THE FUTURES MARKET

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 41

FUTURES

THE FUTURES MARKET:

A futures contract is a promise; the person who initially sells the contract promises to

deliver a quantity of a standardize commodity to a designated delivery point during a certain

month called a delivery month. The other party to the trade promises to pay a predetermined

price for the goods upon delivery. The person who promises to buy is said to be long; the

person who promises to deliver is short.

UNDERSTANDING FUTURES MARKETS:

Why Futures Markets?

Physical commodities and financial instruments typically are traded in cash markets. A cash

contract calls for immediate delivery and is used by those who need a commodity now (e.g.,

food processors). Cash contracts cannot be canceled unless both parties agree. The current

cash prices of commodities and financial instruments can be found daily in such sources as

The Wall Street Journal.

There are two types of cash markets, spot markets and forward markets. Spot markets are

markets for immediate: delivery. The spot price refers to- the current market price of an

item available for immediate delivery.

Forward markets are markets for deferred delivery. The forward price is the price of an item

for deferred delivery.

Futures Contracts:

A forward contract is an agreement between two parties that calls for delivery of a

commodity (tangible or financial) as, a specified future time at a price agreed upon today.

Each contract has a buyer and a seller: Forward markets have grown primarily because of

the growth in swaps, which in general are similar to forward contracts.

Forward contracts involve credit risk--either party can default on their obligation.

These contracts also involve liquidity risk because of the difficulties involved in

getting out of the contract. On the other hand, forward contracts can be customized

to the specific needs of the, parties involved.

A futures contract is a standardized, transferable agreement providing for the deferred

delivery of either a specified grade or quantity of a designated commodity within a specified

geographical area or of a financial instrument (or its cash value). In simple language, a

futures contract locks in a price for delivery, on a future date.

The futures price at which this exchange will occur at contract maturity is determined today.

The trading of futures contracts means only that commitments have been made by buyers

and sellers; therefore,, "buying" and "selling" do not have the same meaning in futures

transactions as they do in stock and bond transactions. Although these commitments are

binding because futures contracts are legal contracts, a buyer or seller can eliminate the

commitment simply by taking an opposite position in-the same commodity or financial

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instrument for the same futures month.

Futures contracts are standardized and easily traded. Credit risk is removed by the

clearinghouse (explained below) which ensures performance on the contract. On the

other hand, they cannot readily be customized to fit particular needs.

Futures contracts are not securities and are not regulated by the Securities and Exchange

Commission (SEC). The Commodity Futures Trading Commission (CFJC), a federal

regulatory agency, is responsible for regulating trading in all domestic futures markets. In

practice, the National Futures Association, a self-regulating body, has assumed some of the

duties previously performed by the CFTC. In addition, each futures exchange has a

supervisory body to oversee its members.

Futures vs. Options:

Some analogies can be made between futures contracts and options contracts. Both involved

a predetermined price and contract duration. An option, however, is precisely that. The

person holding the option has the right, but not the obligation, to exercise the put or the call.

If an option has no value at its expiration, the option holder will allow it to expire

unexercised. But with futures contract, a trade must occur if the contract is held until its

delivery deadline. Futures contracts do not "expire" unexercised. One party has promised to

deliver a commodity, which another party has promised to buy.

An important concept keep in mind with futures is that the purpose of contracts is not to

provide a means for the transfer of goods. Stated another way, property rights to real or

financial assets cannot be transferred with futures contracts. Futures contracts do, however,

enable people to reduce some of the risks they assume in their business.

People who buy puts or calls do not usually intend to exercise them; valuable options are

sold before expiration day. Similarly, an individual who is long a corn futures contract

usually does not want to take delivery of the 5,000 bushels covered by the contract. Also, a

farmer who has promised to deliver wheat through the futures market may prefer to sell the

crop locally rather than deliver it to an approved delivery point. In either case the contract

obligation can be satisfied by making an offsetting trade, or trading out of the contract. An

individual with a long position sell a contract, canceling the long position. The farmer with

short position would buy. Both individuals would be out of the market after these trades.

