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Chapter 16 Commodities and Financial Futures

Chapter 16 Commodities and Financial Futures






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    Chapter 16 Commodities and Financial Futures Chapter 16 Commodities and Financial Futures Presentation Transcript

    • Chapter 16 Commodities and Financial Futures
    • Learning Goals
      • Understand the essential features of a futures contact
      • Understand motivations of hedgers and speculators
      • Describe the commodities segment of the futures market
    • Learning Goals (continued)
      • Discuss the various trading strategies employed
      • Explain the difference between a physical commodity and a financial future
      • Discuss the trading techniques used and how they can be used in conjunction with other investments
    • Commodities & Financial Futures
      • The organized futures market offers standardized contracts in commodities and financial futures
      • Recent growth is due to an increase in available futures contracts and the acceptance of use in financial and investment management
    • The Cash Market and The Futures Market
      • The cash market
        • where transactions involving present exchanges are conducted.
      • The futures market
        • involves transactions which require exchange at a specified future time
    • A Futures Contract
      • A futures contract
        • obligates the holder to buy or sell a specified amount of a given commodity at a stated price by a stated date, usually within a year
    • Commodities & Financial Futures
      • Unlike options, futures have unlimited downside risk
      • The delivery month specifies when the item must be delivered
      • Trading hours for futures vary with the commodity (or financial future) and are shorter than stock market hours
      • All trading is on margin basis
    • Options vs. Futures Contracts
      • Options differ from futures contracts:
        • A futures contract obligates a person to buy or sell a specified amount of a given commodity on or before a stated date
        • An option gives the holder the right to buy or sell, but NO obligation
        • Options have a specified price - not stated on a futures contract
        • Futures contracts have no downside limits
    • Futures
      • Futures have been traded on a negotiated or OTC basis since biblical times, but on organized exchanges in the U.S. only since the Chicago Board of Trade opened in 1848. These exchanges have experienced rapid growth
    • Futures Trading
      • Futures trading is through the open outcry auction method, in which a series of shouts, body motions, and hand signals are used
    • Types of Traders
      • Hedgers
        • producers and processors, including financial institutions and corporate treasurers
        • use futures to protect a cash position or interest in the underlying commodity or financial instrument
    • Types of Traders (continued)
      • Speculators
        • give the market liquidity, and take the risks, in order to attempt to profit from expected price changes in the underlying asset
    • Trading Futures
      • Investors trade futures through a broker
      • A special commodity trading account must be established
      • Buying a contract is a long position
      • Selling a contract is a short position
      • Commissions amount to $50 to $80 per round trip (buy and sell) transaction
    • Trading Futures (continued)
      • Required margin is 2- 10%
      • There are no borrowed funds as such, the margin is to protect any loss in a contract's market value due to adverse price movements
      • The initial deposit is the amount an investor must deposit with the broker at the time of the futures transaction
    • The Maintenance Deposit
      • The maintenance deposit is the minimum amount of margin which must be kept in the margin account at all times
        • If the margin falls below this deposit, the investor will receive a margin call to deposit enough cash to bring the deposit back to the required level
    • Mark-to-Market
        • Mark-to-market is a daily check of an investor's margin position, determined at the end of each session, at which time the broker debits or credits the account as needed
    • Trading Futures
      • Each contract has its own specifications which include:
        • The product
        • The exchange on which the contract is traded
        • The size of the contract (and in what units: bushels, pound, etc.)
        • The pricing unit (such as cents per pound)
        • The delivery month
        • Settle price is the closing price (last price of the day) for commodities and financial futures
        • Open interest is the number of contracts currently outstanding on a commodity or financial future
    • Commodity Prices
      • Move up and down in relation to economic, political and international pressure, as well as the weather
        • These pressures cause the prices of the underlying commodities to change
      • The large size of commodity contracts magnify small changes in the price of an underlying commodity into substantial changes in the commodity futures price
    • Commodity Prices
      • To restrict daily price movements on commodity futures, a daily price limit has been established
      • The maximum daily price range represents the maximum a price can change within a day-it is twice the daily price limit
    • Return on Invested Capital
      • Futures have only one source of return.
      • Return on invested capital (ROI)
      • ROI = (Selling price - purchase price) of contract
      • amount of margin deposit
    • Speculators
      • Speculators attempt to profit from the wide price swings of commodity futures contracts
        • Speculators go long when they feel the price of an underlying security (commodity) will appreciate
        • They go short when they feel the underlying security (commodity) price will fall
