Finance 300 Financial MarketsChapter VIII – FuturesSlide 3Slide 4Slide 5Slide 6Slide 7Key Terms for Futures ContractsFutures: Trading MechanicsSlide 10Margin and Trading ArrangementsSlide 12Futures Market ParticipantsBasis and Basis RiskMargin Account & Trading ExampleSlide 16Slide 17Slide 18Slide 19Finance 300Financial MarketsLecture 22Professor J. Petry, Fall, 2002©http://www.cba.uiuc.edu/jpetry/Fin_300_fa02/http://webboard.cites.uiuc.edu/2Overview of Futures•Futures are similar in basic concept to Forwards which we reviewed when discussing interest rates•Forward - an agreement calling for a future delivery of an asset at an agreed-upon price•Futures - similar to forward but feature formalized and standardized characteristics•Key differences of Futures compared to Forwards–Secondary trading – liquidity is much higher•Vast majority of contracts are reversed before delivery (99% or so)–Marked to market–Standardized contract units–Clearinghouse guarantees performance•Therefore no default riskChapter VIII – Futures3Overview of Futures•Forwards, followed by futures, were first developed to eliminate the price risk in buying and selling of agricultural commodities for delivery sometime in the future.–Consider the risk that a farmer faces if the price for his only product goes down dramatically during the growing season?–Some years you may benefit from an increase in prices compared to the price when you are first planting your crops, but some years you may lose. –Given that this is likely your only crop, losing on price, could mean losing the farm.–Futures markets allow you to lock in a price months down the road, right now, with a buyer guaranteed. Then all you have to worry about is growing your product.Chapter VIII – Futures4Futures Quotes•Contract Definition: futures on Soybeans, traded on Chicago Board of Trade, each contract is for 5,000 bushels, and prices are cents per bushel. Prices are for future month as indicated and represent the identical product.•Open, Hi, Low: Quote for Nov delivery showed the contract opened at $6.32 on last trading day, reached a high of $6.37750 and a low of $6.3050Chapter VIII – FuturesFutures PricesLifetime OpenOpen Hi Low Settle Change Hi Low InterestSoybeans (CBT) 5,000 bu; cents per bu.Nov 632 637 3/4 630 1/2 637 1/4 +7 757 1/2 555 1/2 8046Jan 640 1/4 647 3/4 640 1/2 646 3/4 +6 1/2 756 576 1/2 69140Mar 647 654 1/4 647 653 1/2 +6 3/4 754 589 3/4 28910May 651 3/4 658 651 657 3/4 +6 751 592 1/2 17739Est vol 70,000; open interest 155,797, +7265Futures Quotes•Lifetime Hi, Low: Indicate full range of prices reached on this future since inception. The price on November (’93) delivery has ranged from $5.555 to $7.575 since trading first opened.•Settle: The representative price over the closing period for the last trading day, as established by the exchange. In this case, the exchange uses the average price of the last two minutes of trading. The settlement is up +7 cents from the day prior at $6.37125 or $31,856.25 per contract.•Open Interest: The number of outstanding contracts as of the close of trading. Open interest generally increases until a month before the contract matures, and then declines rapidly as investors reverse their positions.Chapter VIII – Futures6Chapter VIII – FuturesFutures Contracts Are Available For Many Different ProductsForeign Currencies Agricultural Metals & Energy Interest Rates Equity IndexesBritish pound Corn Copper Eurodollars S&P 500Canadian dollar Oats Aluminum Euroyen Dow Jones IndustrialsJapanese yen Soybeans Gold Euromark S&P MidcapEuro Soybean meal Platinum Eurolira Nasdaq 100Swiss Franc Soybean oil Palladium Euroswiss NYSE indexFrench Franc Wheat Silver Sterling Russell 2000 indexDeutschemark Barley Crude oil British gilt Nikkei 225US dollar index Flaxseed Heating oil German gov't bonds FTSE indexAustralian dollar Canola Gas oil Italian gov't bonds CAC-40Mexican peso Rye Natural gas Canadian gov't bonds DAX-30Brazilian real Cattle Gasoline Treasury bonds All ordinaryHogs Propane Treasury notes Toronto 35Pork bellies CRB index Treasury bills DJ Euro STOXX 50Cocoa Electricity LIBORCoffee EURIBORCotton Municipal bond indexOrange juice Federal funds rateSugar Banker's acceptanceLumberRiceSource: CBOT7Chapter VIII – Futures0501001502002503001976 1980 1984 1988 1992 1996CommoditiesFinancialTotalFutures Trading Volume (CBOT, mlns of contracts)8Key Terms for Futures Contracts•Futures price - agreed-upon price at maturity•Long position - agree to purchase•Short position - agree to sell•Profits on positions at maturityLong = spot minus original futures priceShort = original futures price minus spot9Futures: Trading Mechanics•Closing out positions–Reversing the trade–Take or make delivery–Most trades are reversed and do not involve actual delivery•Clearinghouse - acts as a party to all buyers and sellers.–Obligated to deliver or supply delivery–Eliminates credit risk of transaction10Futures: Trading MechanicsLongPositionLongPositionLongPositionShortPositionClearinghouseMoneyCommodityCommodityCommodityMoney Money11Margin and Trading ArrangementsInitial Margin - funds deposited to provide capital to absorb lossesMarking to Market - each day the profits or losses from the new futures price are reflected in the account.Maintenance or variance margin - an established value below which a trader’s margin may not fall.12Margin and Trading ArrangementsMargin call - when the maintenance margin is reached, broker will ask for additional margin fundsEquity - the equity in your account represents what your broker would return to you if your position was unwound at the closing priceConvergence of Price - as maturity approaches the spot and futures price convergeDelivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement13Futures Market Participants•Hedgers - Interested in insulating against price movement. –long hedge - protecting against a rise in price–short hedge - protecting against a fall in price•Speculators - Interested in profiting from anticipated price movement. –short - believe price will fall–long - believe price will rise–Transactions costs lower and leverage higher than if speculating in actual good or asset14Basis and Basis Risk•Basis - the difference between the futures price and the spot price–over time the basis will likely change and will eventually converge•Basis