Market Participants:

Two types of participants are required in order for a futures market to be successful: hedgers

and speculators. Without hedgers the market would not exist, and no economic function

would be performed by speculators.

1. Hedgers:

In the context of future market, a hedger is someone who is engaged in some type of

business activity with an unacceptable level of price risk. A farmer must decide what crop

to put in the ground in each spring. The welfare of the farmer's family or business depends

on the price of the chosen commodity at harvest. If the price is high the farmer will earn a

nice profit in the crop. Should prices be low because of overabundance or reduced demand,

and then prices may fall to such a level that operating costs cannot even be recovered.

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It is important to recognize that the farmer cannot eliminate the risk of a poor crop through

the futures market; only price risk can be eliminated. Crop insurance may help protect

against such an eventuality, but the futures market cannot.

2. Speculators:

In order for the hedger to eliminate unacceptable price risk, someone must be willing to

assume that risk is the hedger's place. This person is the speculator. The speculator has no

economic activity requiring use of futures contract, but rather finds attractive investment

opportunities there and takes positions in futures in hopes of making a profit rather than

protecting one. In certain aspects, the speculator performs the same role that insurance

companies perform when they prepare policies. The person who buys insurance is unwilling

to bear the full risk of economic loss an accident occur, consequently chooses to transfer

that risk to the insurance company. The insurance company is willing to bear the risk

because it feels a profit can be made by providing this coverage in exchange for the

insurance premium.

A speculator might promise to deliver 5,000 bushels of wheat at $ 4.00 for September

delivery if he or she feels that wheat will not sell for that much at delivery time. Speculators

cannot conveniently deliver wheat because they are not in the business of growing it, but

this point is not relevant because speculators can easily exit the market by buying

September wheat contracts to cancel out the previous position. The difference in price on

the two trades will be the speculator's profit or loss.

In considering what makes a futures contract valuable and what makes the price of the

contract fluctuate from day to day, remember that a futures contract is a promise to

exchange certain goods at a future date. You must keep your part of the promise unless you

get someone to take the promise off your hands. In other words, you must make a closing

transaction. The promised goods are valuable now, and their value in the future may be

more or less than their current worth. Prices of commodities change for many reasons such

as new weather forecasts, the availability of substitute commodities, psychological factors,

and changes in storage or insurance costs. These factors all involve shifts in demand for a

commodity, changes in the supply of the commodity, or both.

3. Marketmakers:

Marketmakers provide liquidity for the marketplace. These people on the floor of the

exchange seek to buy from one person and sell to someone else at a slightly higher price

many times during the day. Marketmakers seldom have the capital to hold large positions

and hope prices move in a particular way. Their bread and butter us earning a spread

between the bid and ask prices prevailing at the moment.

Without marketmarkes, hedgers and speculators would face a less efficient market. The cost

of trading would be higher because the spread between buying and selling prices would be

wider.

THE STRUCTURE OF FUTURES MARKETS:

Futures Exchanges:

As noted, futures contracts are traded on designated futures exchanges, which are voluntary,

nonprofit associations, composed of members. There are several major, U.S, exchanges.

The exchange provides an organized marketplace where established rules govern the

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conduct of the members. The exchange is financed by both membership dues and fees

charged for services rendered.

All memberships must be owned by individuals, although they may be controlled by firms.

The limited number of memberships, like stock exchange seats, can be traded at market

determined prices. Members can trade for their own accounts or as agents for others. For

example, floor traders trade for their own accounts, whereas floor brokers (or commission

brokers) often act as agents for others. Futures commission merchants (FCMs) act as agents

for the general public, for which they receive commissions. Thus, a customer can establish

an account with an FCM, who in turn may work through a floor broker at the exchange.

