Futures

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Futures

  1. 1. FUTURES
  2. 2. FUTURES CONTRACTS <ul><li>WHAT ARE FUTURES? </li></ul><ul><ul><li>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 </li></ul></ul>
  3. 3. FUTURES CONTRACTS <ul><li>ASSETS INVOLVED IN FUTURES TRADING </li></ul><ul><ul><li>agricultural goods (wheat, corn, etc.) </li></ul></ul><ul><ul><li>natural resources (oil, natural gas, etc.) </li></ul></ul><ul><ul><li>foreign currencies (pounds, marks, etc.) </li></ul></ul><ul><ul><li>fixed-income securities (T-bonds, etc.) </li></ul></ul><ul><ul><li>market indices (S+P 500, Value Line, etc.) </li></ul></ul>
  4. 4. HEDGERS AND SPECULATORS <ul><li>MARKET PARTICIPANTS </li></ul><ul><ul><li>HEDGERS are traders who buy or sell to offset a risk exposure in the spot market </li></ul></ul><ul><ul><li>for example, a U.S. exporter will be paid in 30 days in a foreign currency </li></ul></ul>
  5. 5. HEDGERS AND SPECULATORS <ul><li>MARKET PARTICIPANTS </li></ul><ul><ul><li>SPECULATORS are traders who buy or sell futures contracts for the potential of arbitrage profits </li></ul></ul>
  6. 6. THE FUTURES MARKET <ul><li>WHAT DISTINGUISHES IT FROM STOCK AND OPTIONS MARKETS? </li></ul><ul><ul><li>there are no specialists or market-makers </li></ul></ul><ul><ul><li>members are floor traders or locals (“scalpers”) who execute orders for personal accounts </li></ul></ul><ul><ul><li>open outcry mechanism </li></ul></ul><ul><ul><ul><li>verbal announcement of trading price in the pit </li></ul></ul></ul>
  7. 7. THE FUTURES MARKET <ul><li>THE CLEARINGHOUSE </li></ul><ul><ul><li>FUNCTIONS: </li></ul></ul><ul><ul><ul><li>provide orderly and stable meeting place for buyers and sellers </li></ul></ul></ul><ul><ul><ul><li>prevents losses from defaults </li></ul></ul></ul><ul><ul><li>Procedures </li></ul></ul><ul><ul><ul><li>imposes initial and daily maintenance margins </li></ul></ul></ul><ul><ul><ul><li>marks to market daily </li></ul></ul></ul>
  8. 8. THE FUTURES MARKET <ul><li>THE CLEARINGHOUSE </li></ul><ul><ul><li>INITIAL MARGIN </li></ul></ul><ul><ul><ul><li>the performance margin that represents a security deposit intended to guarantee the buyer and the seller will be able to fulfill their obligations </li></ul></ul></ul><ul><ul><ul><li>set at the amount roughly equal to the price limit times the size of the contract </li></ul></ul></ul>
  9. 9. THE FUTURES MARKET <ul><li>THE CLEARINGHOUSE </li></ul><ul><ul><li>MAINTENANCE MARGIN </li></ul></ul><ul><ul><ul><li>investor keeps the account’s equity equal to or greater than a certain percentage </li></ul></ul></ul><ul><ul><ul><li>if not met, margin call is issued to the buyer and seller </li></ul></ul></ul><ul><ul><ul><li>variation margin </li></ul></ul></ul><ul><ul><ul><ul><li>represents the additional deposit of cash that brings the equity up to the margin </li></ul></ul></ul></ul>
  10. 10. THE FUTURES MARKET <ul><li>MARKING TO MARKET </li></ul><ul><ul><li>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 </li></ul></ul>
  11. 11. THE FUTURES MARKET <ul><ul><li>Process </li></ul></ul><ul><ul><ul><li>each day the clearinghouse replaces the existing contracts with new ones </li></ul></ul></ul><ul><ul><ul><li>the purchase price = the settlement price that day </li></ul></ul></ul><ul><ul><ul><li>the amount of the investor’s equity may change daily </li></ul></ul></ul>
  12. 12. THE FUTURES MARKET <ul><li>MARKING TO MARKET </li></ul><ul><ul><li>Price Limits </li></ul></ul><ul><ul><ul><li>exchanges impose dollar limits on the extent to which futures prices may vary (to avoid excess volatility) </li></ul></ul></ul><ul><ul><ul><li>Reasoning behind limits: The Exchanges believe futures traders may overreact to major news stories </li></ul></ul></ul>
  13. 13. BASIS <ul><li>WHAT IS THE BASIS? </li></ul><ul><ul><li>DEFINITION: basis is the current spot price minus the current futures contract price </li></ul></ul><ul><ul><li>Current spot price is the price of the asset for immediate delivery </li></ul></ul><ul><ul><li>the current futures contract price is the purchase price of the contract in the market </li></ul></ul>
