DERIVATIVES – FUTURES MARKETS (CH 22)
Futures → arrangement calling for future delivery of an asset at an agreed-upon price
Futures contract → contract to deliver/take delivery of a commodity in some future month
at a price determined by auction
Convergence → process by which price of futures contract moves toward price of the
underlying cash commodity
THE FUTURES CONTRACT
HOW DO FUTURES & FORWARDS WORK & HOW ARE THEY USEFUL?
Consider the portfolio diversification problem facing a farmer growing a single crop. The
entire planting season’s revenue depends critically on the highly volatile crop price. It’s
difficult for the farmer to diversify her position because all the wealth is tied up in the crop.
A miller faces mirror image risk management problem of the farmer. They are both subject
to possible loss of profits because of price volatility and uncertainty. They can both hedge
their risk through a forward contract.
Note:
- forward contract: deferred-delivery sale of asset with sales price agreed upon now
▪ protects buyer & seller
- futures markets: formalize & standardize forward contracts
- buyers & sellers trade in a centralized futures exchange
- contracts call for a daily settling of any gains or losses on the contract
Difference between forward & futures contract?
- Forward = customised
- Futures = standardised
FUTURES EXCHNAGES
Standardizes the contracts that may be traded.
Disadvantage: standardization eliminates flexibility available in forward contracting
Advantage: liquidity (many traders concentrate on same contracts; help reach correct
trading price quickly)
,Centralized market, standardization of contracts, and depth of trading in each contract
allows futures positions to be liquidated easily.
- deep market → consistently achieves a high volume of trades
▪ volume: amount of trading activity in a contract over a trading day
▪ open interest: number of outstanding contracts at the end of a trading day
Exchanges establish:
- contract size
- acceptable grade of commodity
▪ i.e. for grains or metals
▪ quality specified at contract inception
▪ if quality different at delivery then trader add a premium/discount
- contract delivery dates
- guarantees the performance of each party
FUTURES CONTRACTS (BASICS)
“Calls for delivery of a commodity at a specified delivery or maturity date, for an agreed
upon futures price, to be paid at contract maturity.”
- specifies precise requirements for the commodity (quality, etc.)
- specifies place and means of delivery of the commodity
- @ contract inception → no money changes hands.
- Delivery rarely occurs, most parties close out their positions before maturity, taking
gains or losses in cash.
- The fraction of contracts that result in actual delivery of the underlying asset ranges
from less than 1% to 3%, depending on the commodity and activity in the contract.
Delivery:
- agricultural commodities → transfer of warehouse receipts issued by approved
warehouses
- financial futures → may be made by wire transfer
- index futures → cash settlement procedure
Delivery rarely occurs → usually close out positions before maturity (take gain/loss in cash)
- 1% to 3% of contracts result in actual delivery of the underlying asset
- depends on the commodity and activity in the contract
, EXISITING CONTRACTS
Futures & forward contracts traded on a wide variety of goods divided into the following
broad categories:
1. foreign currencies
2. commodities (agricultural, metals, minerals & energy)
3. financial futures (fixed-income securities & stock market indices)
FUTURES TRADERS
Long position → commits to purchasing the commodity on the delivery date
- buys the contract
- profit to long at maturity = spot price at maturity (PT) – original futures price (F0)
Short position → commits to delivering the commodity at contract maturity
- sells the contract
- profit to short at maturity = original futures price (F0) – spot price at maturity (PT)
At end of each day a process called marking to market occurs
- compare futures price to futures price in contract the day before
▪ prices go up → long trader makes a profit
▪ prices go down → short trader makes a profit
Illustration
Each contract calls for delivery of 5,000 bushels & prices in are quoted in cents per bushel.
Futures → arrangement calling for future delivery of an asset at an agreed-upon price
Futures contract → contract to deliver/take delivery of a commodity in some future month
at a price determined by auction
Convergence → process by which price of futures contract moves toward price of the
underlying cash commodity
THE FUTURES CONTRACT
HOW DO FUTURES & FORWARDS WORK & HOW ARE THEY USEFUL?
Consider the portfolio diversification problem facing a farmer growing a single crop. The
entire planting season’s revenue depends critically on the highly volatile crop price. It’s
difficult for the farmer to diversify her position because all the wealth is tied up in the crop.
A miller faces mirror image risk management problem of the farmer. They are both subject
to possible loss of profits because of price volatility and uncertainty. They can both hedge
their risk through a forward contract.
Note:
- forward contract: deferred-delivery sale of asset with sales price agreed upon now
▪ protects buyer & seller
- futures markets: formalize & standardize forward contracts
- buyers & sellers trade in a centralized futures exchange
- contracts call for a daily settling of any gains or losses on the contract
Difference between forward & futures contract?
- Forward = customised
- Futures = standardised
FUTURES EXCHNAGES
Standardizes the contracts that may be traded.
Disadvantage: standardization eliminates flexibility available in forward contracting
Advantage: liquidity (many traders concentrate on same contracts; help reach correct
trading price quickly)
,Centralized market, standardization of contracts, and depth of trading in each contract
allows futures positions to be liquidated easily.
- deep market → consistently achieves a high volume of trades
▪ volume: amount of trading activity in a contract over a trading day
▪ open interest: number of outstanding contracts at the end of a trading day
Exchanges establish:
- contract size
- acceptable grade of commodity
▪ i.e. for grains or metals
▪ quality specified at contract inception
▪ if quality different at delivery then trader add a premium/discount
- contract delivery dates
- guarantees the performance of each party
FUTURES CONTRACTS (BASICS)
“Calls for delivery of a commodity at a specified delivery or maturity date, for an agreed
upon futures price, to be paid at contract maturity.”
- specifies precise requirements for the commodity (quality, etc.)
- specifies place and means of delivery of the commodity
- @ contract inception → no money changes hands.
- Delivery rarely occurs, most parties close out their positions before maturity, taking
gains or losses in cash.
- The fraction of contracts that result in actual delivery of the underlying asset ranges
from less than 1% to 3%, depending on the commodity and activity in the contract.
Delivery:
- agricultural commodities → transfer of warehouse receipts issued by approved
warehouses
- financial futures → may be made by wire transfer
- index futures → cash settlement procedure
Delivery rarely occurs → usually close out positions before maturity (take gain/loss in cash)
- 1% to 3% of contracts result in actual delivery of the underlying asset
- depends on the commodity and activity in the contract
, EXISITING CONTRACTS
Futures & forward contracts traded on a wide variety of goods divided into the following
broad categories:
1. foreign currencies
2. commodities (agricultural, metals, minerals & energy)
3. financial futures (fixed-income securities & stock market indices)
FUTURES TRADERS
Long position → commits to purchasing the commodity on the delivery date
- buys the contract
- profit to long at maturity = spot price at maturity (PT) – original futures price (F0)
Short position → commits to delivering the commodity at contract maturity
- sells the contract
- profit to short at maturity = original futures price (F0) – spot price at maturity (PT)
At end of each day a process called marking to market occurs
- compare futures price to futures price in contract the day before
▪ prices go up → long trader makes a profit
▪ prices go down → short trader makes a profit
Illustration
Each contract calls for delivery of 5,000 bushels & prices in are quoted in cents per bushel.
