Option Valuation

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CHAPTER 14
Futures Contracts
Chapter Sections Futures Contracts Basics Why
Futures? Futures Trading Accounts Cash Prices
versus Futures Prices Stock Index Futures
There are two times in a mans life when he
should not speculate when he cant afford it and
when he can. Mark Twain
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What are Futures?

• Futures contract
• A commitment to deliver a certain amount of some
  specified item at some specified date in the
  future
• A buyer and a seller specify a commodity or
  financial instrument to be delivered and paid
  when the contract matures
• The futures price is guaranteed by the contract
• Futures started with commodities
• a.k.a. hard assets, real assets
• Examples wheat, soybeans, cattle, pork bellies,
  gold, oil, etc.
• But have since moved to financial assets

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What is the Purpose of Futures?

• Producers of commodities use futures contracts
  extensively
• Example A wheat farmer in Iowa plants 1,000
  acres of wheat in April. He knows that if all
  goes well, Lord Willing, come September he will
  have 500,000 bushels of wheat. September wheat
  futures are currently (in April) selling for 6
  per bushel
• Our farmer can sell his wheat (via a wheat
  futures contract) while it is still in ground.
  He can guarantee a price that he is happy with
  and will result in a profit
• The contract states he will deliver the wheat in
  September and receive 6 per bushel no matter
  what happens to wheat prices

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What is the Purpose of Futures?
(continued)

• Consumers of commodities also use them
• Example Kelloggs and General Mills and Post
  Cereal need tons and tons of wheat each year to
  make cereal and other foodstuffs
• Via futures contracts, in April, they can
  purchase the wheat to be delivered in September
  and pay 6 per bushel no matter what happens to
  wheat prices

What are the advantages and disadvantages of
using futures contracts when you are the producer
and when you are the consumer?
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What is the Purpose of Futures?
(continued)

• Futures contracts allow producers and consumers
  of commodities to hedge
• Hedging Taking a futures position opposite to an
  existing position in the underlying commodity or
  financial instrument

Hedge your bet! Have you ever heard this
saying? The farmer is protecting himself from
wheat prices falling. The cereal companies are
protecting themselves from wheat prices rising.
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Major Classes of Commodities
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What are Financial Futures?

• The financial world adopted the technique of
  futures contracts to financial assets, treating
  financial assets like commodities
• Examples currencies, interest rates, stock and
  bond indexes, etc.
• I will deliver 25,000 worth of British Pounds
  to you next April
• I will purchase 10,000 worth of the SP 500
  stock index from you next August

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Purpose of Financial Futures?

• For those working in the World of Finance and
  especially, the World of International Business,
  they can be very useful tools
• Example A car manufacturer knows it will need
  to purchase 50,000 engines from Japan next
  October
• The manufacturer can buy a currency future for
  20,000,000 worth of Japanese Yen payable in
  October
• This protects the manufacturer from adverse
  currency fluctuations
• Example The dollar falls relative to the yen

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Can Anyone Purchase Futures?

• Lucky You! You do not have to work in either the
  commodities world or the finance world to buy and
  sell futures contracts
• You can be a speculator!
• You simply buy and sell the futures contracts
• You never actually deliver or take delivery of
  the commodity nor the financial asset
• You could buy the 500,000 bushels to be delivered
  in September even though you live in a condo in
  West Los Angeles and have never even seen a farm!

What do you think of this strategy? What is the
limit of your losses?
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Speculating with Futures

• Speculating Accepting the futures price risk
  without having a position opposite to an existing
  position in the underlying commodity or financial
  instrument
• It is the opposite of hedging
• futures speculation is risky, but it is
  potentially rewarding if you can accurately
  forecast the direction of future commodity price
  movements. page 456, 4th edition

Can anyone accurately forecast the future? If
our LA speculator sitting in her condo had
purchased the futures contract for 500,000
bushels of wheat to be delivered in September and
wheat prices plummeted, she could potentially
lose hundreds of thousands of dollars!
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Trading Futures

• Chicago Board of Trade
• Largest, most active futures exchange
• Many other exchanges
• Long position
• The buyer of the futures contract
• Protected from futures price increases
• Wheat Example Kelloggs, Post Cereal
• Short position
• The seller of the futures contract
• Protected from futures price decreases
• Wheat Example Our farmer

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Futures Seem Like Options

• In fact, the two are very similar
• Financial futures work very much like options
• There is the potential for great rewards
• But there is also much more of the likelihood of
  sustaining great losses
• In fact, the potential losses from futures
  contracts are staggering!
• And, just like options, they are a tremendous
  source of commissions for your broker

By the way, you can purchase options on futures
contracts. What do you think about that?
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Final Comments on Futures?

• STAY AWAY FROM THEM!

They are even more potentially dangerous than
options.
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CHAPTER 14 REVIEW
Futures Contracts
Chapter Sections Futures Contracts Basics Why
Futures? Futures Trading Accounts Cash Prices
versus Futures Prices Stock Index Futures
Next Brokerage Accounts, Buying on Margin, and
Selling Shorting