Chapter Nineteen
Principles of the Futures Market
KEY POINTS
The futures market is a very misunderstood part of our economic system. Its primary
purpose is enabling hedgers to reduce risk they find unacceptable and transfer it to
someone else (usually a speculator) who is willing to bear it. Speculators do so because
they believe they will earn a profit by taking the risk.
Unlike options, futures contracts are promises. The buyer promises to pay, while the
seller promises to deliver a quantity of the commodity. While a delivery process is
essential to a well-functioning futures market, most futures contracts are eliminated by an
offsetting transaction before the delivery month.
TEACHING CONSIDERATIONS
Ensure that students understand why we have futures markets. You may want to use an
insurance analogy to illustrate risk transfer. People reduce or eliminate risks by buying
insurance, thereby transferring the risk to the insurance company.
The exchanges have excellent videotapes useful in reinforcing basic principles of the
futures market. Several of my favorites are “The Financial Marketplace,” 17 minutes,
Chicago Mercantile Exchange; “The Trading Floor,” Chicago Board of Trade; and “Risk
Management with Listed Options,” Chicago Board Options Exchange. These are
inexpensive (or free to educators); you can find current publication catalogs at the
exchange websites.
ANSWERS TO QUESTIONS
1. The same contract can be traded often. A single contract represents an open interest
of one, but if it is traded five times in one day this is volume of five contracts.
2. It is the delivery option that causes the futures price and the cash price to converge in
the delivery month. The pricing of futures would be less certain if delivery were not
an option.
3. There is disagreement about this. On the one hand they seem to preclude the market
finding a new equilibrium price as quickly as it would like. On the other hand, they
probably reduce panic trading when prices move sharply and provide a time-out so
that trades can be made based on accurate news rather than rumors.
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Chapter Nineteen
Principles of the Futures Market
4. Hedgers are users or producers of a product; their activities are usually considered
less risky than those of the speculator. To the extent this is the case, the lower
margins make sense.
5. If the basis narrows, this means the futures price and the cash price have moved closer
together. This can happen for several reasons, such as the passage of time or a decline
in interest rates or carrying costs. Many hedgers choose to remove their hedge before
the delivery month and deliver the commodity locally. A decline in interest rates or
carrying costs often is of general benefit to the hedger.
6. As in question 1, a given contract can trade more than once. There is no necessary
relationship between open interest and trading volume.
7. The futures exchanges enable the farmer (and other users) to reduce price risk. If they
had to carry the full risk of a bad crop year, they would have to charge a higher price
for their commodity to compensate for the off-years.
8. Is there a hedgeable interest? How many potential users of the product are there?
Would the contract attract speculators? (If it would not attract speculators, it is not
likely to succeed.)
9. There is debate about this, but the open outcry system seems very well suited to the
trading of futures contracts. Computerized trading (such as that at the New Zealand
Futures Exchange and that associated with the new GLOBEX system) is more likely
to replace the marketmaker system than is the specialist system.
10. Lettuce is non-fungible. Even in the grocery store, adjacent heads of lettuce are not
equally desirable to the consumer. It would be difficult to describe adequately the
characteristics of lettuce deliverable against such a contract.
11. There are 5,000 bushels in one contract: a) selling 8 contracts would be less than a
100% hedge, and this is what most hedgers would do; b) selling 10 contracts would be
a 100% hedge, which is also okay; c) selling 12 contracts would be over-hedging,
which is essentially speculating on the two odd contracts.
12. a. a cereal manufacturer
b. a manufacturer of class rings
c. a soybean processor who produces soy oil and soy meal
13. This is because of the cost of carry. If more distant delivery months did not cost more
than the near months, it would not be economic to store goods for future consumption.
This would lead to oversupply short term, which would depress the spot price. Nearterm delivery prices would then again be below far-term delivery month prices.
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Chapter Nineteen
Principles of the Futures Market
14. If someone anticipated receiving foreign currency at a specific point in the future, a
short hedge in which the hedger promised to deliver the foreign currency at a
predetermined price could reduce the foreign exchange risk.
15. Refer to Table 19-3. If the local currency rate (the Japanese rate) rises, the futures
price will decline. So this is not good news to the yen speculator.
ANSWERS TO PROBLEMS
$6.32  $6.305
5000 bushels
x 4 contracts x
 $300
bushel
contract
1.
2. a. The hedger receives no money at the time the hedge is established when using the
futures market.
b.
$6.32
5000 bushels
x 8 contracts x
 $252,800
bushel
contract
3. The futures price is the best estimate of the future cash price according to the
expectations hypothesis.
4. DM 8 million x
contract
 64 contracts
DM 125,000
5. If interest rates rise by 0.5% in Leptonia relative to the US (perhaps because of
inflation fears), Leptons will likely depreciate by 0.5% relative to the US dollar. If
the initial rate is $0.4817/Lepton, the new rate will be $0.4817 x 1.005 = $0.4841
6.
($0.5610  .5600)
DM 125000
x 3 contracts x
 $375 gain
DM
contract
7. If the euros are delivered against the futures contracts there are no cash market
transactions. The hedger went short at $0.5622; this is the realized price when the
euros are delivered. Had the hedge not been used, the realized price would have been
$0.5610. Hedging resulted in a gain of
($0.5622  .5610)
DM 125000
x 8 contracts x
 $1,200 gain
DM
contract
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