FUNDAMENTALS OF THE FUTURES MARKET — KEY TERMS you will find in this chapter: Acapuleo trade arbitrage baclverdtion basis broker buying hedge cash price Clearing Corporation Commodity Futures Trading Comission ‘contango market crack onda deposit hedges Intereommodity spread Intermertet spread intracommmedity spread inverted market limit cedar Jong hedge market order market variation cal ark to market normal backwardation crush aly price iit ‘open interest ‘open outery cout trade pit position trader price discovery price risk processor scalper short hedge Galivery month expectations hypotness forward contact {ull carving charge market futures commission merchant (FCM) futures contract speculator spot price stop order stop price “Tapioca Cty Unmatched Tade Notice 4s near as Tcan learn, and from the best information I have been able to obtain on the Chicago Board of Trade, at least 95% of the sales of the Board are of this fictitious character, where no property is actually owned, no property sold or delivered, or expected to be delivered but simply wagers or bets as to what that property may be worth at a designated time in the future. Wheat and cotfon have beconte as much gambling tools as chips on the farobank table. The prop: erty ofthe wheat grower and the cotton grower is treated as though it were a “stake” put on the gambling table at Monte Carlo, The producer of wheat is comapelled to see the stocks in his barn dealt with like the peas of a thimblerigger, or the cards ofa three-card-monte man. Between the agrain-producer and loaf eater, there has stepped in a “parasite” between them robbing them bot. Senator William D. Washburn (D-Minn.), July 11, 1892108 Derivatives: a introduction nn Stock Inoices ——_ S SOYBEANS Ds CBOT DJIA BO soveeay ott ‘SM SOYBEAN MEAL Mev wo we YG 38.2 pine TRoy ounce aoto an YE 1000 rRov ounce sive Ooms RR -RoUH RICE Frnnncas Perr eee eee eee US 30-vear U.S. Treasury ons oe TY 10-vean U.S. Treasury ores FV. _ S:vear U.S. TREASunY NOTES TU ~ 2-year U.S. Treasury NoTeS © FF 30-a” FEDERAL Funos MB 10-year mUNICPAL NOTE INDEX DN 1G-Yexr acenov nores DF 5-Yea acency Noves Svar Cap ere a, ‘The futures matket is a very useful, and very misunderstood, part of our economic system. it Cnables farmers, businesses, financial institutions, and the managers of investment portfolios fo lessen price risk, the risk of loss because of uncertainty over the future price ofa commad ity or financial asset. AS with options, the two major market participants are the hedger and the speculator, withthe former transferring some price risk to te latter. ‘Futures contracts trade on a variety of assets, including grains, petroleum products, pre- cious metals, and cattle, among others. Table 8-1 lists some of them and their trading sym- pols: Financial futures, Tike those traded on Treasury bonds, stock indexes, and foreign Currencies, are an extremely popular and fast-growing segment ofthe futures market, While hs chaptor introduces them, the primary discussion of financial fuures [sin Chapters through 12. Fist we look a the role of futures markets inthe financial system. Then we wil Sue Row the trading system functions, followed by an overview of futures contract pricing. Tue Concept oF Futures Contracts THE FUTURES PROMISE 7 a Atmomeonwacis 4 futures contract \s a legally binding agreement to Duy OF sell something in the Spomsecobiver funire. Futures contracts are promises, he pessan who The cont 7 Satcyte “ses to deliver a qua piandardiZed Commodity 10 4 designated delivery point SGGiSeet na cenip monk cle thelGetvery sone) Sead prom {Fes to pay a predetermined price for the goods upon delivery. cox “The Tcaas Board oF Trade onjginated in TS48 to provide a centralized place where root aeiculzural doods could meet in an onder) asker. By TS 4 Saver ae cecomiracts were being traded and procedures were in place to ensure i Cevformance on the contracts. Today there area least 85 futures exchanges worldwide |(chaptor 8 Fundamontals of he Fetures Markot 168 Futures Compared to Options i ‘There are some analogies between futures contracts and options contracts. Both involve a predetermined price and contract duration, But an option i precisely that: an option. The person holding the option has the rt, but not the obligation, 19 exercise the put or an option has no value at its expiration, the option holder will ormally allow it to expire unexercised. With futures contracts, a trade must occur if the contract is held until its delivery deadline. Futures contracts do not “expire” unex: | Erelsed, One party has promised to deliver a commodity that another party has prom- | ised to buy.! Futures Compared to Forwards ‘A futures comtract is more similar to a forward contract than to an options contract. Forwards are different from futures in two principal respects: they are not marketable and they are not marked to market. A forward contract is an agreement Bet7een & Fonmrdconrace business and"a Paandal Tattigtion, usually a bank, to ex@hange SOMETHING ara set we potmarkeable price in the future. Most forward contracts involve foreign currency. A business may to marker. anticipate receiv currency in the fulure or aw Ma i Ha cee eee Sener A bracing snes wis Comore nigh lorie, arenge ih bun to buy €100,000 at $1.2027 in 97 days, | Once a fim enters into such a forward contract there is no convenient way o trade out of Caneling the wade regugs mutual agement beeen he aes involved. This is unlike futures where either side can quickly transfer their half of the promise to someone else. Because there is no macking to market, forwards also require no good-faith deposit. The two parties exchange assets at the agreed upon date with no intervening cash fos. Other aferences between fares and forwards sem Tom The oe that ER fora he quan and qualiy of he undedving eset ane the deli exy time and delivery place are all negotiable, while they are standardized with futures. { Futures Regulation 1 Legally, futures are not securities; they are contzacts. As a consequence, they are not under the ursdicton ole Securities and Exchange Coamilssan, In 1974 Congress. i passed the Commodity Exchange Act establishing the Commodity Futures Trading ‘Commission (CFTC) to ensure a fair futures market. The GFTC performs much the fame function wth futures asthe SEC does vith shaces of took tHeRe Balto FET Fegulatory organization, the National Funures Association (formed in 1982), thet enforces financial and membership requirements. I also provides customer protection and grievance procedures, Any organization that deals with the public must belong to i the NEA and abide by its rules. Trading Mechanics Suppose a speculator purchases a July soybean contract at the Chicago Board of Trade. i ‘The purchase price might be $622 per bushel. This contract calls for the delivery of 5,000 bushels of No. 2 yellow soybeans to a specially designated regular warehouse at i ‘an approved delivery point by the last business day in July. Upon delivery, the pu ‘chaser of the contract must pay $6.22 for each of the 5,000 bushels, or a total of $31,100. If the current price (called either the spot price or the cash price) for soy- Deane is greater than $6.22, the purchaser of the contract will Profit. A spot price of $6.33, for instance, results in profit of 11 cents on each of 5,000 bushels, or $550. On the other hand, if the spot price were only $6.15, the buyer would lose $0.07 per bushel, or $350. “pene ab onion or bth past de tater alletbe omits sone deve170 Derivatives: Aa tat ‘Alternatively, a speculator may anticipate that long. term interest rates are going to | rise, This means thatthe price of U.S, Treasury bonds will fell. One contract of Treasury bonds calls for delivery of $100,000 face value of bonds that have at least 15 vears until ‘helt matuyty. Because the spcculator thinks the price of the bonds will fall, he or she right sel a futures contract ta price of 93, thereby promising to deliver $100,000 face Fa rice oat araaekac aT 950 ol pax SDS OUT ne value of he Done sub Fequenily drops to 92.5% of par the speculator gains 0.5% of $100,000, or $500, See eae etn nd wth fares tore purpore atte cons Properyrghs is ot to provide a means for the transfer of goods. Stated another way, property rights camocbe’",,, to real or financial assets cannot be transferred with futures contracts. They do, hov- qarstered wih yey, enable people to reduce some risks they assume in their businesses. ‘Most futures contracts are eliminated before the delivery month. This is analogous to Me Seehof arses opoes Peoae bs by puts pr euligo not usally intend 0 exercise tem: ghey sell their valusble options an or before expiration day. A speculator ‘who is long a com futures contract does not want to take delive sels of Ee cami Beals any be tar @ meer io Tas hedged by seling « contact prefers to sell the wheat locally rather than transport it to an approved delivery point iether case makdngan olsen rede, or uading ou” of te cOnTEG CaN SRST the contract obligation. The speculator with a long position would sell a contract Wereby iceling the long position. The hedger with a short position would buy. Both individ- uals would be out of the market after these trades. WHY WE HAVE FUTURES CONTRACTS Perhaps no other part of the financial marketplace has received as much scrutiny as the futures market, Unlike other markets where tangible items change hands (stock certifi- cates, diamonds, real estate), the participants in the futures market deal in promises. A trader can buy of sell thousands of bushels of wheat or tons of soybean meal and have absolutely no intention of ever growing the commodity or taking delivery of it. In fact, tmnotaganblee fewer than 2% of the commodig Jing all futures contracts are ever actuall Se eee Er Renta ata comedy ssepesented bythe oul umber aT SpeSclaccr en's SonbEacts som le supply worldwide. These facts give a cue EGteece” why would-be marker reformers frequently attack the commodity markets. ingarbing jou Let's Look at an example of how the futures market benefits a specifi group of geal people: Eolege SHMEGE)Many graduating seniors buy a class ring, often made of god. SSomemerse Students typically order rings months before graduation. When ordering, buyers want romaiS0™ a firm price quotation from the manufacturer; they do not want 10 hear that “it + Hee eeE SE depends on the price of gold when we make your ting.” A company like Jostens or Bal- Soasrfeem four can lock in the price they have to pay for gold by appropriate trades in the furures andmen’st market. Because the firm wants gold, they buy contracts, promising to pay a set price for the gold when its delivered. This would be long hedge. A gold mining company, on the other hand, would sell contracts, promising to deliver the gold, This