foreign currency
Futures Regulation

In 1974, Congress passed the Commodity
Exchange Act establishing the Commodity
Futures Trading Commission (CFTC)
–
6
Ensures a fair futures market
Futures Regulation (cont’d)

A self-regulatory organization, the National
Futures Association was formed in 1982
–
7
Enforces financial and membership
requirements and provides customer protection
and grievance procedures
Trading Mechanics

Most futures contracts are eliminated
before the delivery month
–
–
8
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
Market Participants




9
Hedgers
Processors
Speculators
Scalpers
Delivery


Delivery can occur anytime during the
delivery month
Several days are of importance:
–
–
–

Several reports are associated with
delivery:
–
10
First Notice Day
Position Day
Intention Day
–
Notice of Intention to Deliver
Long Position Report
Principles of Futures Contract
Pricing



11
The expectations hypothesis
Normal backwardation
A full carrying charge market
The 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
–

12
Price discovery is an important function
performed by futures
There is considerable evidence that the
expectations hypothesis is a good predictor
Normal Backwardation

Basis is the difference between the future
price of a commodity and the current cash
price
–
–
13
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:
–
–

14
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
15
A Full Carrying Charge Market
(cont’d)
16

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

In a full carrying charge market, the basis
cannot weaken because that would produce
an arbitrage situation