CHAPTER TWENTY
FUTURES
FUTURES CONTRACTS
WHAT ARE FUTURES?
• Definition: an agreement between two investors under which the seller promises to deliver a specific asset on a specific
future date to the buyer for a
predetermined price to be paid on the
delivery date
FUTURES CONTRACTS
ASSETS INVOLVED IN FUTURES TRADING
• agricultural goods (wheat, corn, etc.)
• natural resources (oil, natural gas, etc.)
• foreign currencies (pounds, marks, etc.)
• fixed-income securities (T-bonds, etc.)
• market indices (S+P 500, Value Line, etc.)
HEDGERS AND SPECULATORS
MARKET PARTICIPANTS
• HEDGERS are traders who buy or sell to offset a risk exposure in the spot market
• for example, a U.S. exporter will be paid in
30 days in a foreign currency
HEDGERS AND SPECULATORS
MARKET PARTICIPANTS
• SPECULATORS are traders who buy or sell futures contracts for the potential of
arbitrage profits
THE FUTURES MARKET
WHAT DISTINGUISHES IT FROM STOCK AND OPTIONS MARKETS?
• there are no specialists or market-makers
• members are floor traders or locals
(“scalpers”) who execute orders for personal accounts
• open outcry mechanism
verbal announcement of trading price in the pitTHE FUTURES MARKET
THE CLEARINGHOUSE
• FUNCTIONS:
provide orderly and stable meeting place for buyers and sellers
prevents losses from defaults• Procedures
imposes initial and daily maintenance margins
marks to market dailyTHE FUTURES MARKET
THE CLEARINGHOUSE
• INITIAL MARGIN
the performance margin that represents a security deposit intended to quarantee the buyer and the seller will be able to fulfill their obligations
set at the amount roughly equal to the price limit times the size of the contractTHE FUTURES MARKET
THE CLEARINGHOUSE
• MAINTENANCE MARGIN
investor keeps the account’s equity equal to or greater than a certain percentage
if not met, margin call is issued to the buyer and seller
variation margin– represents the additional deposit of cash that brings the equity up to the margin
THE FUTURES MARKET
MARKING TO MARKET
• DEFINITION: the process of adjusting the
equity in an investor’s account in order to
reflect the change in the settlement price
of the futures contract
THE FUTURES MARKET
• Process
each day the clearinghouse replaces the existing contracts with new ones
the purchase price = the settlement price that day
the amount of the investor’s equity may change dailyTHE FUTURES MARKET
MARKING TO MARKET
• Price Limits
exchanges impose dollar limits on the extent to which futures prices may vary (to avoid excess volatility)
Reasoning behind limits: The Exchangesbelieve futures traders may overreact to major news stories
BASIS
WHAT IS THE BASIS?
• DEFINITION: basis is the current spot price minus the current futures contract price
• Current spot price is the price of the asset for immediate delivery
• the current futures contract price is the
purchase price of the contract in the market
BASIS
SPECULATING ON THE BASIS
• Basis risk
the risk that the basis will narrow or widen• speculating on the basis means an investor will want to be either
short in the futures contract and long in the spot market, or
long in the futures contract and short in theFUTURES PRICES AND FUTURE SPOT PRICES
CERTAINTY
• futures price forecasts have no certainty because if so
the purchase price would equal the spot
the purchase price would not change as delivery neared
no margin would be needed to protect against unexpected adverse price movementsFUTURES PRICES AND FUTURE SPOT PRICES
UNCERTAINTY
• How are futures prices related to expected spot prices?
EXPECTATION HYPOTHESIS– the current futures purchase price equals the consensus expectation of the future spot price
P
f= P
swhere Pf is the current purchase price of the futures
FUTURES PRICES AND FUTURE SPOT PRICES
NORMAL BACKWARDATION
• KEYNES: criticized the expectation hypothesis and stated that
hedgers will want to be short futures
this entices speculators to go long in the futures markets
to do this hedgers make the expected return from a long position greater that the risk free rateFUTURES PRICES AND FUTURE SPOT PRICES
NORMAL BACKWARDATION
• which can be written
P
f< P
s•
this relationship known as normal backwardation•
which impliesP
f can be expected to rise during the life of the futures contractFUTURES PRICES AND FUTURE SPOT PRICES
NORMAL CONTANGO
•
a contrary hypothesis to Keynes•
states that on balance hedgers want to go long in the futures and entice speculators to be short in the futures•
to do this hedgers makeP
f> P
s• this implies that
P
f can be expected to fall during itsFUTURES PRICES AND FUTURE SPOT PRICES
NORMAL BACKWARDATION AND CONTANGO
P
SP
fFUTUTES PRICES AND CURRENT SPOT PRICES
AT WHAT PRICE SHOULD FUTURES CONTRACTS SELL?
P
f= P
s+ I where
P
f=
futures contract priceP
s=
current spot asset priceI =
the dollar amount of interest corresponding to the periodFUTUTES PRICES AND CURRENT SPOT PRICES
• Benefits of ownership
What if there are benefits that accrue to owner of the asset, thenP
f= P
s+ I - B
where B is the benefit
FUTUTES PRICES AND CURRENT SPOT PRICES
COST OF OWNERSHIP
• What if there are costs that accrue due to owning the asset?
P
f= P
s+ I - B + C
where C is the cost of owning
FUTUTES PRICES AND CURRENT SPOT PRICES