would be a short hedge. ‘Assume a futures trade in gold occurs at a price of $416.00 per ounce, with delivery set for December. There are 100 toy ounces? of gold in York Mercantile change contgee. Ths means at IAG Sopany oa deliver TOO ounces nt FeceWve $7,600 for them, regardless of the price of gold at delivery time. The suppliers ‘of gold know their ultimate selling price, and the manufacturers of the rings know their major material cost. If these two companies were not able to lock in the future price of gold, the price to the consumer would be highter to account for the added price risk faced by both the miner and the manufacturer. Aor ounce weighs 9.7 tard (eed ounceChapter 8 Fundamental of the Futures Warket Unfortunately, there are still influential people vrho share the views Senator Wash- bum expressed in the quotation at the beginning of this chapter. They are in the minority. The commodity exchanges are continually adding new products, and the number of people and organizations who find useful opportunities with furures is ™ increasing. The basic function of the commodity futures market is to transfer risk from 2 business (ie edger} to someone ho fe Wag i bear ne specaaiery The apse Iger) to someone who Is willing to bear It (the speculator). The «pec: TGIF assumes HHIs risk because of the opportunity for profit. We will discuss these pepbinpean dallas ENSURING THE PROMISE IS KEPT A reasonable question is, What happens if someone won't pay for the commodity as promised or if a particular farmer is unable to deliver the goods? If it were possible to back out of the trade without fulfiling your part of the promise, the futures exchanges would die a quick death. People would lose confidence in the system, and it would not he attractive to either hedgers or speculators. Bliminating this uncertainty is the role of the Clearing Corporation, ‘Each exchange has a clearing corporation that performs a critical duty: ensuring the integrity of the futures Qupacr-Abough Gades in the pit occur Between two specific ‘palviduals, the tader vcrually become sales to or by the Clearing Corporation, In essence, the Clearing Corporation becomes a party to every trade? Futures contracts are promises, and promises must be kept. A professional trader's accetat may Tuctuste Evalue by move Tats Gillon ollars dally. Mistoruine of incompetence sometimes forces a member into bankruptcy, yet the member's positions remain promises with other exchange members. ‘The Clearing Gormoration assumes the responsibility for those positions when a member jal distress. If this were not so, the integrity of the trading system would break down, and members would tend to trade only with other members who were financially strong. In such a situation itis likely that prices at the exchange would become less competitive. You cannot overstate the value of a sound clearing system at a commodities ex- change. The Chicago Mercantile Exchange publishes a short document entitled “The Financial Safeguard System of the Chicago Mercantile Exchange.” One section of this paper deals with financial integrity of the marketplace and reads in part as follows: ‘The accounts of individual members and non-member customers doing business throught the fail- ities ofthe CME must be carried and guaranteed by a clearing member. In every matched transac tion executed through the Exchange's facilites, he Clearing House is substituted asthe buyer for ‘the seller and the seller forthe buyer. The Clearing House isan operating division ofthe Exchange ‘and all rights, obligations andlor Kabiltes ofthe Clearing House are rights, obligations, and/or Tiabilities of the CMB. Clearing members assume full nancial and performance responsibilty for all transactions executed through them and positions they carry. The Clearing Howse, dealing exclusively with clearing members, holds each clearing member accountable for every position it ‘carves regardless of whether the position is being carried forthe account ofan individual member, Jor the acount of a non-member customer or forthe clearing member's own aecount. Conversely, asthe contra side to every position, the Clearing House is held accountable to the clearing members Jor performance om al open positions. B the possibilty that the collective members of the Clearing Corporation right have o absorb lange bass due toe er of one OF HOTS embers, Ingen ‘Haaaeal requirements fe a covilidon of membershjp. The exchanges slay enforce ‘hese requirements. > tsi thesame tncionpertomned bythe Opuons Clean Carport, “he Charing Coxportiog eres Shelnegiyteach fires comeactby ‘merposingioel Broan ehh yer tnd1m. Thee oerareesthe ‘nce ofthe Derivatives: introduction POE oe DDATA AS OF JANUARY 2, 2004 ‘epronmare ‘Coxreacr Sue Vawe Sovseans 55,000 eusweis $39,700 Gouo 100 Troy ounces $41,600 ‘Treasury Bows $100,000 pre vue $108,000 S&P 500 Srock Ioex $250 x INDEX $278,500 Hearing On. 42,000 eaLtons $38,346 ‘Nl igo ac ped on tc exchange Web pen andar abject to equa’ anaes Good-faith deposits {or performance bonds) are required from every member on every contract to help ensure that ave the financial capacity 10 meet their Spiastone should matic prices not go thelr way-In practice the Gooo- RN CeposT is “GR called ¢ margin deposi or targm requifement. As with the margin require: ‘ment on certain stock option spreads, this use of the term margin does not imply that mmsrooft someone is borrowing money or paying interest. Table 8-2 lsts some representative initial margin requirements. er i Let us ttm now to a discussion of how a futures contract originates on the ex- conaage changes Market Mechanics TYPES OF ORDERS A broker in commodity futures is technically a futures commission merchant (FCM). 1tis important that there be no misunderstanding between the FCM and the in- dividual who places an order. When placing an order, the dient should specify the type of order, because each type involves different fponsibiliies and insiructons. The su ‘let onder so Gare orders mses tne rok fo executes lent oder Fis best poss Fee a one Sores opportuni] Por iste, te rie bowrd may SRSWING ST ERE oF SOVDESTS aL SHO (55 SU per bushel), and the broker may observe that this commodity is trading at "9Y4 to %.” This means that there are bids to purchase soybeans at 529¥2 and that there are sellers of soybeans at 529%. The “tick” size. or smallest trading interval, is one-quarter of cent for soybeans. A client placing a mar- ket order to buy is instructing the broker to buy at the best avalable price, so the bro- ker would likely buy at 529%, The broker could offer to pay 531 and be certain of attracting attention in the pit and getting the order filled, but this would not be in the client's best intezest and would be inappropriate broker behavior. With a limit order, the client specifies a time and a price. For instance, the order right be to sell five December soybeans at 540, good until canceled.* Here the client will accept a selling price of $5.40 per bushel or more, but no less. "Good until can- cceled” indicates that this jsan open order, and that the broker js wo éxeculs The Order ‘Wenever a price of 540" or better can be obtained, even if that price does not occur hal weeks from now Insead of a good-until-canceled instruction, the client might have specifedCor the day This means that it te order eannot be led during that fin abbrevined Gt, whch nce or good" enced[chapter 8 Fundamentals of the Futures Market day's trading hours, the order is canceled, and the client would have to enter a new order to sell the commodity at a later date. ‘A third, very useful type of order is a Stop order. A stop order becomes a market order when the stop price is touched during trading action. Stop orders, when exe- cuted, close out an existing commodity position. A stop order to buy would be placed by someone with an existing short position; a stop order to sell would be placed by per- sons with a long position. A person using a stop order to buy might be a short seller who wants protection against large losses due to rising commodity prices. A stop order to buy three Septem- ber soybeans at 533 mueans that if the price of soybeans advances 19. per bushel, ‘Sie teeter iso bay three couttachs ihe best baile price [which may be higher then 533). ‘Another speculator might place a stop order to sell at 528, This would mean that if 173 Wie a bey sop,* the wop pre below te arene pce Wha salh opie sop price isabor. the price of September sovbeans falls to $5.28, then “sell my soybeans and get me out OL REECE This person could bernimteung losses or PORE an exny pT Note that a person with a long position always places the stop price below the current price, while a person with short position does the opposite. Protecting profits isa very important use of a stop order, although few individuals make use of stop orders for this purpose. Suppose someone bought five September soy- bean contacts a 329 and they now trade at 330, Each coaTac 5000 Geshels Wen beans advance 16 cents per bushel, the owner of five contracis has a profit of $2,500 in their account. To protect most of this profit, the speculator might have a stop order at 528. I prices fall to this level, the speculator will automatically trade out of the market Fh nto the prof wl be preweved stead. soybeans Hse to333-The stop ee Hebe moved Dethapeto 531, hts helping to protea anather S750 im profs Moving a stop price up behind a rising commodity leaves your profit potential untouched but reduces your downside risk, It is important to remember that stop orders become market orders when the asset trades atthe ston gee Unlike a mis ore where the penn FR ‘person placing the order knows ‘Hata trade iit occurs, willbe at a certain price or better, the person using ¢stop order Eo cerain of trading at che stop price. When the stop is touched, this gives your bro- ker instructions to trade out of the contract immediately az the going price, which may bbe more or less than the stop price, n a last market, prices can change very quickly, so the price realized via the stop order may be substantially ifferent than the stop price. AMBIENCE OF THE MARKETPLACE The visitor to ¢ commodity exchange is often struck by the apparent confusion in the exchange. Trades occur by open outery of the floor traders, meaning that traders ver- bally call out buy and sell orders. There is no standing in line or computerized order entry taders stand ina sunken area called the pitand bark their offers to buy or sel at certain prices to others within the trading circle. Besides spoken offers, traders use a series of hand signals to signal their wishes con- cerning quantity, price, and whether they wish to buy or to sell. Figure 8-1 shows some of these signals for Treasury bend futures. . Only members of the