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Futures. Chapter 27. Background. Futures traders can take either a Long position Entitles buyer to take delivery of the commodity Short position Obligates seller to make delivery of the commodity If the short seller does not own the commodity they must Buy back the short position, or

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  1. Futures Chapter 27 Chapter 27: Futures

  2. Background • Futures traders can take either a • Long position • Entitles buyer to take delivery of the commodity • Short position • Obligates seller to make delivery of the commodity • If the short seller does not own the commodity they must • Buy back the short position, or • Buy a similar futures contract to deliver to fulfill the short position, or • Buy the underlying commodity to deliver at the appropriate date • Speculators taking a • Long (short) position expect an increase (decrease) in the price of the underlying commodity Chapter 27: Futures

  3. Mechanics of Commodities Trading • Commission brokers (AKA: floor brokers) • Execute trades on the commodity exchanges for people who are not members of the exchange • Locals execute trades only for their accounts • Each commodity is traded in a pit using open outcry method • Specialists are not used to trade commodities Chapter 27: Futures

  4. In The Pits • A different color trading card is used for each commodity • When a transaction occurs, trader records • Price • Delivery month • Quantity Chapter 27: Futures

  5. The Commodity Board • Futures contracts exist with different delivery months • Prices of the contracts are different for each delivery month • A commodity board lists the futures prices of each delivery month Traders watch the commodity board to get a feel for the direction of the market. Chapter 27: Futures

  6. Price Fluctuation Limits • Minimum price fluctuations (ticks) are set on futures contracts • Typical tick size (depends on commodity) is a fraction of one penny • For bushel of grain • Per ounce of gold • Maximum daily price fluctuations (limit moves) are set • Prevents potentially destabilizing price changes • May be several cents above (below) the day’s opening price • Reported on the commodity board Chapter 27: Futures

  7. Price Fluctuation Limits • If a limit move occurs trading is halted and cannot occur at prices differing from the opening price by more than the daily limit • Some argue that limit moves distort the natural supply/demand movements • Others argue the limits enhance price stability Chapter 27: Futures

  8. Example: Limit Moves • Limit moves rarely halt trading • However, in late 1979 to 1980 the Hunt brothers tried to corner the silver market • Price went from $9/ounce to $35 in 1980 but collapsed to $9/ounce in 1981 • Caused several limit up and limit down moves Chapter 27: Futures

  9. Clearing House Guarantees • Every futures contract is transferred through a clearing house • Becomes the middleman in every transaction • Collect a small fee from each contract and place this money in a guarantee fund • Use this money to guarantee the performance of every transaction • The use of a clearing house allows traders the freedom of not having to check each others credit every time they trade • Makes for a liquid market Chapter 27: Futures

  10. Mechanics of Trading Commodity Futures • Commodity trader opens an account with a commodities broker • Full service brokers • Examples include Merrill Lynch, Pierce, Fenner and Smith, Goldman-Sachs • Discount brokers • Examples include Jack Carl Futures, Lind-Waldlock & Company • Futures contracts are only available in standard quantities (or units) • For example, the Chicago Board of Trade specifies that 100 tons is the unit for one futures contract of soybean meal • A Treasury bond with a $100,000 face value and an 8% coupon rate is the unit for a Treasury bond contract Chapter 27: Futures

  11. Mechanics of Trading Commodity Futures • The trader must specify • Type of position (long or short) • Number of units • Bid or ask price • Desired delivery month • Must either pay cash in advance or pay the initial margin requirement when placing an order • Ranges from 3% to 10% • Remainder of cash is due upon delivery • Few contracts remain open until delivery date Chapter 27: Futures

  12. Mechanics of Trading Commodity Futures • Over 90% of contracts are closed prior to delivery date • Closure occurs by reversing out of the position • A long (short) position is eliminated by taking a similar short (long) position Chapter 27: Futures

  13. Mechanics of Trading Commodity Futures • A trader with a short position typically has alternatives as to • Where to make delivery • Penalties arise if delivery is not made to sanctioned location • When to make delivery • Quality of delivered goods • Cash settlements are allowed for some commodities (such as S&P500 index future) Chapter 27: Futures

