CHAPTER TWENTY-FIVEFUTURES CONTRACTSSlide 3HEDGERS AND SPECULATORSSlide 5THE FUTURES MARKETSlide 7Slide 8Slide 9Slide 10Slide 11Slide 12BASISSlide 14FUTURES PRICES AND FUTURE SPOT PRICESSlide 16Slide 17Slide 18Slide 19Slide 20FUTURES PRICES AND CURRENT SPOT PRICESFUTUTES PRICES AND CURRENT SPOT PRICESSlide 23Slide 241CHAPTER TWENTY-FIVEFUTURES2FUTURES 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 date3FUTURES 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.)4HEDGERS 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 currency5HEDGERS AND SPECULATORS•MARKET PARTICIPANTS–SPECULATORS are traders who buy or sell futures contracts for the potential of arbitrage profits6THE 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 pit7THE 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 daily8THE FUTURES MARKET•THE CLEARINGHOUSE–INITIAL MARGIN•the performance margin that represents a security deposit intended to guarantee 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 contract9THE 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 margin10THE 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 contract11THE 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 daily12THE 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 Exchanges believe futures traders may overreact to major news stories13BASIS•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 market14BASIS•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 the spot market15FUTURES 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 movements16FUTURES 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 pricePf = Pswhere Pf is the current purchase price of the futures Ps is the expected future spot price at delivery17FUTURES 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 rate18FUTURES PRICES AND FUTURE SPOT PRICES•NORMAL BACKWARDATION–which can be writtenPf < Ps–this relationship known as normal backwardation–which implies Pf can be expected to rise during the life of the futures contract19FUTURES 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 make Pf > Ps–this implies that Pf can be expected to fall during its contract life20FUTURES PRICES AND FUTURE SPOT PRICES•NORMAL BACKWARDATION AND CONTANGOPSPf21FUTURES PRICES AND CURRENT SPOT PRICES•AT WHAT PRICE SHOULD FUTURES CONTRACTS SELL?Pf = Ps + Iwhere Pf= futures contract price Ps= current spot asset price I = the dollar amount of interestcorresponding to the periodof time from present to delivery date22FUTUTES PRICES AND CURRENT SPOT PRICES–Benefits of ownership•What if there are benefits that accrue to owner of the asset, thenPf = Ps + I - Bwhere B is the benefit23FUTUTES PRICES AND CURRENT SPOT PRICES•COST OF OWNERSHIP–What if there are costs that accrue due to owning the asset? Pf = Ps + I - B + Cwhere C is the cost of owning24FUTUTES PRICES AND CURRENT SPOT PRICES•COST OF OWNERSHIP–The Cost of Carry (I-B+C)•the total value of interest less benefits received plus cost of ownership–The Futures Price•can be greater or less than the spot price depending on whether the cost of carry is positive or