exchange are allowed in the trading pit itself. There are over 3,600 members of the Chicago Board of Trade, of whom 1,402 are full members with the right to wade in any of the commodities at the exchange. There are also associate members and other membership interests that allow treding in certain products. The price of a full membership varies and can fluctuate widely. As an example, a full miem- bership at the Chicago Board of Trade sold for $530,000 on October 6, 1887. The first sale of a seat after the market crashed on October 19th was on October 28th ata price of $321,000, On May 22, 2000, a seat sold for $540,000. Eleven montis iter (April 20, 2001) a'scat sold for $325,000. In December 2003 a seat sold for $555,000. Apeson wings fRoporderis ot certain aang Saat ae thesop pacem4 Derivatives: A ntraduction POSE ck ea “The price signaled fr either bids orotfers andthe | Onée again, the dstincon between bcs any Tare sales for calm of putciae ae determined by | 1s made by whit dreetion the palm faces: Inport: Guan dae cone vaca or htzontaly |. Al pce quotes ate gven with the hanc dest n Fe ret eee Gee quoted wih the fingers | ‘Tonto an aay frm the body All volume oF Guan ty Numba jericalky Numbers 6 though 9 are quoted | indicallons ate given wit the hand uching he a2 ‘aith fingers extended horizontally, and the qumber zero ae is quoted with a closed ft Two Offered Four Offered Call Option Put Option Palm Facing toward Body one Bid SixBid “Quentty of 100 Offered Cuantityof 100 Bid Sears: hig ede Wate Many neweomers to the exchange choose to lease a membership from someone subi tying to develop the expertise an capital to warrant geting their own membes- Tiip. At che Chicago Mercantile Exchange, in January 2004 It cost about $2,950 per ‘month to lease a seat? : "Newt ro each trading itis a raised structure called a pulpit. where representatives of the cuchange’s Market Report Department enteral price changes into the price report ing system, The walls surrounding the trading arca dplay # massive electronic wale j end reflecting price information about the commodities being traded. Current prices, sere asthe two previous prices, are shown, with the high and low prices at which a parcular contact has traded during its life, This wallboard also powers a network of | afc information to which investors and brokerage firms subscribe from around the ‘world. | ‘Hundreds of order desks, where telecommunications personnel from member firms receive orders from dients and relay order confirmations, line the perimeter of the TeShunge, Most telephone clerks tape thetr conversations to protect themselves against Slleged order exvors There are approximately 1,200 workstations atthe Chicago Mer- éantile Exchange, and 153,600 telephone lines. “croup ning rss. Te BT ns prasies dur ae‘chapter 8 Fundamectals of the Futuros Market Atone time the Chicago Board of Trade contained more computer screens than any other building in the world except NASA headquarters. There is so much activity within the building that in the history of the exchange it has seldom been necessary to tum on the heat! + Visitors to any of the exchanges will note the colortul display of trading jackets worn by people on the trading floor. Exchange policy requires every employee to wear either a business suit ora trading jacket. The Chicago Mercantile Exchange provides red Jack- ets to any member who desires one, and for a nominal fee will provide a freshly iaun- dered one every Wednesday. At all exchanges, brokers from a particular firm have the option of wearing some distinctive jacket color to make it easier for their messenger and dezical people to locate them. At the Chicago Board of Trade, all messengers weet yellow jackets, royal blue signifies telecommunications individuals, price reporting supervisors wear tan, and price reporters wear dark brown jackets. For certain commodities, here are designated areas within the ple for the trading of a particular delivery month. The pit itself is either octagonal or polygonal, with steps descending into the center. The edge of the pit is approximately waist high to an ‘observer outside. Each trader in the pit wears a large badge containing a two- or three Teter (up to four at the Merc) personal identification code and an indication of which firm he or she works for (or clears trades through—more on this later) As in most professions, there is a jargon with which people on the trading floor quickly become familiar. On days when there is little trading activity, people say you can “see through the’pit” An unusually large trade by someone who normally trades Just a few contracts at a time is called an Acapulco trade, presumably because if you are successful with the trade it wil fi our ip tp an Sto place” Waa Tages iBeSeeey aos Te asket and lose all ther wading capa they have “busted out or gone to Tapioca City. A sudden rush of pit activity for no apparent reason is called a “fire drill” A big price move is a “lights out” move. Traders riding a winning streak joke about establishing an “O'Hare Spread,” referring to O'Hare airport. The O'Hare + spread is “Sell Chicago, Buy Mexico” ‘The wading Hor will occasionally observe a moment of slleuce from 11:00 a.m. until 11°01 a.m. This will happen when a long-time member of the exchange dies, or ‘when there is a national or world disaster (Such as the Challenger space shuttle explo- sion or the Chemoby! nuclear power plant accident). CREATION OF A CONTRACT Suppose trader 222. buys five contracts of September Treasury bonds from Dan Hen- nebry at 77°¥2. The trading unit for Treasury bonds is $100,000 par value of U.S, Trea- sury bonds that have a maturity of at least fifteen years. The price of 77%¥s: means 7D Ma percent of par, of $77,968.75, A price change of sz would be the equivalent of $31.25. The two traders confirm their trade verbally and with the hand signals appro- pfiate to the U.S. Treasury bond pit. Each of them then fils out a card recording this information. (See Figure 8-2 for an example.) One side ofthe card is blue for recording purchases. The other side, for sales, is red. Each commodity has a symbol, and each delivery month has a letter code. On Dan Hennebry's card, we see his notation that he sold five contracts of September U.S. Treasury bonds (ticker symbol US) at a price of 7 Pha to wader ZZZ at firm GOO. Phe letter A is circled and written in atthe far right, of the cart. This isthe time block at which the trade occurred. The first 30 minutes of. wading is Block A. the second 30 minutes block B, and so on until the close of trading. Sea a nat wl CHRGTGHa the later rote in, bute both The time loge helps to ensure that orders are correctly matched during the clearing process. This card ‘also shovrs a second, independent trade to TTT for two contracts of September T-bonds ata price of 734% ‘At the conclusion of trading, each trader submits thetr cards (called thetr deck) 10 15m8 Jarrow is ae Derivatives: A Intreducti FIGURE 8-2 Trader's Card Exit PcE wot Co oan nenmesRY pepe tei yt & € 2 aaa [=a __| w their clearinghouse, where all the cards are matched up and errors identified. The role Of the clearing operation is crucial to a well-functioning exchange, and Is discussed. shortly. cl There is a gradual technological progression in the trading mechanics at ll ‘exchanges. The Chicago Board of Trade has been phasing in certain electronic trading Systems over the past few years. The exchenge estimates it eliminated 6 million pieces ‘of paper in 2002 by the electronic submission of orders. For calendar year 2003 nearly 5 million futures and options orders were electronically sent directly to floor brokers using spedal order receipt devices called electronic clerks. The Chicago Mercantile Ex- ‘change has a facility called the Electronic Transition Center that “provid{es] valuable resources for those interested in making the ansision from floor trading to screen based trading.” | Market ParricipAaNts __| MARKET PARTICIPANTS 0 Hedges easter paceriseeo Speclaaee who are hinge Bear “There need to be two types of participants in order for g,futures market to be successful: ‘edgers and speculators. Without hedgers the market would not exist, and there would ‘be no economic function performed by speculators. HEDGERS: In the context of the futures market, a hedger is someone engaged in a business activ- ity where there is an unacceptable level of price risk. For instance, a farmer must decide each winter what crops to put in the ground in the spring. The farmer knows about such things as crop rotation but still may face a decision between soybeans and ‘wheat, for instance. To a large extent, the welfare of the farmer's family or business{chapter 8 Fundamentals of the Futures Markot A a STRATEGY Benjamin Bates, founder of the Bates ‘Manufacturing Company. in Lewiston, Maine, began construction on a series of cotton mulls in 1852, The resulting com- plex that opened in 1858 continues 0 be known today as the Bates Mill project. In the late 1850s dissent between the North and the South was increasing, Like many other people, Mr. Bates saw war clouds fon the horizon. Unlike others, however, hae felt that if war did come it would be a lengthy conflict rather than a swift action ‘The Bates Mill processed Souther com ton, a commodity a Northem manulac- ‘turer would find in short supply if war did come. ‘To hedge against this oceurtence he ™ bought as much cotton as he could on | Doth the spot and futures markets, an action that today could raise dalms that he was comering the market for cotton. ‘When war did break out in 1861, Bates ‘Manufacturing was the largest employer in Maine with about 5,000 folks on the payroll AS he anticipated, the war dls- rupted the supply of cotton to New England. His Massachusetts Competitors Went out of business for lack of raw mate- vial. With bis substantial stockpile of cot- ton he made all of the blankets for the ‘Union ary. + Re Speer “Dace be Ina Ll of» Mane lyr, Newer of te Nata rd beg ae bia al eter a depends on a future price ofthe chosen commodity Ifthe prices are subsequently high the farmer will ear a fair profit on the crop. Should prices be low because of over- abundance or reduced demand, prices may fall to sucha level that operating costs can- not be recovered. To reduce this risk, the farmer may choose to hedge inthe futures market, Farmers transfer the ris they are unwilling to bear tothe speculators who are willing to bear it In March, for instance, September soybeans might be selling for $5.80. Assume the farmer finds this price attracive, because it provides for a reasonable proft level and climinates the price risk associated with growing the commodity. The farmer can hedge the price risk by promising to sell ll or part ofthe crop through the futures market : someone who is willing to pay $5.80 per bushel fort. As long asthe farmer grows the ‘cop and delivers i, he or she will receive the agreed upon $5.80 per bushel Ttis important to recognize that the farmer cannot eliminate the risk ofa poor crop ‘The frues markt through the fatures marset, only pric risk ansbe SHinatee Coop Henan SEES. Powe vide protection against such an event but the farures market cannot. rowaton mise ‘With agricultural futures the hedger normally goes short in the futures market, because the farmer wants to deliver something. The farmer promises to deliver, with the speculator going long (promising to pay). It is also possible for a hedger to go long ‘to protect some economic interest. Consider the earlier example of the class ring man- ‘ufacturer who must quote prices to upcoming graduates all across the country in early " fall fr spring delivery ofthe rings. Should the price of gold rise dramatically after the price quotation on the rings, the manufacturer could see the entire profit eroded. The ‘maniufacturer going long sufficient gold contracts to guarantee a supply of gold at rea- sonable prices could hedge this risk. This s along hedge or a buying hedge PROCESSORS Some people earn their living by transforming certain commodities into another form. ‘A good example is the soybean processor who buys soybeans and crushes them into soybean meal and soybean oil, In their natural form soybeans are not particularly usefulSree ret : v8 Derivatives: A introduction efore they can be fed to animals or used as flour they must be ground into meal ‘The Bt from crushing beans is used in salad dressings and in industrial applications ‘on a crush, When the ‘A common activity of the soybean processor is putting processor discovers a profit margin that is acceptable, this profit can be Tocked in by arproptiate ectivities in dhe futures market, Gonsier the following example "The processor knows this information: 1. bushel of soybeans weighs 60 pounds; each bushel preduces 47 pounds of mesl, 11 pounds of ol, and 2 pounds of water. 2, 1 facures contract of soybeans is $,000 bushels, priced in cents/bushel + forures contract of soy meal is 100 tons, priced in dollars/ton. + furures contract of soy el is 60,000 pounds priced in cents/pound |4, The morning's Wall Stee journalists these prices forthe three commodities: May beans 654% July soy 19.96 Julysoymeal 196 cessor wants to leam is the profit margin implied in oa cee ree Dtcaute the processor Uses Deans asa raw material an els oll and eat aes ei products, “‘purhing ona crush” involves buying beans, selling oll and selling thea in the futures market, Table 8-3 shows the steps. en te cosor must decide f §0.2541 per bushels enough profit to cover te O2Net cone of processing, such 2s elecziiy, labor, nd so on. If so, then the processor ot coo re esd by this erash. The last step Is to figure out how many contracts of soe aes Prommodity need be bought of sold. Suppose the processors crushing cae is 100,000 bushels of beans. Table 8-4 shows the resulting calculations Pay Mpoiaional contracts of futures are not alowed, it is not possible for the processor to hedge perfec. In general, the processor does not want 40 Prone Seliver more than will be produced, bly round down. This means so he or she will proba seer rr ie processing is complete, there willbe a smell aiount of soy meal nd SOY cil to be sold in the cash market. ‘The primary statistic the pro Putting on a Crush: The Profit Margin ‘One eusner oF scans costs $6.5475 (rnoM pmices ABOVE). “en” 2,000 tb $0,996 2110 . Ae ee 7 92 19860 $198, Ltn. A77 = $4.6060/ bu ous ReveNUe FROM GO00S SOL¢ From nea $4.6060 rrom oi. $2.1956 $6.8016 Cost oF RAW MATERIALS PURCHASED: ‘Soybeans -$6.5478 $0.2541 Gross Prom:‘chapter @ Fundamentals of the Futures Markt Coe 100,000 bu 57000 bufcontract Beans: ‘BUY 20 covrascrs of sovatans ou 1,00 bc ‘SELL 18 conreacrs oF soybean ox i 5471 2 contact we 100,000 bux AZ «3 sorta ‘SELL 23 cantmacts oF SovBEaN NEAL 178 Putting on a Crush: Determining Hedge Size Oil refiners engage in a similar activity called a crack. This strategy involves the pur- chase of oil, and the sale of futures contracts in gasoline and #2 heating oll. Pre- cisely the same principles apply in determining a profit margin and Tocking it in. THE SPARK SPREAD ‘The spark spread is a type of exotic op- tion on commodities that basically allows fis owner to exchange one asset for an- other. There are two underlying assets, electricity and either natural gas, coal, ot heating oll. As with the traditional op- tions spreads discussed in Chapter 4, the spreader buys one option and writes an- other. The value of the option is deter mined by the difference beqween the price for electricity and the price of the fuel that is used to generate that electrie- ity, and the chosen striking price. This corresponds to the gross profit margin for a power producer. When the spread is positive the electricity is worth more than the cost of producing it. When itis nega- tive, power plants will go off-line. In one version the option holder has the right to buy electricity and sell natural gas: this is a spark spread call. The other version, where you sell electricity and buy natural gas is a spark spread put. TODAY VATIVES [DERI Johnson and Doege* point out that the owmer of 2 power plant owns a series of spark spread calls. At any point in time the power plant operator can exercise the option to produce electricity (thereby ac- quiring it) by paying the exercise price (using up natural gas, for instance}. If the spread is negative the power plant op- erator may choose to go off-line and not produce. Further, this is equivalent 10 holding a series of European call options. Blectricity generally cannot be stored; it can only be produced at a certain time. ‘This gives exercise a European flavor rather than American Risk managers establish the spread using the energy contracts traded at the Chicago and New York commodities ex- changes. “Lamy 3, Jonson ad Jong Dogg. “The Saeco ‘tural Gas Peed Power sn,” Woig pape 2003 Fae ‘Stbtanagement Atcnceson snnoal mei, erwer Co—_—_—_—_—— 10 Insome repeces, ‘peclacrspeform ‘hesameroleas companies. Derivatives: An ntrauetion SPECULATORS i onder forthe hedgers o eliminate an unacceptable pice sk, they must find some- Ie oe rn ne ay thar ak in thelr lace. This pezon isthe speculator. The one ho ec at Fequling use of utes contracts, bu athe nds Fee a a penile nthe futures market and rakes poskions in futures aaa manga profit rather than protecting ose hopes of mang Pron lator performing the same role that nsurance companies Fee a or pal Palides The person who buys insurance Is unwiling © bear perfor wien the) 23 Hows should an ecldent occur as eaooses to transfer that the full isk of economic om rhe insurance company 15 wing to beat the cs because it feels there is a profit to be made by providing this coverage in exchange for Because eel er Dr ping theory hols thatthe hedge does, in fact, pay a te ae Pi insurance ts theocy wl be examined ltt, ite section on Fricing fundamentals? ing onda speculation normally goes long. As with other types of secur eae ane ET USA TRVeROR envision rice rises rather than a eae snp go shoreiliey Tel that curent prices are coo hig SE eather 5 obo busily of woeer a S200 Tor Seprenber delivery if they feel wheat will not sell for that much at delivery time. Most speculators detivery if they oe liver wheat because they do ot grow it this doesnot mate, though, because any speculator can quickly exit the market by buying a September though, because sn¥ SEN ponton. The difference in pice onthe to tades wl be the speclators profi or los, See eee resus dasifed as eiher postion traders or day traders. A Freee ae erage who routinely Majpuags{utures postions overnight and Bosiion ade or open for weeks, Bay Ladersose out al thet positions Sometimes ieee forthe day taking whatever profits or losses they have incurred ‘SCALPERS Sealpers are individuals who wade for thei own account, making living by buying seater arcgnirecs in thetgitystudes have show thatthe most sucessful trades aa ee conc aee those Mrwhich the ce between the purchase and sale of the rte a seas 30 seconds! Seapers may buy and sel the same contrat often dur- saa eeading day. he value of thet account can change dramatically on days woth wide price swings Peas eee awe caw that Hennebry sold five contracts of September Treasury 20 ehneboy sa seaiper and what he wants do after this trade s Buy five aoa yes puce as quckly a5 he con, Perhaps a custome phones bis broker sae et onier io ell ve September Treasury bond contacts. When this a ces Rei the salpers lal etempt to provide the other side ofthe trade aoe ae cuypove Hennebry gets this trae, and that he buye the five con- aera easing old five contracts earle at 77%, this sa gain of son each fn contract 20 the foal dolar profi he just made is Hox 500000 55 contracts contract 312.50. ‘Three hundred bucks for a minute's work isn't bad! «wile ns anaogy maybe help you should oot at tof nsrane compan pera on the bas of he eo ingest ty ean cette handprints Cpr cere nr rr owe he edge ds, fos pay aren fhe osc neon he ‘pede peoChapter Fundamentals of the Futores Market Scalpers are also called locals, meaning that they are “part of the neighborhood” and someone with whom it is desirable to maintain good relations. Although the business of commodity trading for a living is treacherous, locals place a high emphasis on Integrity and accuracy, and these traders will sometimes help each other out of ajam in the pit. Doing so usually involves one or more other locals incurring small opportunity losses through lost trades or channeling business to a trader who has had a bad day. The trader in trouble gets a tick® here and a tick there, and hopefully recovers from att otherwise catastrophic loss. ‘Scalpers play a crucial role in the economic functioning of the futures markets. By their active trading with yntinuous and accurate, ‘Which is the hallmark of the U‘S. financial system. The futures market would be much, lesligud witnourtheseaiees” CC) ce fumebion o& SGAye> Tne CLearine Process Integuity, honesty, and accuracy are crucial features of a viable wading system. At the Chicago Board of Trade, more than a million contracts change hands each day, with 2 total dolar value n the bilions. Large suite of Money are Hee aad Tost each minute in the trading pits; it is imperative that a mechanism be in place to ensure that traders keep their promises, even when large wealth transfers occur. Making sure promises are keptis the role of the clearing process. ‘Each trader in the pit prepares trading cards on his or her transactions, The clearing process begins with attempts to match up the cards describing 2 particular trade. In Fig- ure 