  14. Open Interest • Open interest—the amount of outstanding futures contracts • Measures public’s interest in a commodity • When first contract is sold, open interest goes from zero to one • During early months of trading volume increases • More contracts are opened than closed • Rises to a peak approximately halfway through life of contract • As delivery date approaches, those speculators not wanting to take delivery close out their contracts Chapter 27: Futures

  15. Electronic Markets • Have become popular in recent years relative to the open outcry method • Exchanges using electronic markets • Deutsche Terminborse • Sydney Futures Exchange • Cantor Financial Futures Exchange • London International Financial Futures Exchange (LIFFE) Chapter 27: Futures

  16. Regulating Futures • Commodity Futures Trading Commission was established in 1974 • Must approve all futures contracts and changes to existing contracts in the U.S. • To gain approval contract must provide useful economic purpose • Requires continuous availability of current futures prices • Requires disclosure of the size of a trader’s position (once certain levels are exceeded) • Licenses dealers who offer services to public • Deals with complaints Chapter 27: Futures

  17. Regulating Futures • National Futures Association • Formed in 1982 • Purpose was to shift some of CFTCs regulatory responsibility to the futures industry itself • Authorized to monitor trading and take disciplinary action • Jurisdictional turf battles • Other governmental bodies have occasionally asserted jurisdictional rights over futures trading • Concerned about impact of futures trading on spot markets for different securities, including stocks, T-bills, T-bonds Chapter 27: Futures

  18. Prices and Pricing Relationships • A normal market exists when • A commodity’s futures price is greater than the spot price by an amount sufficient to cover carrying charges for storage • Induces profit-seekers to buy commodities when prices are low (at harvest) and store for later sales (when prices are higher) Chapter 27: Futures

  19. Prices and Pricing Relationships • Basis is the difference between the futures price and the spot price • Basist = futures pricet – spot pricet • When basis is positive (negative) futures prices are at a premium (discount) to spot prices • If basis is negative an inverted market is said to exist Chapter 27: Futures

  20. Price Convergence • Convergence Principle • As a futures contract approaches its expiration date, the futures price will converge with the spot price • Arbitrage opportunities would exist if convergence did not occur • If futures prices exceed spot prices (normal market) • Arbitrage profits could be earned by • Selling a futures contract short • Buying the physical commodity in the spot market • Delivering the commodity to fulfill the maturing futures contract • Short selling would drive the futures price down Chapter 27: Futures

  21. Price Convergence • If futures prices exceed spot prices (normal market) by more than the carrying charges • Arbitrage profits could be earned by • Selling a futures contract short • Buying the physical commodity in the spot market • Delivering the commodity to fulfill the maturing futures contract • Short selling would drive the futures price down • If spot prices exceed futures prices (inverted market) for a storable commodity, arbitrage may be profitable • Buy a futures contract (long) and wait for delivery Chapter 27: Futures

  22. Price Convergence • Convergence occurs because a futures contract becomes a spot contract in the delivery month • Problems arise causing non-convergence • Physical delivery of a good may require shipping costs • Commodities delivered may be of a different quality level than required • Some contract holders may ‘roll-over’ their contracts instead of taking delivery Chapter 27: Futures

  23. Relationship Between Spot and Futures Prices for Storable Commodities • Under normal conditions market prices for storable commodities follow this relationship • Spot pricet + Carrying Costs  Futures pricet • For grains the carrying cost is approximately 3¢ per bushel • Total carrying costs = Monthly carrying costs  number of months inventory is carried • For financial commodities the carrying cost is interest expense for financing a securities inventory Chapter 27: Futures

  24. Relationship Between Spot and Futures Prices for Storable Commodities • Futures prices should not rise above spot price + carrying costs • Carrying costs explain why futures that differ only with respect to delivery dates have different prices • Also explains why prices on separate futures contracts for the same commodity differ • If they have different delivery dates • Futures pricenear future + Carrying cost  # of months difference Futures pricedistant future • If the inequality reversed arbitrageurs would quickly restore it Chapter 27: Futures

