Chapter 16 Commodities and Financial Futures


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Chapter 16 Commodities and Financial Futures

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