8-2, we saw Hennebry’s trade of five September U.S. Treasury bond contracts at ‘7P¥sa to buyer 222 of firm OOO. Somewhere in the system there should also be a card. from 222 showing a purchase from Hennebry with similar terms. When these two cards are matched, a futures contract exists. Besides matching trades, the clearing process performs other 1s: guaranteeing trades, supervising the accounting for perlormence bonds, handling intramarket settements establishing setlement prices ‘and providing for delivery. We now examine each of these functions in greater detail, MATCHING TRADES Itis the responsibility of each trader on the floor to ensure that his or her deck promptly enters the clearing process. Every trade must be ceated by or through a member firm of the Board of Trade Clearing Corporation. Scalpers make arrangements with a member firm to process their decks each day. Scalpers normally use only one clearinghouse, and the name of this organization will be displayed on their trading jackets. This name will be the firm name entered on trading cards by parties to the scalper’s trades. Brokers are people in the pits who are members of the exchange trading for their cowm account an Tor Whatever public accounts they choose to accept. They also can be Fifed by brokerage Rouses such as Merail Lynch vo handle the Erm’ transactions on the exchange floor. Brokers also fill out trading cards, but it is common practice for them to submic their cards periodically while trading rather than turning in a deck at the end of the day. : ‘Although affiliated with the Board of Trade, the Clearing Corporation is an indepen- dent organization with its own officers and rules. Some members of the Board of the ‘Trade are also members of the Clearing Corporation, These people can clear their own, trades, and, for a fee, will sometimes clear trades for nonmembers. Scalpers might pay $1.50 per trade to a member firm for clearing their trades. All tredes must go through the clearing process. “+ asteie smalls pestle pr change na parte coma ve Locals provide Beuiyo uares morte \eara ry | Eiqarelionee be ative: An Intadction Aiter @ Clearing Corporation member receives trading cards, she information oa sacl ed an cheiad becom. cars wit mang informatonaze ured Bee Sariag member for conection. The infomation on valid cards's stored in com- ‘eter miensory Once all cards have been edited and fed to uae computer, the computer hems to mateh cera forall trades that occurred om the exchange that day. ‘Sometimes it is not possible to match all trades exactly. These mismatches, called out trades, result in an Unmatched Trade Notice being sent to cach clearing mem 2a this the responsibilty of the reders themselves to recone their out trades and anv ata solution to the mismatch. A(price out, "}here the two traders wrote down Giierent prices fora elven trade, someuines occurs when one person writes down ¢ ie tac sway from Uae market or faraway from the curent wading range. A con pt ght rade between $5.97 and $6.01 during time block Con a given day. Writing see BF gSiol rather Man $6.01 would result in an out trade that i easly reconciled PPA co participants tothe trade. Where the errors nat cbvious, such asa price of $U.57 anda potential match with e price of $5.98, the bvo taders often compromise by splitting the difference. Anofher mismatch is the (DIE oak) where an incorrect member frm is sted on the trading card. This is normally easy t0 rectily because there will likely be two trades Reco mach except forthe fim, ACQHEHETY-OuEDnccurs when the number of con tacts in a particular trade is in displite. A trader may think he bought 8 contracts, while the seller sold 18, (Strike out” and “ime out occur primarily with futures options, when errors occu Witirelther the surking price or the delivery month. The worst out trade is thesides out.“vhen both cards show the same side of the market, that is, both indicate buy oF both indicate sell. These are difficult to reconcile but do not happen very often. Despite the reason for the Unmatched Trade Notice, it is the tader’s individual responsibility to resolve the error. On the rare occasions when this cannot be done, the dispute may be taken to arbitration with the Clearing Corporation. "At the Chicago Board of Trade, out trades account for 1% or 2% of daily volume. It js estimated that floor brokers lose between 10% and 17% of gross billings to out trades. A preliminary run Is completed at the Chicago Board of Trade by 5:00 rat. each trading day. The clearinghouse distributes a listing of unmatched trades to each firm with apparent out trades from this preliminary run. Many entries on the listing are Simply clerical errors. Firms have until 8:00 ra, to make corrections. Large firms, ‘which clear for many scalpers, sometimes have preliminary run listings several inches thick, Trade checkers attempt to resolve mismatches by checking orcer cards and call~ ing clearing clerks in other firms. Any mistakes discovered are submitted to the clear inghouse, and another computer run then occurs. According to the market report department at the Chicago Board of Trade, about 90% of out trades are cleared by the Second computer run. The remainder must be cleared the following morning by an individual trader involved before the trader begins trading for the day. The exchanges employ out trade clerks to help in the process of reconciling trades. This job is a stress ful one, since out trades are no fun, and the parties involved are not always in the best of moods. Price disputes are frequently seitled by simply splitting the difference. ‘After resolving all out trades, the computer prints a daily Trade Register showing a ‘complete record of each clearing member's trades for the day. Within a register are sub sidiary accounts for each customer clearing through the firm. These accounts show all positions in each commodity and delivery month, much like other types of brokerage statements. ACCOUNTING SUPERVISION ‘The performance bonds deposited by the member firms remain with the Clearing Cor- poration until each firm closes out its positions by either making an offseting trade orae Chapter 8 Fundamentals of the Futures Market by delivery of the commodity. When successful delivery occurs, good-faith deposits are returned to both parties, payment for the commodity is received from the buyer and remitted tothe seller, and the warehouse receipt for the goods is delivered to the buyer. ‘On a daily basis, the accounting problem is formidable, even when no deliveries occur. Unlike most other types of investment accounts, futures contracts are marked to the market every day, meaning that funds are transferred from one account to another based on unrealized for paper) gains and losses. For instance, i the initial Sepou in neater ecosunt 32.000 oa purchase ofa soVbean contact a $6.00 per bushel, a dectine in the price of the soybeans to $5.99 would result in a $50 loss, and the member's account would show only $1,950 remaining from the $2,000 Geposit. After each trading day the Clearing Corporation makes these transfers and prepares a summary of positions and cash in the account for each member: ‘able &5 presents a hypothetical series of transactions in the soybean commodity futures market showing the handling of the various transactions. The example begins ‘with soybeans selling at $5.30 per bushel. When someone initially establishes a futures position, the trade that does so is called an opening transaction, just asin the options ‘market. Each opening transaction creates half a futures contract. Each Closing trensac- tion eliminates half a fucures contract. Closing transactions can occur by either delivery of the commodity or by an offsetting trade. A short seller, for instance, can get out of the market by buying an identical contract or by delivering the promised commodity. Table 8-6 shows how open interest varies in the example from Table 8-5 and how the cash at the clearinghouse exactly works out by contract delivery. ‘Open interest is a measure of how many futures contracts in a given commodity exist a a particular time. This is the same idea as exists with stock options. There is 20 set number of option or furure contracts. When someone writes an option, they create a new contract, Similarly, when someone decides to go short a futures contract, they have created a new contract. The number of futures “promises” can increase or decrease every day, depending on the relative proportion of opening and closing trans- actions, ‘Open interest increases by one every time two opening transactions are matched and decreases by one every time two closing transactions are matched. If a trade involves a closing transaction by one participant and an opening transaction by the other, then open interest will not change: the number of “promises” remains ‘unchanged, although the players may change. This is a consequence of the fuagibility of futures contracts, If Delta Dan owes $10 to Gabby Gamma, and Gabby Gamma ovres $10 to Thaddeus Theta, then Gabby Gamma does not need to be in the picture: the Clearing Corporation can close her out and instruct Delta Dan to pay Thaddeus Theta. The dearinghouse maintains information about open interest and publishes these fig ‘ures in the financial pages dally, Large open interest figures are desirable to ensure a competitive market. ‘Open interest is different from trading volume. A single futures contract might be traded often during its life. A bank that hedges interest rate risk by buying T-bond futures might keep this position for several months. But the speculators who take the other side of this trade might exchange their half of the promise 100 times before the delivery date. : Figure 8-3 shows soybean prices from Friday, June 16, 2000. The two columns on the far right indicate that volume and open interest can be substantialy different. A tick in soybean futures is ¥ of a cent. The newspaper shows prices in pennies and cighths, A price of 5046, for instance, means $5.04%, or $5.0475 per bushel ‘When people leave the market by an offsetting trade, their profi or loss comes from the gains or losses that have been posted to their account each day after trading. In Day 1 of Table 8-5, we sce Speculator A buy a contract at $5.30 per bushel. Instead of ‘advancing, the price of soybeans went down the following day. This speculator chose to Qericranste bors 183Derivatives: a Introduction 1 ou ‘oy “ysodop \ey-poo8 oun 10 000'T$ 2040 ol SuoRoIa! ue jousNg oneses vue‘ 22s Jed ye°G§ Bulfed “Y Ja899} wo FoRRUOD Buywlews ayy sanfoaas fe sofeL ‘9 J08OH| "909 UiBHeW 0O'T Buns oue jaysnq 10d OES 'y 498baH "yor UlBueW QoO'Z$ Sia you | owoy jong sod "96 shed pue g J9BpOH Wow tsk | oos'vss sjoeijuoo 2 senieaes 9 .28p9H “y9eq UBseW 000'Z¢ aun BuMeB sted | SOL sje pue jousna 94 ga'ag BuIAGo04 ‘s}oenIU09 Z SHON @ Jeg Keg cares | ones | osce "}/0U! 0} pamueW BI SURGDOY “GEG St ep awoy ‘9 Jee} 0} (uonesueA, owes 06 9 sored ioenuod & sfng 9 JeBDeH by Mea onaig | o0se | oovs | ewou “yaxs2U payieW aie sjuneDoy osc es 91 Kop eva Jo puo ay, ye ead yuowo;yes ayy “(voH}oesUeN, seyel | “awoy Bursoyo) & selnoedg wou enuOD aLy shng pue yOrLeU oes 2p Jo 3n0 68 0} S29I9 9 s04eIn0edg “(uoRoesUAN BUSO!) EES soyel 1 PeUod si S95 pue Youd sIY 942} 0 sepIo—p goeINaRdS _& he ar oe 000'9s “16 st Aep ou Jo pus ous 3 201 sojengeds pue g Je8peH WOM, con's oes cones wou o58'1§ Sve zfeq cari one ooze 00'T$, uwuad Ue 1 SIUL “08S Ve JoeNLOD T 9S 0% SopIoeP Y Jeet AEG o|af[wvi[o ofa |v 03H sworn ‘s2anvIVg JNO} OHIOHEL SVEarket 8 th the Clearing House | Open irenesr Casi Cash Casn OW | (Gumuanve) —__Reesven Pan Haro i Dw Heooen A +e $1,000 $1,000 SpecuaronA 4 $2,000 $3,000 H 1 Dav 2 ——Specuaron A ~* $1aso $1,160 Specusaor B +e $2,000 $3,150 Heooee & +1 $2,000 $5,150 Seecuaror © + $2,000 $7,150 SrecutorD +1 $8,000 $13,150 sl Dav3 ——Specuaror B $2,300 $10,850 i Sercutaron C $1,750 $9,100 | Dav4 —— Heoser © +e $3,000 $12,100 | SeecurorD il $6,900 $5,200 3 DayvS ——Heooen 8 2 $54,200 ~$49,600 Hosen C = $51,400 $1,800 Hosen A ~” $27,500 ~$26,700 Hensen C “* $25,700 ° ‘Ac the end ot Dy 5a postions have een eliminated open interest 2) and he Clearing House has dbus leah, FIGURE &-3 Soybean Futures Prices June 16, 2000 | Dever Oren | Monn Oren Hoh Low = Semi Guanoe = Votume —_Intenes | ju2000° 61445144 50405086 = 6232004 «46746 | Aus2000 50705074 = 5004-5012 4 7a89 19480 Ser 2000 4980 4994 4950 4960 44396015487 | Nov2000 5020 504249945006 56 22629 62655, Jw 2001 51105130 50845100 54 10056305 | WMae2001 6208 © 5204 5160 5180 64 10154987 | May2001 $240 527052308230 15 202 | Ju 2001 6290 5330 5280529040 534187 | Novzoo1 53805400 6880538080 371371 as fom Bir BS, take his lumps and get out of the market. The broker was able to sell his contract at $5.27. This $0.03 per bushel loss is incurred on each of the 5000 bushels represented by a single soybean contract, so the speculator loses $150. Although the initial good faith deposit was $2,000, only $1,850 goes back home.“The pres of some ‘inure conracte Sreconsealned by Seip tn Derivatives: An Introduction Another important point is illustrated by the activities on Day 5. Hedger C receives 10,000 bushels of beans from Hedger B. When Hedger B entered the market, he sold beans for 528. Hedger C, however, agreed to pay 534. Because Hedger C pays more than Hedger B reccives does not mean there is something wrong with the market or that there is @ “parasite,” to use Senator Washbum's word. All market participants per form exactly as promised, and by the end of Day 5 we see that everything nets out exactly t0 zero, Open interest is also zero after the last closing transaction occurs. INTRAMARKET SETTLEMENT On rare occasions, commodity prices move so much in a single day that good faith deposits for many members are seriously eroded even before the day ends. When deemed necessary, the president of the Clearing Corporation may call on members to deposit more funds into furing the day. This is a market variation call, See aie one hoe rom ene ofthe call The po: cedure also helps to ensure the integrity of commodity farures contracts. ‘SETTLEMENT PRICES In the commodity pits itis difficult 10 tell precisely what the last wade was when the bell rings to signal the end of the trading day. This is understandable given the open outery system, where other people in the pit do not always see every trade that occurs. Because all commodity accounts are marked to market daily, a final price is necessary 50 that funds can be transferred among accounts. The settlement price is analogous to the closing price on the stock exchanges, and itis this figure that will appear in the moming’s Gnancal pages. While procedures vary slightly from commodity to com- tmodity, the setlement price is normally an average of the high and low prices during the last minute or 30 of trading, Establishment of the official setlement price is another of the Clearing Corporation’s functions. ‘Unlike the prices established on stock and option exchanges, many commodity futures prices are constrained by a daily price limit. This means that the price of a contract is not allowed to move by more than a predetermined amount each trading day. For instance, ifthe daily price limit for soybeans is 30 cents, this means that today’s settlement price cannot be raore than 30 cents higher or 30 cents lover than yester- day's settlement price, Commodities are said to be limit up or limit down when a big move occurs. Sometimes it may take several days for prices to work their way to a new equilibrium price. ‘On December 23, 2003, ive cattle sold for approximately 92 cents per pound. Later this day the government reported a case of mad cow disease in Washington state. Such an announcement dramatically increased uncertainty in the cattle business and was dearly not good news for beet producers. Cattle futures at the Chicago Mercantile Exchange immediately went down the limit of 1.5 cents per pound. The exchange took emergency action the following day and doubled the limit to 3 cents per pound, with futures immediately falling by this new level and staying there for the rest of the trad~ ing day. After the Christmas holiday the Merc increased the limit to five cents. Prices continued t0 fall, down to just over 73 cents per pound on January 2, 2004. This is approximately a 21% decline in ten days. Such volatility helps indicate why hedging is a good idea for those who deal in commodities. DELIVERY [Although the Clearing Corporation interposes iseif between every buyer and selles, it never takes or makes delivery of any commodity. It does, however, provide the frame ‘work that ensures accurate delivery. Ler’s look at the delivery procedure for a grain contract at the Chicago Board of Trade.Chapter 8 Fundamentals ofthe Fut Market ‘When a seller decides 10 deliver, a Notice of Intention w Deliver Is filed with the Clear~ Ing Corporation. This shows the seller's intention to deliver the commodity on the next, business day. Delivery can occur anytime during the delivery month, and the first busi- ness day before the first day of the delivery month is called First Notice Day. ‘On the day prior to first notice day, each member with long positions in his or her account must submit a Long Position Report to the Clearing Corporation. This document shows all the members’ long positions and their date of purchase. This document also must be updated each day during the delivery month. The due date for this report is, position day. On the next day, intention day, the Clearing Corporation may assign deliv- ery to the member with the oldest long position in the particular commodity. The price of the delivered commodity is adjusted for quality differentials and any other associ- ated costs such as temporary storage or transportation. ‘As aule, speculators and their brokers do not like to handle deliveries. Given that delivery can occur anytime in the delivery month, speculators tend to move out of the inarket in the few days prior to first notice day. Delivery procedures vary somewhat among the exchanges, and are quite different when financial futures are involved. At the Chicago Mercantile Exchange, for instance, both buyers and sellers ofits Treasury bill contracts may Initiate delivery, and delivery must occur ona single, predetermined day of the delivery month, | Principtes oF Futures Contract Pricing T In considering what makes a futures contract valuable and what makes the price of the contract luctiate from day to day, itis important to remember the basic fundamental thot a furures contract js a promise ro exchange certain goods ata future date, You must keep your part of the promise ane yo "You get someone to take the promise off your hands (.¢., you make 2 closing transaction). The promised goods are valuable how, and thelr 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 availabll- ity of substitute commodities, psychological factors, and changes in storage or insur- ance costs. These factors include shifs in demand for a commodity, changes in the supply ofthe commodity, or both. There are general principles of futures pricing applicable to all contracts. Specific examples of pricing with financial futures appear in Chapters 9 through 12. ‘There are three main theories of futures pricing: 1. Expectations hypothesis 2. Normal backwardation 3. Full carrying charge marker ‘THE EXPECTATIONS HYPOTHESIS Remember Senator Washburn’s comments about these “fictitious contracts." Of course, the contracts are very real, with brokerage houses and the Clearing Corpora- tion to enforce compliance with the terms of the contract. Because the contract calls for delivery of a specified good in the future, it seems likely that one of the major determi- rants of the futures contract value is the current value of the commodity in the cash market, This is exactly what we find. ‘The simplest generalization about this relationship is the expectations hypothe- sis, This states that the futures price for a commodity is what the marketplace expects the cash price to be when the delivery month arrives. Under this hypothesis, if Septem- ber soybeans are selling in the futures market for $5 per bushel, this means the market- place expects soybeans to sell for $5 in September. There is considerable evidence that 187188 Normal baconardacon suggest tie ures prceina downard Gites enirar of Derivatives: ntroduetion the expectations hypothesis is a good predictor. This is a very important fact for the user of the futures market, because it provides an important source of information about what the future is likely o bring. Price discovery, in fac, is an important func- tion that futures perform. IfT want to know what people expect the price of heating oll to be this fall, can look in the Wall Street Journal for the price of a heating oll futures contract and know that this figure is a reliable estimate based on current information. (Remember that the price for the retail customer would be somewhat higher then the price that a wholesale distributor would pay.) For instance, an investor may be interested in learning consensus estimates of the price of gold or eaTar sear Ron HOM Aceovting tothe exgecatons hypothe ee Rear ans Fine fencl pages, OusmnDYy HeaP iD Hee what a futures contract with a delivery month one year hence settled at yesterday. We have previously seen that there needs to be a relationship between the price of a commodity in the cash market and the price of that commodity in the futures market ‘There isa definite relationship between the cash price of a commodity, the various