    • Speculators (continued)
        • When speculators hit, they can hit it big because of the high leverage
        • There is also high risk of loss due to the high leverage
    • Spreading
      • Spreading combines two or more commodity futures contracts in order to restrict exposure to loss
        • A spreader simultaneously buys one contract and sells another
        • Spreading allows for a potential profit, but not as high as with the pure speculative approach
    • Hedging
      • Hedging is used to protect a position in a product or commodity
        • Nabisco (needs wheat in 2 months) might buy a futures contract which has a two-month maturity. This lets Nabisco know the price today and thus reduce his risk
        • A wheat farmer can short a futures contract and eliminate the risk of an unknown selling price
    • Commodities
      • Commodities appeal to individual investors because of:
        • high rates of return
        • commodities often act as a hedge against inflation
    • Commodities (continued)
      • Require time and special knowledge
        • In the past, the overall return to individuals active in the commodities market has been negative
        • Mutual funds which invest in commodities give investors diversification and professional management
    • Financial Futures
      • A type of futures contracts in which the underlying 'commodity' is a financial asset
        • debt securities, foreign currencies, or market baskets of common stocks
        • currency futures are futures contracts on foreign currencies, traded much like commodities
    • Foreign Currencies
      • Seven currencies are traded against the dollar, and they are:
          • British pound
          • German mark
          • Swiss franc
          • Mexican peso
          • Canadian dollar
          • Japanese yen
          • Australian dollar
    • Interest Rate Futures
      • Interest rate futures are futures contracts on debt securities. Trading is carried out in a variety of US and foreign debt securities, including:
        • US Treasury bills
        • Notes, Bonds
        • Foreign government bonds, such as those of the UK, Germany, and Canada
    • Stock Index Futures
      • Stock index futures are futures contracts written on broad-based measures of stock market performance (e.g., the S&P500 Stock Index)
      • Allow investors to participate in the general movements of the stock market
      • Stock indexes are quoted in terms of the index, but have a value of 500 times the index
    • Index Price (1 of 3)
      • Index price is a technique used to price T-bill and other short-term securities futures contracts, by subtracting current yield from an index of 100
      • This index changes the normal discount quote to one more consistent with other futures
    • Index Price (2 of 3)
      • By using this pricing index, a long position gains when the price goes up and a short position gains when the price goes down
      • The index price is not the actual contract price, it must be calculated using the following formula:
    • Index Price (3 of 3)
      • Price of a 90-day contract =
      • $1,000,000 - security's yield x 90 x $10,000
      • 360
    • Trading Strategies & Objectives
      • Similar for financial and commodity futures
      • Financial institutions, large multinational firms, and pension funds and portfolio managers use interest rate, currency, and stock index futures to hedge
    • Speculation with Foreign Currency Contracts
      • Speculation with foreign currency contracts
        • investing with the expectation that the foreign currency will appreciate (long position) or depreciate (short position) relative to the US dollar
    • Speculating with Interest Rate Futures
      • Speculating with interest rate futures
        • take position based on whether they feel interest rates will rise (short position because fixed-income security prices fall when interest rates rise) or fall (long position)
      • Financial futures are used for spreading just as with commodities contracts
    • Stock Index Futures (1 of 4)
      • Relatively new and most investors use them to speculate or hedge. The stock index options are used the same way
      • Successful use of stock index futures requires accurate prediction of the future course of the stock market
    • Stock Index Futures (2 of 4)
      • Speculators take long positions when they feel the market will rise and short positions when they feel the market will fall
      • An investor can hedge a diversified portfolio of stocks with a stock index future
    • Stock Index Futures (3 of 4)
      • This is not likely to be a perfect hedge
        • the investor's holdings are unlikely to precisely match the composition of the index used in the contract
      • OTC and highly volatile stocks probably require more protection in the form of additional offsetting futures contracts
        • it is hard to find appropriate indexes that would represent such stocks
    • Stock Index Futures (4 of 4)
      • With hedging, an investor can protect against a long (short) position. If he owns a foreign stock, the investor can hedge against the dollar declining relative to the currency of the foreign investment
    • Financial Futures
      • Financial futures can be used by individual investors, but they must recognize the high risk and be prepared to cover some losses
    • Options On Futures
      • Puts and calls on futures contracts are offered in the organized options and futures markets
      • These are standardized options contracts
        • The key difference between futures and options on futures is that the option limits the investor's loss exposure to the price paid for the option-not so on the futures contract
    • Case Review
      • Billy Jo and Danielle Hobert
        • Review case and questions 4, 5, 17, 18, 19, 20 and 24, Volume III
      • Paul and Kristi Roth
        • Review case and questions 7, 8, 9, 10, 11 12, 13, 18 and 20, Volume III