CHAPTER

TWENTY-FIVE
FUTURES

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

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

HEDGERS AND SPECULATORS

MARKET PARTICIPANTS
SPECULATORS are traders who buy or sell
futures contracts for the potential of arbitrage
profits

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

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

THE FUTURES MARKET

THE CLEARINGHOUSE
MAINTENANCE MARGIN
investor keeps the accounts 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

THE FUTURES MARKET

MARKING TO MARKET
DEFINITION: the process of adjusting the
equity in an investors 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 investors 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

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 > P s
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 =
futures contract price
Ps =
current spot asset price
I =
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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