Chapter 8
Fundamentals of
the Futures Market
1
© 2004 South-Western Publishing
Outline
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The concept of futures contracts
Market mechanics
Market participants
The clearing process
Principles of futures contract pricing
Spreading with commodity futures
Introduction
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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
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As with options, the two major market
participants are the hedger and the
speculator
Introduction
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A futures contract is a legally binding
agreement to buy or sell something in the
future
Introduction (cont’d)
5
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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
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The other party to the trade promises to pay
a predetermined price for the goods upon
delivery
Futures Compared to Options
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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
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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
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Most forward contracts involve foreign currency
Futures Compared to Forwards
(cont’d)
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Forwards are different from futures
because:
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Forwards are not marketable
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Forwards are not marked to market
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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
Futures Regulation
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In 1974, Congress passed the Commodity
Exchange Act establishing the Commodity
Futures Trading Commission (CFTC)
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Ensures a fair futures market
Futures Regulation (cont’d)
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A self-regulatory organization, the National
Futures Association was formed in 1982
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Enforces financial and membership
requirements and provides customer protection
and grievance procedures
Trading Mechanics
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Most futures contracts are eliminated
before the delivery month
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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
Ensuring the Promise is Kept
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The Clearing Corporation ensures that
contracts are fulfilled
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Becomes party to every trade
Ensures the integrity of the futures contract
Assumes responsibility for those positions
when a member is in financial distress
Ensuring the Promise is Kept
(cont’d)
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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
Ensuring the Promise is Kept
(cont’d)
Selected Good Faith Deposit Requirements
Data as of January 2, 2004
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Contract
Size
Value
Initial Margin
per Contract
Soybeans
5,000 bushels
$39,700
$1,620
Gold
100 troy ounces
$41,600
$2,025
Treasury Bonds
$100,000 par
$108,000
$2,565
S&P 500 Index
$250 x index
$278,500
$20,000
Heating Oil
42,000 gallons
$38,346
$3,375
Market Participants
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Hedgers
Processors
Speculators
Scalpers
Hedgers
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A hedger is someone engaged in a
business activity where there is an
unacceptable level of price risk
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E.g., a farmer can lock into the price he will
receive for his soybean crop by selling futures
contracts
Processors
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A processor earns his living by
transforming certain commodities into
another form
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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
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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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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
Scalpers
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Scalpers are individuals who trade for their
own account, making a living by buying and
selling contracts
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Also called locals
Scalpers help keep prices continuous and
accurate
Delivery
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Delivery can occur anytime during the
delivery month
Several days are of importance:
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Several reports are associated with
delivery:
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First Notice Day
Position Day
Intention Day
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Notice of Intention to Deliver
Long Position Report
Principles of Futures Contract
Pricing
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The expectations hypothesis
Normal backwardation
A full carrying charge market
Reconciling the three theories
The Expectations Hypothesis
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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
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Price discovery is an important function
performed by futures
There is considerable evidence that the
expectations hypothesis is a good predictor
Normal Backwardation
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Basis is the difference between the future
price of a commodity and the current cash
price
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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)
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John Maynard Keynes:
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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
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A full carrying charge market occurs when
the futures price reflects the cost of storing
and financing the commodity until the
delivery month
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The futures price is equal to the current
spot price plus the carrying charge:
F  St  C
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A Full Carrying Charge Market
(cont’d)
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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
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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
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People know about storage costs and other
costs of carry (insurance, interest, etc.) and
we would not expect these costs to
surprise the market
Reconciling the Three Theories
(cont’d)
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Because the hedger is really obtaining price
insurance with futures, it is logical that
there be some cost to the insurance
Spreading with Commodity
Futures
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Intercommodity spreads
Intracommodity spreads
Why spread in the first place?
Intercommodity Spreads
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An intercommodity spread is a long and
short position in two related commodities
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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
Intercommodity Spreads
(cont’d)
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With an intermarket spread, a speculator
takes opposite positions in two different
markets
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E.g., trades on both the Chicago Board of Trade
and on the Kansas City Board of Trade
Intracommodity Spreads
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An intracommodity spread (intermonth
spread) involves taking different positions
in different delivery months, but in the
same commodity
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E.g., a speculator bullish on what might buy
September and sell December
Why Spread in the First Place?
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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