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Jim Chatterton. The Futures Market. An agreement between two parties Seller of underlying (short) Buyer of underlying (long) Quantity of underlying, price per unit, date and method of delivery all determined Profit and loss is determined by daily movement of price of contract

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what s a futures contract

An agreement between two parties

    • Seller of underlying (short)
    • Buyer of underlying (long)
  • Quantity of underlying, price per unit, date and method of delivery all determined
  • Profit and loss is determined by daily movement of price of contract
    • Increase: seller looses and buyer profits
    • Decrease: seller profits and buyer looses
What’s a Futures Contract?
futures contracts cont

If the contract is carried to expiry, the underlying must be delivered

  • This is not usually the case
    • Contracts are usually settled prior to expiry
    • Long will sell, Short will buy
  • When a futures contract expires the cash and futures prices converge
Futures Contracts (cont.)
hedging vs speculating

Hedger

    • Sells to secure current price to protect against price decline
    • Buys to secure current price to protect against price increase
  • Speculating
    • Sells to secure current price in anticipation of declining price
    • Buys to secure current price in anticipation of increasing price
Hedging vs. Speculating
hedging

Soybean Farmer

Sell Hedge – Declining Price

Current Futures Price: 980 Cash Price at T: 850

Futures Price at T: 870

Sale Price: 850

Profit on Futures: 110

Relative Sale Price: 960

Hedging
hedging1

Soy Product Manufacturer

Buy Hedge – Declining Price

Current Futures Price:980Cash Price at T: 850

Futures Price at T: 870

Purchase Price: 850

Loss on Futures: 110

Relative Purchase Price: 960

Hedging
hedging2

Sell Hedge – Rising Price

Current Futures Price:980Cash Price at T: 1210 Futures Price at T: 1225

Sale Price: 1210

Loss on Futures: 245

Relative Sale Price: 965

Hedging
hedging3

Buy Hedge – Rising Price

Current Futures Price:980 Cash Price at T: 1210

Futures Price at T: 1225

Purchase Price: 1210

Profit on Futures: 245

Relative Purchase Price: 965

Hedging
pricing futures

Price when asset is in plentiful supply

    • F(t) = S(t)er(T-t) (Rational Pricing)
    • The underlying price discounted at risk free rate
  • Expectation Pricing
    • F(t) = Et {S(T)} (unbiased expectation)
    • Determined by supply and demand
Pricing Futures
margin

Acts as collateral

Margin rates: 5-10 % (can vary)

Used to pay for loss over the time of the contract

Maintenance - adverse change in position results in additional margin

At expiry all margin is returned

Margin
leverage

Controlling large cash amounts with small capital

  • Initial margin small compared to dollar value of the asset being traded
  • Example
    • Soybeans at 980 cents per bushel for 5000 bushels
    • Controlling $49,000 with a margin of $4900
    • An increase to 1210 brings the dollar amount to $60,500
    • That is $11,500 profit while only investing $4900
Leverage
how is a contract traded

Buyers and Sellers

    • Standardized contracts
  • Broker
    • Execute the trade through the exchange
  • Clearing Houses
    • Third Party to the buyers and sellers
    • Require margin
    • Take on defaults to control risk
How is a Contract Traded?
futures vs forwards

Forwards are not standardized

  • No cost to enter into a forward contract
  • Payoffs
    • Long: fT= ST – K
    • Short: fT= K – ST
    • K is price of asset agreed on at the start
    • ST is the forward price
  • This payoff is only realized at expiry
    • It could be a huge loss or gain
    • Creates much larger credit risk
Futures vs. Forwards
frequently traded futures

Financials

    • Indexes (S&P 500)
    • Government debt (Treasury Bonds)
    • Currencies
    • Short term interest Rates (Eurodollars)
  • Commodities
    • Agriculture (soybeans, wheat, meats)
    • Energy (oil, power)
    • Metal (gold, copper)
Frequently Traded Futures
sources

Schwager, Jack D. A Complete Guide to the Futures Market. New York: John Wiley & Sons, 1984.

Kaufman, Perry J. Handbook of Futures Markets. New York: John Wiley & Sons, 1984.

http://en.wikipedia.org/wiki/Futures_contract

http://en.wikipedia.org/wiki/Forward_contract

http://www.cmegroup.com/

http://www.investopedia.com/university/futures/default.asp

Sources