The Clearing House:

The clearinghouse, a corporation separate from, but associated with, each exchange plays an

important role in every futures transaction. Since all futures trades are cleared through the

clearinghouse each business day, exchange members must either be members of the

clearinghouse or pay a member for this service. From a financial requirement basis, being a

member of the clearinghouse is more demanding than being a member of the associated

exchange.

Essentially, the clearinghouse for futures markets operates in the same way as the

clearinghouse for options. Buyers and sellers settle with the clearinghouse, not each other.

Thus, the clearinghouse, and not- another investor, is actually on the other side of every

transaction and ensures that all payments are made as specified. It stands ready to fulfill a

contract if either buyer or seller ^defaults, thereby helping to facilitate an orderly market in

futures. The clearinghouse makes the futures market impersonal, which is the key to its

success, because any buyer or seller can always close out a position and be assured of

payment. The first failure of a clearinghouse member in modern times occurred in the

1980s, and the system worked perfectly in preventing any customer from losing money.

Finally, as explained below, the clearinghouse allows participants easily to reverse a

position before maturity, because the clearinghouse keeps trade of each participant's

obligations.

THE MECHANICS OF TRADING:

Basic Procedures:

Because the futures contract is a-commitment to buy or sell at a specified future settlement

date, a contract is not really .being solder bought, as in tire case of Treasury bills, stocks, or

Certificate's of Deposit (CDs), because no money is exchanged at the time the contract is

negotiated. Instead, the seller and the buyer simply are agreeing to make and take delivery,

respectively, at some future, time for a price: agreed upon today. As noted above, the terms

buy and sell do not have the same meanings here. It is more accurate to

think in terms of;

1. A short position (seller), which commits a trader to deliver an item at contract

maturity.

2. A long position (buyer), which commits a trader to purchase an item at contract

maturity

Selling short in futures trading means only that a contract not previously purchased is

sold. For every futures contract, some one sold it short and someone else holds it long. Like

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options, futures trading are a zero-sum game.

Whereas an options contract involves the right to make or take delivery, a futures contract

involves an 'obligation to take or make delivery. However, futures contracts can be settled

by delivery or by offset. Delivery, or settlement of the contract, occurs in months that are

designated by the various exchanges for each of the items traded. Delivery occurs in less

than 2 percent of all transactions.

Offset is the typical method of settling a contract. Indeed, about 95 percent of futures

contracts are closed before the contract expire by offset. Holders liquidate a position by

arranging an offsetting transaction. This means that buyers sell their positions, and sellers

buy in their positions sometime prior to delivery. When an investor offsets his or her

position, it means that their trading account is adjusted to reflect the final gains (or losses)

arid their position is closed.

Thus, to eliminate futures market position, the investor .simply does the reverse of what was

done originally. As explained above, the clearinghouse makes this easy to accomplish. It is

essential to remember that if a futures contract is not offset, it must be closed out by

delivery.

An option involves the right, but not the obligation to take action

A futures contract involves an obligation either offset occurs or delivery occurs.

Margin:

Recall that in the case of stock transactions, the term margin refers to the down payment in

a transaction in which money is borrowed from the broker to finance the total cost. Futures

margin, on the other hand, is not a down payment, because ownership of the underlying

item is not being transferred at the time of the transaction. Instead, it refers to the "good

faith" (or earnest money) deposit made by both buyer and seller to ensure the completion

of the contract. In futures trading, unlike stock trading, margin is the norm. All futures

markets participants, whether buyers or sellers, must deposit minimum specified amounts

in their futures margin accounts to guarantee contract obligations.

In effect; futures margin is a performance bond.

Each clearinghouse sets its own minimum initial margin requirements (in dollars).

Furthermore, brokerage houses can require a higher margin and typically do so. The margin

required for futures contracts, which is small in relation to the value of the contract itself,

represents the equity of the transactor (either buyer or seller). It is not unusual for the initial

margin to be only a few thousand dollars although the value of the contract is much larger.

As a generalized approximation, the margin requirement for futures contracts is about 6

percent of the value of the contract. Since the equity is small, the risk is magnified.

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