stor- age costs associated with the commodity, and the futures price. In a well-functioning marketplace, arbitrage opportunities will not appear often; when they do they are quickly eliminated as people exploit ther, Consider the situation in which in June, cash corn sells for $2 per bushel, the local grain elevator charges 5 cents per bushel per month to store the grain, and an August futures contract sells for $2.15. If these prices were accurate, an arbitrage opportunity ‘would be there for the taking. Simply buy comm in the cash market, sella futures con- tract promising to deliver the com in two months for $2.13 per bushel, store the corn in the clevator for two months, and then arrange for delivery. You would have a little ‘more than $2.10 invested in the corn (2 cost plus 10 cents storage costs plus a small ‘amount of interest to finance the purchase) and you would receive $2.15 from the Clearing Corporation when you deliver. You have made about 5 cents per bushel profit, without taking any risk, NORMAL BACKWARDATION ‘All participants inthe futures market are very concerned with the idea of basis. Basis is the difference between the future price of a commodity and the cuxrent cash price. Normally, the futures price exceeds the cash price; this is a contango market. if the furures price is less than the cash price, this is called backwardation, or an inverted market. As the gap between the futures price and the cash price narrows, we say that the basis has strengthened: basis wealxens ifthe gap gets wider Remember that investors do not like risk and that they will only take a risk if hey think they will be properly rewarded for bearing the risk, if the futures price is what people think the cash price will be at delivery time, then why would anyone be inter~ sted in speculating? It seems that the hedger can get rd of his or her price risk without any cost and that the speculator agrees to take the risk off the hedger’s back for noth~ ing. This seems improbable in rea life. “The idea of normal backwardation is attributed to the famous economist John Maynard Keynes. Like much of good economics, the idea is simple and very logical. Feige Who tats the futures market is essentially buyiig insurance. Locking in a future price that is acceptable eliminates price risk. When we obiain insurance we pay for it, because the insurance company could not remain in business if it offered this protec- tion for nothing. Keynes argues that this means that the futures price must be a down: stand based ereuist of etutgee cach PERE her words ste The cash price Tilieay becomewhat higher than the pice predicated by ‘ue haies mage THE because the -speculator must be rewarded for taking that the hedger was Sefaurecah pre. unwilling to beer. The hedger might really believe thet the cash price of soybeans in‘Chapter 8 Fundamentals ofthe Futures Market September will be about $5.04, but might elso be perfectly willing to tale $5 per bushel for certain. Though this less than the anticipated price, the risk that the soybean mar- ket might collapse to $4.75 or less is unacceptable. The peace of mind that $5 per bushel brings is valuable. ‘The speculator, on the other hand, has access to the same information as the hedger, and might agrce that $5.04 is a good bet for the cash price of beans in September. Remember that one contract of soybeans Is 5,000 bushels, so if the speculator can promise to pay $5 per bushel and turn around and sell it for $5.04, this is a $200 gain per contract. The high leverage associated with futures contracts can make this an impressive rate of return when annualized. On the other hand, prices could take a dive and result in big losses for the speculator (but not for the hedged farmer), ‘The concept of normal backwardation does not really mean that the expectations hypothesis is wrong. Keynes agrees that the futures market provides useful informa- tion about the future. With the logic of normal backwardation, though, we may be able to fine-tune our estimate of furure cash market prices. A FULL CARRYING CHARGE MARKET ‘You can buy commodities in the cash market and store them for later consumption. As ‘we have seen, the person who performs the storage function gets a fee for this service. It is necessary to keep grains dry, to protect them against fire, to keep the rat popula tion to @ minimum, and to provide insurance on the stored commodities. Insurance is necessary fo protect against loss of the goods due to tomadoes, floods, fires, and even explosions. Every few years we read about a spectacular blowup of a grain elevator. ‘The dust and fine seed particles that can get suspended in the air during filling and stor- age will, under certain circumstances, ignite with a vengeance. A full carrying charge market occurs when futures prices reflect the cost of storing and financing the com- modity until the delivery month. In a world of certainty, the futures price F is equal to the current spot price S, plus the carrying charges C until the delivery month: Pasre (ey F- Seed Although we do not live in a world of certainty, the difference in price betwen a Toccata, futures pric id the cash price is often quite close to the carrying costs between the eee Fwopoinsintime.Insucha marke hisbas imporantimpleavonsTor Mespeculatr, Reema ‘Suppose in early September we see prices as follows and that it costs 2.5 cents per month to store soybeans: Cash price For soybeans: s4.85 Futures prices: November: $4.90 January: $4.95 March: $5.00 The speculator might be arying to dectde between the January and March delivery months. If the speculator wants to go long (thinking that soybean prices will increase), itis wise to buy the near delivery month (January). To go short (anticipating a down tum in prices), iis best to sell the far delivery month (Merch). Le’s see why. ‘Arbitrage exists if someone can buy a commodity store it at a known cost, and get someone to promise to buy it later at a price that exceeds the cost of storage. in a full carrying change market like in this example, the basis must either stay the same or strengthen; it cannot weaken because that would produce an arbitrage situation. Tn other words, the difference between a January and a March contract could become lessthan five cents, but it should never be more. Ifit were more, then you could buy Jan- uary, sell March, pay a nickel storage for two months, and still be ahead without hav- ing taken any risk. ‘Although there is never certainty in any investment situation, in a full carrying charge market the bullish speculator who buys the near contract can be very confident fof one of two things. Ifthe price of soybeans does go up, then January soybeans should ‘ise by more than March beans. If soybean prices fall, then January soybeans should fall less than March beans. In either case, the speculator is beter off buying the near delivery month, ‘The logic holds erue in reverse for the speculator who is bearish: go short the far contract, because it will ether fall in value more or rise in value less than the near delivery month.!° RECONCILING THE THREE THEORIES ‘The three theories of furures pricing are actually quite compatible. The differences in them are somewhat like the chicken and the egg question, in that it may not be easy to decide which comes first. The expectations hypothesis says that a futures price is sim- ply the expected cash price at the delivery date of the futures contract. People know about storage costs and other costs of carry (insurance, interest, etc.), and we would rot expect these costs to surprise the market when they are incurred. It therefore seems logical that people would “expect” the futures price to be partially determined by these costs Bia ol aata tL} ‘As the Wall Street Journal reported, “It would have given a new meaning to ‘suike price,” It seems that in the sum- mer of 2003 a Pentagon think tank (the Defense Advanced Research Projects “Agency, or DARPA) was considering tm- plementation of a futures market that ‘would allow participants to profit “by cor- rectly predicting assassinations and ter- rorist strikes in the Middle East.” The market was to have been coordinated by a group of Cal Tech faculty members. ‘The motivation was to take advantage of the price discovery function of the fu- tures market. According to the expecta tions hypothesis, the futures price is an extremely good indicator of likely future price levels. There are many people who would like to be able to anticipate terror- Ist acts. According 10 the WSJ, “Middle ‘East specialists would buy and sell futures contracts from self-financed accounts, and defense officials would monitor their trad- ing patterns to glean insights into the like- lihood of certain events.” Not surprisingly, there were very few people outside DARPA who thought this was a good idea. Both Republican and Democratic members of Congress reacted sharply against the proposal and it didn’t get any government backing. ‘The project resurfaced in November 2003 as the Policy Analysis Market.t Un- like its failed predecessor, this market will have no goverment involvement and vill only involve events that have a posi- tive or neutral slant, such as the level of OPEC oil production. There will be no trading on terrorist activity + Spat Mary, Peaagon Rates From Teos Faces inPuce bl Cuscah Wal er trne fly 32 003.) * aoe Geng “ide Rat Futures Maveet Ress [ENN Hovanber [620035 ea *-tnsjsumes hat monty orge cn en ona The carpe alo stumes tha the aPbiragear can dvr the com Inthe ght sce ar seq eqs teladnships lees obvinws wih ancl us. The ners ae ll curve ear laa he rena atthe ost tng aes etsing oie time sp vee The sage ote ed cave can change sch akon tt eee oscted above wan ac, nee Ges whan ated ai os[chapter 8 Fundamentats of the Futures Market ‘The essence of normal backwardation is that the hedger is willing to take a bit less than the actual expected futures cash price for the peace of mind that comes with insurance, Because the hedger is really obtaining price insurance with futures, itis 1og~ fecal that there be some cost (0 the insurance. The hedger might expect a higher price, but be willing to accept a lower price to reduce risk. In a full carrying charge market, the futures price reflects the actual cost of storing a commodity until delivery time, This Js consistent with the expectations theory. SPREADING WITH CommopiTy FuTuRES We have previously seen how the risk and return relationship of a stock option pos tion can be altered by the inclusion of one or more other option positions in the portfo- lio, The same general result is true with futures contracts. Fucures spreading is a type of speculation and involves taking offsetting positions in two related commodities or in the same commodity. As with options, fulures spreads have less