Futures markets

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Futures markets

• Todays price for products to be delivered in the
  future.
• A mechanism of trading promises of future
  commodity deliveries among traders.
• Biological nature of ag production
• Prices not known when production decision is made
• Processors need year around supply

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Futures Market Exchanges

• 12 organized exchanges
• Two largest
• Chicago Board of Trade (CBOT)
• Grains, interest rates
• http//www.cbot.com/
• Chicago Mercantile Exchange (CME)
• Livestock, financial, currencies
• http//www.cme.com/
• Combined for 75 of futures volume

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Futures Market Exchanges

• Trading pits
• Centralized pricing
• Buyers and sellers represented
• All information represented
• Perfectly competitive market
• Open out-cry trading

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The futures contract

• A legally binding contract to make or take
  delivery of the commodity
• Form (wt, grade, specifications)
• Time (delivery date)
• Place (delivery location)
• Possession (seller delivers, buyer receives)

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The futures contract

• Standardized contract
• No physical exchange takes place when the
  contract is traded.
• Deliveries are made when the contract expires
  (delivery time)
• Payment is based on the price established when
  the contract was initially traded.

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Standardized contract

• Certain delivery (contract) months
• Fixed size of contract
• Grains 5,000 bushels
• Livestock in pounds
• Lean Hogs 40,000 lbs carcass
• Live Cattle 40,000 lbs live
• Feeder Cattle 50,000 lbs live
• Specified delivery points
• Relatively few delivery points

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Market position

• Objective Buy low, sell high
• You can either buy or sell initially
• Sell a December Corn contract initially
• Short the market
• Buy back at a later date
• Buy a February Live Cattle contract initially
• Long the market
• Sell back at a later date

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Margin account

• Highly leveraged trades
• Margin is the earnest money that must be
  maintained in the traders account
• Often 5-10 of full value
• Margin account settled everyday
• Must maintain account balance
• Margin call
• Calculate as if you had to get out of the market
  every day.

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Margin Account

• Initial margin The amount needed to open and
  account.
• Maintenance margin The minimum amount needed to
  keep and account open.
• Mark to the Market at the close of each trading
  day.

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Margin Account Example

• Initial margin 1,000
• Maintenance margin 800
• Corn contract (5000 bushels)
• Day 1 Sell at 2.55

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Margin Account Example

• Day Price Chg G/L Margin
• 1 2.54 .01 50.00 1050.00
• 2 2.58 -.04 -200.00 850.00
• 3 2.61 -.03 -150.00 700.00
• Below Maintenance Margin
• must make 100 margin call 800.00
• 4 2.52 .09 450.00 1250.00

Changes reflect the initial sell of the contract
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Margin Account Example

• Note that you can calculate your margin account
  if you know the initial margin, any additions or
  removals and the current closing price.

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Market participants

• Hedgers are willing to make or take physical
  delivery because they are producers or users of
  commodity.
• Speculators buy or sell in an attempt to profit
  from price movements.

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Hedgers

• Producers with a commodity to sell at some point
  in the future
• Short hedgers
• Sell the futures contract first
• Buy the futures contract (offset) when they sell
  the physical commodity

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Hedgers

• Processors or feeders that plan to buy a
  commodity in the future
• Long hedgers
• Buy the futures first
• Sell the futures contract (offset) when they buy
  the physical commodity

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Futures Speculators

• Do not have the commodity nor need the commodity
• They try to profit from price change

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Price discovery

• Must be a buyer and seller for every transaction
• Supply and demand still works
• more sellers than buyers price falls
• more buyers than sellers price rises

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Futures trade on information

• Why would buyers buy?
• They think that the price at delivery will be
  higher than it is currently.
• Why would sellers sell?
• They think that the price at delivery will be
  lower than it is currently.

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Futures Trade Example

• Day 1 Think that the new crop (Dec) corn price
  is going to decline
• Step 1 Decide to Sell a December corn futures
  contract by calculating expected price from
  hedging
• Futures bid 2.34
• Adjust for basis -.31
• Subtract commission -.01
• Expected hedge price 2.02

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Futures Trade Example

• Step 2 Call your broker and place order to sell
  Dec corn at the market
• Step 3 Broker forwards order to CBOT where the
  broker's representative runs the order to the pit
  and tries to fill the order.

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Futures Trade Example

• Step 4 The order is filled at 2.34
• Step 5 Broker calls to confirm fill
• Step 6 Send margin money to broker
• Initial margin account level is 750
• Must maintain at least 600 in margin account at
  end of each day

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Futures Trade Example

• Day 2 Closing price is 2.38
• We sold at 2.34
• Market is 2.38
• We are behind by -0.04
• On 5,000 bushels 200
• Send broker 200 on Day 2

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Futures trade example

• At some later date we decide to offset our
  position
• Last Day Call broker and place order to buy Dec
  corn at the market
• Two things could have happened
• Prices are higher than initially
• Prices are lower than initially

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Futures trade example

• Case 1 Prices are higher gt 2.56
• Calculate returns per bushels
• Sold on Day 1_at_ 2.34
• Bought back later _at_ 2.56
• Gross future return -0.22
• Commission _at_ 50/contract -0.01
• Net return per bushel -0.23
• Local cash price 2.25
• Net price 2.25-.232.02

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Futures trade example

• Convert to contract returns
• Gross returns -0.23
• Contract 5,000 bushels -1,150
• Because we settled the margin account every day
  the broker has this amount plus at least 600
  minimum margin. The remaining margin balance is
  returned.

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Futures trade example

• Case 2 Prices are lower gt 2.20
• Calculate returns per bushels
• Sold Day 1 _at_ 2.34
• Bought back later _at_ 2.20
• Gross return 0.14
• Commission _at_ 50/contract -0.01
• Net return per bushel 0.13
• Local cash price 1.89
• Net price 1.89.13 2.02

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Futures trade example

• Convert to contract returns
• Gross returns 0.13
• Contract 5,000 bushels 650
• Because the margin account is settled every day
  the broker has this amount plus the 750 initial
  margin. We are returned the 1,400.

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Relationship between futures and cash prices

• Difference is call basis
• Basis Cash - Futures
• Grain
• Typically quote the absolute value
• 30 cents under .30 basis
• Cash is .30 less than futures
• Livestock
• The sign is important

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Basis

• Reflects local conditions
• Supply and demand
• Yields, storage availability, processing
  capacity, rail cars, local usage
• Individual basis impacted by factors that effect
  the local cash price relative to the delivery
  point price.

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Basis

• Differs by market
• Time, place, and form
• Basis includes
• Storage to maturity
• Transportation to delivery point
• Grade differences

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Basis generalities

• Cash and futures move together
• Basis narrows at contact maturity
• Cash and futures converge
• Arbitrage of delivery
• Basis is more predictable than price
• Basis generally follows a pattern
• Seasonal patterns

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Position Diagram

• Graph of expected payoff at alternative futures
  prices at contract expiration
• Futures prices on horizontal axis
• Expected net price on vertical axis
• Adjust for basis and commission if needed
• Start with current futures price
• Identify one other futures price
• Futures, cash, and hedge are linear

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Net Price
Long Futures 45o
Short Futures 45o
Long Cash Adjust for basis
Hedge Adjust for basis
Current
Futures