  25. One-Period Returns From Futures • One-period rate of return • Ignores commissions, taxes and other transaction costs • Should be deducted to obtain net returns Chapter 27: Futures

  26. Margin Requirements • When trading futures most investors do not pay the full purchase price • Instead, buy on margin • Minimum margin set by exchange and serves as a • Performance bond—helps maintain financial integrity of futures contracts • Down payment for investors wishing to borrow to leverage their position • Control to prevent excessive borrowing • Initial margin requirement for futures range from 3% to 10% • Much lower than the current 50% required for stocks Chapter 27: Futures

  27. Margin Requirements • Futures investor can receive a margin call • When broker demands additional money within a day or two • Restores the trader’s equity to required level when adverse price fluctuations reduce it below required minimum • If investor does not quickly meet minimum margin requirement broker will liquidate the futures contract • Clearing house requires each account be marked to market each trading day Chapter 27: Futures

  28. Marking to the Market Daily • Requires traders be ready to make cash contributions to their account if the contract’s price moves in an adverse direction • However, if price moves favorably, can withdraw excess margin • Elton, Gruber & Rentzler (1989) suggest leaving excess margin in a T-bill • Reduces margin calls and it earns interest Chapter 27: Futures

  29. Hedging • Hedging can reduce or eliminate losses but also reduces gains • Involves offsetting a short (long) position with a similar long (short) position • A perfect hedge occurs when identical offsetting positions exist • Will earn profits of exactly zero Chapter 27: Futures

  30. Buying Hedges • A long position in a futures contract • To protect buyer from a loss due to a price increase • For instance, if a cereal manufacturer believes the price of grain will rise, they may buy a grain future to protect them from an increase in the price of their raw material • Buying the future will guarantee the price they will pay when the goods are delivered Chapter 27: Futures

  31. Selling Hedges • A short position in a futures contract • To protect from a price decline on a good held in inventory • For instance a mortgage banking firm may have an excess inventory of mortgages (that it plans to eventually sell to FNMA or GNMA) • If banker believes interest rates are going to rise, then the value of the mortgage will decline • To protect bank from losses if interest rates rise, take a short position in a T-bond future Chapter 27: Futures

  32. Basis Risks • Basis risk occurs when offsetting long and short positions do not converge to the same market value as delivery date approaches • Quantity risk—if the hedger does not own the same quantity as that specified in the futures contract • Quality risk—the cheapest-to-deliver contract may not be of a sufficient quality to fulfill the contract specifications Chapter 27: Futures

  33. Basis Risks • Location risk—shipping costs and/or delays will be incurred if delivery is accepted at an inconvenient location • Expiration date risk—if hedger needed a commodity in a month in which a futures contract delivery date did not exist, would incur storage costs • For above reasons most hedges are not perfect • Some speculators make a living trading on the basis • Anticipate spreads Chapter 27: Futures

  34. Spreading With Futures • Involves combining long and short positions that are partially offsetting • Calendar spreads • Trader seeks to profit from misaligned far-term futures prices vs. near-term futures prices • Purchase near-term future and sell distant future • If price spread narrows spread will be profitable Chapter 27: Futures

  35. Spreading With Futures • Inter-Commodity Spread • Used to capitalize on mispricings between two commodities • Such as T-bills and Eurodollars • Soybean Crush spread • A relationship exists between the amount of soybean meal and oil produced from a given quantity of soybeans • May use spreads to capitalize on perceived mispricings Chapter 27: Futures

  36. Economic Effects of Hedging & Spreading • Spreading tends to align prices • Maintaining the basis between spot and futures prices • Supports law of one price • Hedging and spreading can reduce risk • Thus, lower margins are required on hedged positions and spreads Chapter 27: Futures

  37. Theories About Spot & Futures Price Convergence • Competing theories • Normal backwardation • Keynes (1924) and Hicks (1946) argue that futures prices for storable commodities should be slightly less than expected spot prices • Would converge to zero at contract’s delivery date • Contango (AKA: forwardation) • Hardy (1923) argued futures price should be slightly above the expected spot price • Speculators are willing to pay to gamble • Converges to zero as contract approaches delivery date Chapter 27: Futures

