Futures markets •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 difference in futures –Secondary trading - liquidity –Marked to market –Standardized contract units –Clearinghouse warrants performance Futures and Forwards •Futures price - agreed-upon price at maturity •Long position - agree to purchase •Short position - agree to sell •Profits on positions at maturity –Long = spot minus original futures price –Short = original futures price minus spot Key Terms for Futures Contracts Figure 22.1 Futures Listings bod30611_2201 •The trader holding the long position –Purchase the good, profits from price increases •Short position loss is equal to long position profit • •Profit to long = Spot price at maturity – Original future price •Profit to short = Original future price – Spot price at maturity •Zero sum game Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts bod30611_2202 Figure 22.3 CBOT Trading Volume in Futures Contracts bod30611_2203 Existing Contracts •Variety of goods in 4 great categories –Agricultural commodities, metals and minerals, foreign currencies, financial futures • •Electricity or weather futures and option contracts •Prediction market •Forward market in foreign exchange – Table 22.1 Sample of Future Contracts bod30611_t2201 •Eurex •Globex •Clearinghouse - acts as a party to all buyers and sellers. –Obligated to deliver or supply delivery •Position = zero •Closing out positions –Reversing the trade –Take or make delivery –Most trades are reversed and do not involve actual delivery •Open Interest Trading Mechanics Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse bod30611_2204 •Total profit or loss by long trader –Ft – F0 •Short trader earn –F0 - Ft •Initial Margin - funds deposited to provide capital to absorb losses •Marking to Market - each day the profits or losses from the new futures price are reflected in the account. •Maintenance or variation margin - an established value below which a trader’s margin may not fall. Margin and Trading Arrangements •Margin call - when the maintenance margin is reached, broker will ask for additional margin funds •Convergence of Price - as maturity approaches the spot and futures price converge •Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement •Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets Margin and Trading Arrangements Cash versus Actual Delivery •Most contracts call for delivery of an actual commodity –Quality can vary •Higher or lower grade commodities •Some contracts call for cash settlement –St- F0 •Speculation - –short - believe price will fall –long - believe price will rise •Hedging - –long hedge - protecting against a rise in price –short hedge - protecting against a fall in price Trading Strategies Futures market Strategies •Hedging and speculations •Speculators –Lower transaction costs –Leverage •Margin not value of the asset underlying the contract Futures market Strategies •Hedgers –Insulate against price movements •Not possible for some goods –Future contract is not traded •Cross hedging Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15) bod30611_2205 •Basis - the difference between the futures price and the spot price –over time the basis will likely change and will eventually converge –On the maturity date of a contract, the basis must be zero •Basis Risk - the variability in the basis that will affect profits and/or hedging performance •Calendar spread Basis and Basis Risk •Spot-futures parity theorem - two ways to acquire an asset for some date in the future •Purchase it now and store it •Take a long position in futures •These two strategies must have the same market determined costs Futures Pricing Spot-Futures Parity Theorem •With a perfect hedge the futures payoff is certain -- there is no risk •A perfect hedge should return the riskless rate of return •This relationship can be used to develop futures pricing relationship Rate of Return for the Hedge General Spot-Futures Parity Rearranging terms Arbitrage Possibilities •If spot-futures parity is not observed, then arbitrage is possible •If the futures price is too high, short the futures and acquire the stock by borrowing the money at the riskfree rate •If the futures price is too low, go long futures, short the stock and invest the proceeds at the riskfree rate Future Market Arbitraga • Spread •Relation between future prices of contracts of different maturity days –Futures price is in part determined by time to maturity –If rf > d Figure 22.6 S&P 500 Monthly Dividend Yield bod30611_2206 Spread Pricing: Parity for Spreads Figure 22.7 Gold Futures Prices bod30611_2207 Theories of Futures Prices •Expectations •Normal Backwardation •Contango Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged bod30611_2208