1

CHAPTER TWENTY-FIVE

FUTURES

2

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

3

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.)

4

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

5

HEDGERS AND SPECULATORS

• MARKET PARTICIPANTS– SPECULATORS are traders who buy or sell

futures contracts for the potential of arbitrage profits

6

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 pit

7

THE 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 daily

8

THE 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 contract

9

THE 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

10

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

11

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 daily

12

THE 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 stories

13

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

14

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 the spot market

15

FUTURES 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 movements

16

FUTURES 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

Pf = Ps

where Pf is the current purchase price of the futures

Ps is the expected future spot price at delivery

17

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 rate

18

FUTURES PRICES AND FUTURE SPOT PRICES

• NORMAL BACKWARDATION– which can be written

Pf < Ps

– this relationship known as normal backwardation

– which implies Pf can be expected to rise during the

life of the futures contract

19

FUTURES 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 life

20

FUTURES PRICES AND FUTURE SPOT PRICES

• NORMAL BACKWARDATION AND CONTANGO

PS

Pf

21

FUTURES 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 date

22

FUTUTES PRICES AND CURRENT SPOT PRICES

– Benefits of ownership• What if there are benefits that accrue to owner of the

asset, then

Pf = Ps + I - B

where B is the benefit

23

FUTUTES PRICES AND CURRENT SPOT PRICES

• COST OF OWNERSHIP– What if there are costs that accrue due to

owning the asset?

Pf = Ps + I - B + C

where C is the cost of owning

24

FUTUTES 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 negative