  38. Theories About Spot & Futures Price Convergence • Unbiased expectations • Others suggest spot prices should equal futures prices • Futures prices are unbiased estimates of expected spot prices Chapter 27: Futures

  39. Universal Pricing Principle For Forwards and Futures • The Net Present Value (NPV) of an asset is • NPV = Present Value – Purchase Price • A contract’s initial NPV = 0, thus we can solve for the appropriate purchase price of the forward or futures contract Chapter 27: Futures

  40. Includes inventory financing costs, warehousing costs. Universal Pricing Principle For Forwards and Futures • To determine PV need a cash flow and a discount factor • If a contract has three months to maturity and a discount rate of 6%, the discount factor is Chapter 27: Futures

  41. Financial Futures • Financial futures do not incur physical storage costs • Thus, the discount rate is the interest rate on a loan to finance the inventory underlying the contract • Default risk is non-existent in futures contracts (due to clearing house) • Should use risk-free rate as discount rate • The purchase price of a financial future is Chapter 27: Futures

  42. Pricing Futures Contracts on U.S. Treasury Bills • We can use this model to price futures on any original issue discount bond or non-dividend paying stock • Use quasi-arbitrage to price a futures contract • Assume some cash is invested • Create a synthetic position Chapter 27: Futures

  43. A T-Bill Example • An investor wishes to buy a T-bill with the following characteristics • Face value of $1 million • Matures in 180 days • Could either • Directly purchase the T-bill and hold it until it matures • Indirectly purchase a different T-bill by simultaneously • Buying a T-bill at t=0 with 90 days until expiration and a yield of RFR (for a cost of $PV) • Buying (for a cost of F90B/(1+RFR)) a forward contract at t=0 for a 90-day T-bill deliverable in 90 days • The deliverable T-bill will have a face value of $1 million Chapter 27: Futures

  44. A T-Bill Example Both the strategies provide the desired $1 million in 180 days. Thus, according to law of one price, they should have the same purchase price. Chapter 27: Futures

  45. A T-Bill Example • Because of the law of one price, we can equate the purchase price of the two plans • Cost of direct purchase plan  PV = F90B/(1+RFR)  Cost of indirect purchase plan • Suggests that futures price is a function of • Spot and forward prices • Rate of interest Chapter 27: Futures

  46. Economic Forces That Align Prices • If the law of one price is violated economic processes will occur to restore equilibrium • Arbitrage • Buy the cheapest-to-deliver (CTD) • Switching • However, transactions costs may preclude the above • Transaction costs include • Cost of gathering information • Telephone expenses • Postal fees • Brokerage commissions • Taxes • Time and trading effort Chapter 27: Futures

  47. The Cost of Marking-to-the-MarketOn T-Bill Futures • Marking-to-the-market • Forces traders to meet minimum margin requirements daily • Operating cost differences can exist between forward and futures contracts due to marking-to-the-market • Elton, Gruber & Rentzler (1989) estimate the cost of marking a T-bill futures contract to the market to be an average of $4 per contract Chapter 27: Futures

  48. Using a Carrying Cost Model to Price T-Bill Futures • Carrying costs cause a difference in spot and futures prices • For financial futures the only carrying cost is interest expense for financing inventory • Thus, the model for a futures contract on an original issue discount bond is • FPt = SPt (1 + RFR)year Chapter 27: Futures

  49. Example • Last month the National Bank of Dallas bought a futures contract with a 3-month maturity on a $100,000 one-year T-bill • FP = $98,000—delivery price upon maturity of contract with a current price on the underlying T-bill of $96,000 Chapter 27: Futures

  50. Example • What profit can the bank earn by holding the contract to maturity? • $98,000 - $96,000 (1.06)0.25 = $98,000 - $97,408.69 = $591.31 profit in three months • What profit can be earned by selling a forward contract today? • $98,000/1.060.25 - $96,000 = $96,582.76 - $96,000 = $582.76 profit today • Profits are identical because 591.31/1.060.25 = $582.76 Chapter 27: Futures

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