Forward Contract Basics II Chapter Important The price at which the trade will occur is also determined when the agreement is made This price is known as the forward price 14 One party faces default risk because the other party might have an incentive to default on the contract Futures Contracts To cancel the contract both parties must agree One side might have to make a dollar payment to the other to get the other side to agree to cancel the contract McGraw Hill Irwin Copyright 2009 by The McGraw Hill Companies Inc All rights reserved 14 2 Futures Contract Basics I Futures Contract Basics II A Futures contract is an agreement made today between a buyer and a seller who are obligated to complete a transaction at a date in the future The price at which the trade will occur is determined in the pit or increasingly in the electronic market The buyer and the seller do not know each other No one faces default risk even if the other party has an incentive to default on the contract This price is known as the futures price The negotiation occurs in the fast paced frenzy of a futures pit The Futures Exchange where the contract is traded guarantees each trade no default is possible The terms of a futures contract are standardized What to trade Where to trade When to trade How much to trade what quality of good to trade all standardized under the terms of the futures contract To cancel the contract an offsetting trade is made either in the pit or in the electronic market The trader of a futures contract may experience a gain or a loss 14 3 Organized Futures Exchanges Established in 1848 the Chicago Board of Trade CBOT was the first organized futures exchange in the United States Other Major Exchanges include Early in their history these exchanges only traded contracts in storable agricultural commodities i e soybeans corn wheat Agricultural futures contracts are still important to organized futures exchanges During 2007 there were several important events for organized futures exchanges Financial Futures Financial futures are also important to organized futures exchanges Some important milestones Currency futures trading 1972 Gold futures trading 1974 Actually on December 31 1974 The very day that ownership of gold by U S citizens was legalized U S Treasury bill futures 1976 U S Treasury bond futures 1977 Eurodollar futures 1981 Stock Index futures 1982 New York Mercantile Exchange 1872 Chicago Mercantile Exchange 1874 14 4 The IntercontinetalExchange ICE purchased the New York Board of Trade NYBOT The Chicago Mercantile Exchange CME and the Chicago Board of Trade CBOT merged and are now The CME Group Inc Today financial futures are so successful that they constitute the bulk of all futures trading 14 5 14 6 Futures Contracts Basics Why Futures In general futures contracts must stipulate at least the following five terms A futures contract represents a zero sum game between a buyer and a seller Gains realized by the buyer are offset by losses realized by the seller and vice versa The futures exchanges keep track of the gains and losses every day The identity of the underlying commodity or financial instrument The futures contract size The futures maturity date also called the expiration date The delivery or settlement procedure The futures price Futures contracts are used for hedging and speculation Hedging and speculating are complementary activities Hedgers shift price risk to speculators Speculators absorb price risk 14 7 Speculating with Futures Long 14 8 Example I Speculating in Gold Futures You believe the price of gold will go up So You go long 100 futures contracts that expire in 3 months The futures price today is 800 per ounce There are 100 ounces of gold in each futures contract Buying a futures contract today is often referred to as going long or establishing a long position Recall Each futures contract has an expiration date Your position value is 800 100 100 8 000 000 Every day before expiration a new futures price is established Suppose your belief is correct and the price of gold is 820 when the futures contract expires If this new price is higher than the previous day s price the holder of a long futures contract position profits from this futures price increase Your position value is now 820 100 100 8 200 000 Your long speculation has resulted in a gain of 200 000 If this new price is lower than the previous day s price the holder of a long futures contract position loses from this futures price decrease 14 9 Speculating with Futures Short 14 10 Example II Speculating in Gold Futures You believe the price of gold will go down So You go short 100 futures contracts that expire in 3 months The futures price today is 800 per ounce There are 100 ounces of gold in each futures contract Selling a futures contract today is often called going short or establishing a short position Recall Each futures contract has an expiration date Your position value is 800 100 100 8 000 000 Every day before expiration a new futures price is established Suppose your belief is correct and the price of gold is 770 when the futures contract expires If this new price is higher than the previous day s price the holder of a short futures contract position loses from this futures price increase Your position value is now 770 100 100 7 700 000 Your short speculation has resulted in a gain of 300 000 If this new price is lower than the previous day s price the holder of a short futures contract position profits from this futures price decrease 14 11 14 12 Example Short Hedging with Futures Contracts Hedging with Futures Short Hedge Suppose Starbucks has an inventory of about 950 000 pounds of coffee valued at 1 47 per pound A company has a large inventory that will be sold at a future date Starbucks fears that the price of coffee will fall in the short run and wants to protect the value of its inventory So the company will suffer losses if the value of the inventory falls How best to do this You know the following There is a coffee futures contract at the New York Board of Trade Each contract is for 37 500 pounds of coffee Suppose the company wants to protect the value of their inventory 25 futures contracts covers 937 500 pounds 26 futures contracts covers 975 000 pounds Selling futures contracts today offsets potential declines in the value of the inventory The act of selling futures contracts to protect from falling prices is called short hedging Real world decision 14 13 Example Short Hedging with