  14. 14. BASIS <ul><li>SPECULATING ON THE BASIS </li></ul><ul><ul><li>Basis risk </li></ul></ul><ul><ul><ul><li>the risk that the basis will narrow or widen </li></ul></ul></ul><ul><ul><li>speculating on the basis means an investor will want to be either </li></ul></ul><ul><ul><ul><li>short in the futures contract and long in the spot market, or </li></ul></ul></ul><ul><ul><ul><li>long in the futures contract and short in the spot market </li></ul></ul></ul>
  15. 15. FUTURES PRICES AND FUTURE SPOT PRICES <ul><li>CERTAINTY </li></ul><ul><ul><li>futures price forecasts have no certainty because if so </li></ul></ul><ul><ul><ul><li>the purchase price would equal the spot </li></ul></ul></ul><ul><ul><ul><li>the purchase price would not change as delivery neared </li></ul></ul></ul><ul><ul><ul><li>no margin would be needed to protect against unexpected adverse price movements </li></ul></ul></ul>
  16. 16. FUTURES PRICES AND FUTURE SPOT PRICES <ul><li>UNCERTAINTY </li></ul><ul><ul><li>How are futures prices related to expected spot prices? </li></ul></ul><ul><ul><ul><li>EXPECTATION HYPOTHESIS </li></ul></ul></ul><ul><ul><ul><ul><li>the current futures purchase price equals the consensus expectation of the future spot price </li></ul></ul></ul></ul><ul><ul><ul><ul><li>P f = P s </li></ul></ul></ul></ul><ul><ul><ul><ul><li>where P f is the current purchase price of the futures </li></ul></ul></ul></ul><ul><ul><ul><ul><li> P s is the expected future spot price at delivery </li></ul></ul></ul></ul>
  17. 17. FUTURES PRICES AND FUTURE SPOT PRICES <ul><li>NORMAL BACKWARDATION </li></ul><ul><ul><li>KEYNES: criticized the expectation hypothesis and stated that </li></ul></ul><ul><ul><ul><li>hedgers will want to be short futures </li></ul></ul></ul><ul><ul><ul><li>this entices speculators to go long in the futures markets </li></ul></ul></ul><ul><ul><ul><li>to do this hedgers make the expected return from a long position greater that the risk free rate </li></ul></ul></ul>
  18. 18. FUTURES PRICES AND FUTURE SPOT PRICES <ul><li>NORMAL BACKWARDATION </li></ul><ul><ul><li>which can be written </li></ul></ul><ul><ul><ul><ul><li>P f < P s </li></ul></ul></ul></ul><ul><ul><li>this relationship known as normal backwardation </li></ul></ul><ul><ul><li>which implies P f can be expected to rise during the life of the futures contract </li></ul></ul>
  19. 19. FUTURES PRICES AND FUTURE SPOT PRICES <ul><li>NORMAL CONTANGO </li></ul><ul><ul><li>a contrary hypothesis to Keynes’ </li></ul></ul><ul><ul><li>states that on balance hedgers want to go long in the futures and entice speculators to be short in the futures </li></ul></ul><ul><ul><li>to do this hedgers make </li></ul></ul><ul><ul><ul><li> P f > P s </li></ul></ul></ul><ul><ul><li>this implies that P f can be expected to fall during its contract life </li></ul></ul>
  20. 20. FUTURES PRICES AND FUTURE SPOT PRICES <ul><li>NORMAL BACKWARDATION AND CONTANGO </li></ul>P S P f
  21. 21. FUTURES PRICES AND CURRENT SPOT PRICES <ul><li>AT WHAT PRICE SHOULD FUTURES CONTRACTS SELL? </li></ul><ul><ul><ul><li>P f = P s + I </li></ul></ul></ul><ul><ul><ul><li>where </li></ul></ul></ul><ul><ul><ul><li> P f = futures contract price </li></ul></ul></ul><ul><ul><ul><li> P s = current spot asset price </li></ul></ul></ul><ul><ul><ul><li> I = the dollar amount of interest </li></ul></ul></ul><ul><ul><ul><li>corresponding to the period </li></ul></ul></ul><ul><ul><ul><li>of time from present to delivery date </li></ul></ul></ul>
  22. 22. FUTUTES PRICES AND CURRENT SPOT PRICES <ul><ul><li>Benefits of ownership </li></ul></ul><ul><ul><ul><li>What if there are benefits that accrue to owner of the asset, then </li></ul></ul></ul><ul><ul><ul><li>P f = P s + I - B </li></ul></ul></ul><ul><ul><ul><li>where B is the benefit </li></ul></ul></ul>
  23. 23. FUTUTES PRICES AND CURRENT SPOT PRICES <ul><li>COST OF OWNERSHIP </li></ul><ul><ul><li>What if there are costs that accrue due to owning the asset? </li></ul></ul><ul><ul><li> P f = P s + I - B + C </li></ul></ul><ul><ul><li>where C is the cost of owning </li></ul></ul>
  24. 24. FUTUTES PRICES AND CURRENT SPOT PRICES <ul><li>COST OF OWNERSHIP </li></ul><ul><ul><li>The Cost of Carry (I-B+C) </li></ul></ul><ul><ul><ul><li>the total value of interest less benefits received plus cost of ownership </li></ul></ul></ul><ul><ul><li>The Futures Price </li></ul></ul><ul><ul><ul><li>can be greater or less than the spot price depending on whether the cost of carry is positive or negative </li></ul></ul></ul>

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