Chapter 15
Commodities and
Financial Futures
1
Commodities and Financial Futures
• Learning Goals
1. Describe the essential features of a futures contract
and explain how the futures market operates.
2. Explain the role that hedgers and speculators play in
the futures market, including how profits are made
and lost.
3. Describe the commodities segment of the futures
market and the basic characteristics of these
investment vehicles.
2
Commodities and Financial Futures
• Learning Goals (cont’d)
4. Discuss the trading strategies investors can use with
commodities, and explain how investment returns
are measured.
5. Explain the difference between a physical commodity
and a financial future, and discuss the growing role of
financial futures in the market today.
6. Discuss the trading techniques that can be used with
financial futures, and note how these securities can
be used in conjunction with other investment vehicles.
3
The Futures Market
• Cash Market: a market where a product or
commodity changes hands in exchange for a
cash price paid when the transaction is
completed
• Futures Market: the organized market for the
trading of futures contracts
• Futures Contract: a commitment to deliver a
certain amount of some specified item at some
specified date in the future
4
Table 15.1
Futures Contract Dimensions
5
Characteristics of Futures
Contracts
• Transaction will not be completed until some agreedupon date in the future
• Delivery date and quantity are all set when the financial
future is created
• Seller has legally binding obligation to make delivery on
specified date
• Buyer/holder has legally binding obligation to take
delivery on specified date
• Futures may be held until delivery date or traded on
futures market
• All trading is done on a margin basis
6
Advantages of
Using Futures Contracts
• Potential for very high returns
• Margin buying allows use of leverage
– Leverage: the ability to obtain a given equity position
at a reduced capital investment, thereby magnifying
total return
• Allows producers to hedge prices
– Don’t have to sell crops at harvest time when prices
are often low
• Commodities can provide an inflation hedge
7
Disadvantages of
Using Futures Contracts
• High risk of losing more than amount
originally invested; no limit on exposure
to loss
• Involves considerable amount
of speculation
• Requires specialized investor skills
and patience
8
Options versus Futures
Contracts
Options
• Right to buy
• Strike price specified
in option contract
• Loss limited to price
paid for option
Futures
• Obligation to buy
• Delivery price set by
supply and demand
• No limit on
potential loss
9
Futures Exchanges
• Chicago Board of Trade (CBT) began in 1848
• More than a dozen U.S. commodities exchanges
– Chicago Mercantile Exchange (CME) is largest
– Chicago Board of Trade and New York Mercantile
also active
– 95% of U.S. commodities trade on these
three exchanges
• Most U.S. exchanges use “open cry auction”
• European exchanges are rapidly growing and
using more electronic technology
10
Players in the Futures Markets
• Hedgers
– Producers and processors
– Protecting their interests in underlying commodity or
financial instrument
– Provide the actual products being sold
• Speculators
– Investors
– Trying to earn profit on expected swings in prices of
futures contracts
– Provide liquidity
11
Trading Mechanics
• Contracts are easily traded on futures markets
• Bought and sold through brokerage offices
• Same types of orders are used as stocks
– Market
– Limit
• Long position—buying a contract
– Investor wants contract price to go up
• Short position—selling a contract
– Investor wants contract price to go down
• Long and short positions can be liquidated by executing
an offsetting transaction
– About 1% of futures contracts are settled by delivery
12
Margin Trading
• All futures contracts are traded on margin
• No borrowing is required
• Initial margin deposit
– Amount deposited with broker at time of commodity transaction
to cover any loss in market value of futures contract due to
price movements
– Margin requirements range from 2% to 10%
• Maintenance deposit
– Minimum amount of deposit required at all times
– Margin call occurs if value drops below allowed amount
• Mark-to-the-market occurs daily
13
Table 15.3
Major Classes of Commodities
14
Components of Commodity
Contract
• Type of product
• Exchange where contract is traded
• Size of contract (in bushels, pounds, tons)
• Method of valuing contract (e.g., cents per
pound, dollars per ton)
• Delivery month
• Open Interest: the number of contracts currently
outstanding on a commodity or financial future
15
Factors in Commodity Price
Behavior
• Weather and crop forecasts
• Economic factors
• Political factors
