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Chapter 8
Fundamentals of the Futures Market
© 2002 South-Western Publishing

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Outline
 The concept of futures contracts
 Market mechanics
 Market participants
 The clearing process
 Principles of futures contract pricing
 Spreading with commodity futures

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The Concept of Futures
Contracts
 Introduction
 The futures promise
 Why we have futures contracts
 Ensuring the promise is kept

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Introduction
 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

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The Futures Promise
 Introduction
 Futures compared to options
 Futures compared to forwards
 Futures regulation
 Trading mechanics

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Introduction
 A futures contract is a legally binding agreement to buy or sell something in the future

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Introduction (cont’d)
 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

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Futures Compared to Options
 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

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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
– Most forward contracts involve foreign currency

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Futures Compared to Forwards
(cont’d)
 Forwards are different from futures because:
–
–
–
Forwards are not marketable
 Once a firm enters into a forward contract there is no convenient way to trade out of it
Forwards are not marked to market
 The two parties exchange assets at the agreed upon date with no intervening cash flows
Futures are standardized, forwards are customized

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Futures Regulation
 In 1974, Congress passed the Commodity
Exchange Act establishing the Commodity
Futures Trading Commission (CFTC)
– Ensures a fair futures market

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Futures Regulation (cont’d)
 A self-regulatory organization, the National
Futures Association was formed in 1982
– Enforces financial and membership requirements and provides customer protection and grievance procedures

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Trading Mechanics
 Most futures contracts are eliminated before the delivery month
– 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

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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.

Trading Mechanics (cont’d)
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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.

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Why We Have Futures
Contracts
 Futures contracts allow buyers and manufacturers to lock into prices and costs, respectively
– 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 )

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Ensuring the Promise is Kept
 The Clearing Corporation ensures that contracts are fulfilled
–
–
Becomes party to every trade
Ensures the integrity of the futures contract
– Assumes responsibility for those positions when a member is in financial distress

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Ensuring the Promise is Kept
(cont’d)
 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

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Ensuring the Promise is Kept
(cont’d)
Selected Good Faith Deposit Requirements
Contract
Data as of 21 January 2001
Size Value
Soybeans 5,000 bushels $23,837
Initial Margin per Contract
$700
Gold 100 troy ounces $26,640 $1,350
Treasury Bonds
S&P 500 Index
Heating Oil
$100,000 par
$250 x index
42,000 gallons
$103,188
$339,625
$36,918
$1,735
$23,438
$4,050

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Market Mechanics
 Types of orders
 Ambience of the marketplace
 Creation of a contract

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Types of Orders
 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

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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
– E.g., sell five December soybeans at 540, good until canceled

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Types of Orders (cont’d)
 A stop order becomes a market order when the stop price is touched during trading action
– 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

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Ambience of the Marketplace
 Trades occur by open outcry of the floor traders
– 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

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Ambience of the Marketplace
(cont’d)
 The perimeter of the exchange is lined with hundreds of order desks, where telecommunications personnel from member firms receive orders from clients

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Ambience of the Marketplace
(cont’d)
 Jargon
–
–
–
“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

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Ambience of the Marketplace
(cont’d)

Jargon (cont’d)
–
–
–
“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

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Creation of a Contract
 Two traders confirm their trade verbally and with hand signals
 Each of them fills out a card
– 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

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Creation of a Contract (cont’d)
 At the conclusion of trading, traders submit their cards (their deck ) to their clearinghouse

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Market Participants
 Hedgers
 Processors
 Speculators
 Scalpers

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Hedgers
 A hedger is someone engaged in a business activity where there is an unacceptable level of price risk
– E.g., a farmer can lock into the price he will receive for his soybean crop by selling futures contracts

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Processors
 A processor earns his living by transforming certain commodities into another form
–
–
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

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Speculators
 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

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Speculators (cont’d)
 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

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Scalpers
 Scalpers are individuals who trade for their own account, making a living by buying and selling contracts
– Also called locals
 Scalpers help keep prices continuous and accurate

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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

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The Clearing Process
 Matching trades
 Accounting supervision
 Intramarket settlement
 Settlement prices
 Delivery

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Matching Trades
 Every trade must be cleared by or through a member firm of the Board of Trade Clearing
Corporation
– An independent organization with its own officers and rules

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Matching Trades (cont’d)
 Each trader is responsible for making sure his deck promptly enters the clearing process
– Scalpers normally use only one clearinghouse
– Brokers typically submit their cards periodically while trading

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Matching Trades (cont’d)
 After the Clearing Corporation receives trading cards
– 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

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Matching Trades (cont’d)
 Mismatches ( out trades ) result in an
Unmatched Trade Notice being sent to each clearing member
–
–
–
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

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Matching Trades (cont’d)
 After resolving all out trades, the computer prints a daily Trade Register
– Shows a complete record of each clearing member’s trades for the day
– Contains subsidiary accounts for each customer clearing through the firm

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Accounting Supervision
 The accounting problem is formidable because futures contracts are marked to market every day
– Open interest is a measure of how many futures contracts in a given commodity exist at a particular time
 Different from trading volume since a single futures contract might be traded often during its life

Account Supervision (cont’d)
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Delivery
Jul 2000
Aug 2000
Sep 2000
Nov 2000
Jan 2001
Mar 2001
May 2001
July 2001
Nov 2001
Volume vs Open Interest for Soybean Futures
June 16, 2000
Open
5144
5070
4980
5020
5110
5204
5240
5290
5380
High
5144
5074
4994
5042
5130
5204
5270
5330
5400
Low
5040
5004
4950
4994
5084
5160
5230
5280
5330
Settle
5046
5012
4960
5006
5100
5180
5230
5290
5330
Change
-52
4
44
56
54
54
44
40
30
Volum e
32004
7889
3960
22629
1005
1015
15
53
37
Open
46746
19480
15487
62655
6305
4987
6202
4187
1371

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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
– The president of the Clearing Corporation may issue a market variation call for members to deposit more funds into their account

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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
– 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:
– First Notice Day
–
–
Position Day
Intention Day
 Several reports are associated with delivery:
–
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Notice of Intention to Deliver
Long Position Report

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Principles of Futures Contract
Pricing
 The expectations hypothesis
 Normal backwardation
 A full carrying charge market
 Reconciling the three theories

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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
– Price discovery is an important function performed by futures
 There is considerable evidence that the expectations hypothesis is a good predictor

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Normal Backwardation
 Basis is the difference between the future price of a commodity and the current cash price
– Normally, the futures price exceeds the cash price ( contango market)
– The futures price may be less than the cash price ( backwardation or inverted market )

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Normal Backwardation (cont’d)
 John Maynard Keynes:
– 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

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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

S t

C

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A Full Carrying Charge Market
(cont’d)
 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

Reconciling the Three Theories
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 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

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Spreading with Commodity
Futures
 Intercommodity spreads
 Intracommodity spreads
 Why spread in the first place?

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Intercommodity Spreads
 An intercommodity spread is a long and short position in two related commodities
– 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

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Intercommodity Spreads
(cont’d)
 With an intermarket spread , a speculator takes opposite positions in two different markets
– E.g., trades on both the Chicago Board of Trade and on the Kansas City Board of Trade

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Intracommodity Spreads
 An intracommodity spread ( intermonth spread ) involves taking different positions in different delivery months, but in the same commodity
– E.g., a speculator bullish on what might buy
September and sell December

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Why Spread in the First Place?
 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