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CHAPTER
TWENTY-FIVE
FUTURES
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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
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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.)
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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
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HEDGERS AND
SPECULATORS
• MARKET PARTICIPANTS
– SPECULATORS are traders who buy or sell
futures contracts for the potential of arbitrage
profits
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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FUTURES PRICES AND
FUTURE SPOT PRICES
• NORMAL BACKWARDATION
– which can be written
Pf < Ps
– this relationship known as normal backwardation
P
– which implies f can be expected to rise during the
life of the futures contract
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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
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FUTURES PRICES AND
FUTURE SPOT PRICES
• NORMAL BACKWARDATION AND
CONTANGO
P
f
PS
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FUTURES PRICES AND
CURRENT SPOT PRICES
• AT WHAT PRICE SHOULD FUTURES
CONTRACTS SELL?
Pf = Ps + I
where
Pf =
Ps =
I
=
futures contract price
current spot asset price
the dollar amount of interest
corresponding to the period
of time from present to
delivery date
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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
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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
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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
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