• International pressures
• Settle Price: the closing price (last price
of the day) for commodities and
financial futures
16
Commodity Price Behavior
• Prices change daily
• Changes can be sizable
• Because of leverage, small unit price changes can cause
large total dollar changes in contract price
• To protect investors, daily price change limits are set:
– Daily price limit: restriction on the day-to-day change in price
– Maximum daily price range: the amount a commodity price can
change during the day; usually equal to twice the daily price limit
17
Components
of a Commodities Contract
18
Return on Invested Capital
• Commodities allow use of leverage for
potentially high returns
• Return to investors is based upon amount
of money actually invested
Return on invested capital 
Selling price of
Purchase price of

commodity contract
commodity contract
Amount of margin deposit
19
Trading Strategies with
Commodities
• Speculating
– Capitalizing on wide swings that are characteristic of
many commodities
• Spreading
– Used by producers and processors to protect a position in a
product or commodity
– Producer or grower attempts to hedge as high a price
as possible
– Processor or manufacturer attempts to hedge as low
a price as possible
– No limit to the amount of loss that can occur with a
futures contract
20
Financial Futures
• Financial Futures: future contract in which the
commodity is a financial asset, such as debt
securities, foreign currencies or market baskets
of common stocks
• Often used by large institutional investors to
hedge specific types of risk:
– Offset interest rate risk on debt instruments
– Minimize foreign currency rate risk on overseas
business transactions
– Minimize market risk on common stock investments
21
Examples of Financial Futures:
Foreign Currency
• Examples of Currency Futures
– British pound
– Swiss franc
– Canadian dollar
– Japanese yen
– Euro
– Other currencies
22
Examples of Financial Futures:
Interest Rates
• Examples of Interest Rate Futures
– U.S. Treasury securities
– Federal Funds
– Interest rate swaps
– Euromarket deposits
– Foreign government bonds
23
Examples of Financial Futures:
Stock-Indexes
• Examples of Stock-Index Futures
– Dow Jones Industrial Average
– S&P 500 Index
– Nasdaq 100 Index
– Russell 2000 Index
24
Financial Futures
Contract Specifications
• Similar to commodities contracts
• Control large sums of underlying
financial instruments
• Have varying delivery dates
• Stock-index futures are settled in cash
rather than underlying stocks of the
specific
stock index.
25
Speculating in Financial Futures
• Allows large quantities of financial instruments to
be controlled through future contract
• Leverage can provide high returns (or losses)
• “Long” positions are used if investor speculates
values will go up
• “Short” positions are used if investor speculates
values will go down
26
Hedging with Financial Futures
• Effective way of protecting stock or other
securities holdings in a declining market
• Stock-index futures used to hedge stock
portfolios
• Interest rate futures used to hedge bond
portfolios
• Foreign currency futures used to hedge
significant exposure to foreign exchange rate
risk
27
Combining Futures and Options
• Futures Options: options that give the
holders the right to buy or sell a single
standardized futures contract for a
specified period of time at a specified
strike price
– A significant advantage that a futures option
has over a futures contract is that the option
limits the buyer’s loss exposure to the price of
the option.
28
Chapter 15 Review
• Learning Goals
1. Describe the essential features of a futures contract
and explain how the futures market operates.
2. Explain the role that hedgers and speculators play in
the futures market, including how profits are made
and lost.
3. Describe the commodities segment of the futures
market and the basic characteristics of these
investment vehicles.
29
Chapter 15 Review (cont’d)
• Learning Goals (cont’d)
4. Discuss the trading strategies investors can use with
commodities, and explain how investment returns
are measured.
5. Explain the difference between a physical commodity
and a financial future, and discuss the growing role of
financial futures in the market today.
6. Discuss the trading techniques that can be used with
financial futures, and note how these securities can
be used in conjunction with other investment
vehicles.
30
Chapter 15
Additional
Chapter Art
31
Figure 15.1
32
Table 15.2 Margin Requirements for
a Sample of Commodities and
Financial Futures
33
Figure 15.2 Quotations on Actively
Traded Commodity Futures Contracts
34
Figure 15.3 Quotations on Selected
Actively Traded Financial Futures
35
Table 15.4 Futures Options: Puts
and Calls on Futures Contracts
36