risk than an outright long or short position."' Also, there may be special margin requirements with com- ‘modity spreads, meaning that the speculator has to put up a smaller good-faith deposit than would be true on two trades made individually. INTERCOMMODITY SPREADS An intereommodity spread js a long and short position in two related commodities, perhaps corn and live cattle, A speculator might feel that the price of corn is too low relative to the price of live cattle, and that this differential should correct itself in the neat future, So, the speculator might sell live cattle (anticipating a price dectine) and buy com (anticipating a price rise). This type of spread is risky, because there is no assurance that your bunch will be correct. It is entirely possible that corn could decline ‘while live cattle prices increased further, in which case you would lose on both invest- ments. For this reason, there is not always a special margin treatment for an intercom- modity spread. INTERMARKET SPREADS With an intermarket spread, a speculator takes opposite positions in two different markets, Wheat trades on both the Chicago Board of Trade and on the Kansas City Board of Trade. Any difference in price between these two locations should be based primarily on transportation expenses or other administrative costs Some international investment houses routinely spread gold in the cash market between major financial centers. It may be possible to buy gold in Zurich at $250 an. ounce and simultaneously sell it in London at $235. If this $5 difference is sufficient to ‘overcome shipping costs, then a person who bought Zurich gold and sold London gold ‘would realize a profit. INTRACOMMODITY SPREADS An intracommodity spread is also called an intermonth spread: it involves taking dil- ferent positions in different delivery months, but in the same commodity. For instance, 4 speculator who is bullish on wheat might buy September and sell December. These spreads are rather common because they Involve a low margin requirement and sub- stantially reduced risk. ‘An important consideration with these spreads is the difference between a “same crop” spread and a “new crop-old crop” spread. A spread using November and January crane says ue wih sprees in she fare make. pai with lt yea-ae yea or neon ees. 19112 Derivatives: An nto soybeans would be a same crop spread, becauise these beans were harvested during the sare crop Year. Buying July 2000 beans and selling November 2000 beans would be a new crop-old crop spread, and much more risky because the conditions affecting the price of soybeans may be very different next year. One final thought on commodity spreads involves the extent to which your losses are known or limited. Suppose that in March a speculator reads that September meal sells for $174.60 and that December meal sells for $179.60. The speculator, being bull- ish, buys a September contract and sells a December contract. Suppose that in August soy meal has risen (as the speculator had hoped), and that current futures prices are $184.60 for the September contract and $194.60 for the December contract. Ifthe speculator were to close out these two contracts at this point in August, the combined positions would show a loss, even though commodity prices moved in the anticipated direction. On the long side, the contract price rose by $10 per ton, while on the short side the price rose by $15 per ton. Since the speculator was short the December contract, this $15 price rise really translated into a $15/ton loss. ‘Combining this with the $10 per ton gain on the long side yields a net loss of $5 per ton. With 100 tons in a soy meal contract, this means that the combined positions lost $500 even though prices advanced, The teason for this is that the basis on the short position changed adversely relative to the basis on the long position.!? WHY SPREAD IN THE FIRST PLACE? It should be obvious that there can be huge gains and losses in the futures market. Some people, including professional commodity traders, are uncomfortable with the ‘magnitude of loss that could occur from a “lights-out” move. Acapulco is very nice, but ‘we need to remember that Tapioca City is out there somewhere. ‘Many people choose to trade the basis rather than simply go long or short a particu- lar futures contract and hope that prices move your way. I may expect the basis to strengthen or to weaken, but in either event my maximum loss is likely to be much less than with a single furures position. Playing the basis involves more than one contract, and this is by definition a spread. Most intracommodity spreads are basis plays, Intercommodity spreads are not necessary risk-reducing strategies. In the example cealies, where a speculator Sold live catile and bought com, iti certainly possible that both contracts could move adversely. Such a spread is closer to two separate specula~ tive positions than to @ spread in the stock option sense Intermarket spreads are really arbitrage plays based on discrepancies in transporta- tion costs or other administrative costs. When arbitrage is spotted, a spread is the way to take advantage of it: buy in the cheap location and sell where itis dear ‘eth snot something we have fo wor out wah bob spends sng oe opus.‘hater 8 Fundamentals of the Futures Market Futures contracts are promises to buy or to de- liver a certain quantity of a carefully defined commodity by a certain date. Futures contracts enable farmers, bankers, or anyone else with economic interests in a particular commodity to hedge price risk. The futures market cannot pro- vide protection against crop failure or against making bad investments. ‘To ensure the integrity of the contract, all trades are actualy sales to or purchases from the Clearing Corporation. Both hedgers and specu- lacors post a good-faith deposit to. show their FW Urututes markers typically work ‘best when there are relatively few speculators. Rather than having an expiration date like an option, a futures contract has a delivery date TAZ e_ GA forward contract is more si Jar to a futures contract than to an options contract. FE’ @ihe securities and Exchange ‘Commission regulates commodi- ties trading, Property rights cannot be trans- ferred with futures contracts. Ja business that needs a particular ‘commodity in the near future ‘could logically use a short hedge togetit. fF All participants in the futures market must post a good-faith deposit on which they may ear. interest. @m the marketmaker system at the futures exchanges, trades oc- curby open outery. Ia trader has an out trade, he or she receives an unmatched trade notice, ULE TLE Tt tLe Ls capacity to sustain any losses that might accrue to them, ‘There are three main theories of fuvures pric- ing: the expectations hypothesis, the concept of normal backwardation, and the concept of a full carrying charge market. Rather than competing philosophies, these three theories are different perspectives on the fundamental result that fu- tures prices are primarily determined by today’s cash price, by the cost of storing and transport- ing commodities, and by expectations about how the cash price is likely to change in the future, eZ? Q. The funuzes market is aot de- signed to provide protection against crop failure. Ze @L. Putting on a crush involves buy- ing soybeans and selling soybean oifand med In some respects, speculators perform the same function a: insurance companies Sealpers provide liquidity to the market. Futures contracts are matked 10 market weekly. . Open interest is a measure of how many contrac traded on @ particular day. ). A trader who receives a market ‘adiation all hes one hou to put money into his or her account. TF th ta futures contract is limit up, trading essentially stops for the day. TE the concept of nommal back- wardation suggests that the fu- ture cash price will be slightly higher than predicted by the expectations hypothesis.Derivatives: A introduction 7 Le_(19) Basis is the diference verween the futures price and the cash price. (owes pose forthe ang volun 10. a particular futures contract to exceed the ‘open interest in the commodity? ‘Why isa delivery mechanism essential toa ‘well-functioning futures market? Do you think that daily prices limits make sense? Under current rules, hedgers must post @ smaller good-faith deposit than specula~ tors. Do you feel this is a reasonable rule? Explain how itis possible for a hedger to benefit from a narrowing besis in a particu- lar commodity. ‘Why is it that your maximum losses and gains ere rot predetermined with a com- ‘modity spread (as they are with most op- tion spreads)? “Closing all futures exchanges would probably be inflationary because of the baded risk the producers would have to bear." Do you agree? Suppose you were on a commission that ‘was evaluating several proposals for new futures contracts. What would you want to know before you could make a decision fon whether the proposals should be ap- proved? Do you think it would be possible for futures contracts to trade via the specialist system? Why or why not? Commodities with particularly volatile prices lend themseives to furures trading. Lettuce is usually considered to be the gro- cery store commodity whose price is most tuneertain. One day itis 47 cents a head, the next day itis 99 cents. Some people argue that futures contracs will never ‘work for perishable commodities like let- tuce, Do you agree? 20. Unlike options, futures spread is usually riskier than a single futures position. ies of wheat ready for harvest in Septem- ber. What would be the implications of hedging by (a) selling 8 contracts, (b) sell- ing 10 contracts, and (¢) selling 12 con- tracts of September wheat? @pr fxamples of someone who might [profitably use 2 long hedge in (a) com, (b) gold, and (c) soybeans. Briefly explain why prices for futures con- tracts on grains are generally higher for more distant delivery months. 14, “Individual speculators tend to lose money on their purchases of futures contracts.” Do you agree? Refer to Figure 8-3 as needed. Assume that today is June 17, 2000. chased four contracts of September s0y- ‘beans at 4912, What is the person's gain or loss as of the date of this newspaper? (3 suppose a farmer anticipates harvesting 50,000 bushels of soybeans in September. Using the settlement price shown in today's paper, how much money would the farmer receive from hedging by selling eight contracts of September soybeans at the Chicago Board of Trade? (a) Today? (b) Atdelivery? 17. Refer to a current Wall Street Journal. As- sume a soybean processor has a 100,000 bushel capacity. Calculate the processor's profit margin according tothe WSJ prices ‘and put of a crush for October delivery. ‘Assume it takes one month to complete the processing operation.