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24 Cards in this Set
- Front
- Back
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The Futures Market - Cash Market:
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a market where a product or commodity changes hands in exchange for a cash price paid when the transaction is completed
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The Futures Market - Futures Market:
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the organized market for the trading of futures contracts
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The Futures Market - Futures Contract:
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a commitment to deliver a certain amount of some specified item at some specified date in the future
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Characteristics of Futures Contracts
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Transaction will not be completed until some agreed-upon date in the future
Delivery date and quantity are all set when the financial future is created Seller has legally binding obligation to make delivery on specified date Buyer/holder has legally binding obligation to take delivery on specified date Futures may be held until delivery date or traded on futures market All trading is done on a margin basis |
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Advantages of Using Futures Contracts
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Potential for very high returns
Margin buying allows use of leverage - Leverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return Allows producers to hedge prices - Don’t have to sell crops at harvest time when prices are often low Commodities can provide an inflation hedge |
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Disadvantages of Using Futures Contracts
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High risk of losing more than amount originally invested; no limit on exposure to loss
Involves considerable amount of speculation Requires specialized investor skills and patience |
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Options versus Futures Contracts
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- Options:
*Right to buy *Strike price specified in option contract *Loss limited to price paid for option - Futures: *Obligation to buy *Delivery price set by supply and demand *No limit on potential loss |
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Futures Exchanges
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- Chicago Board of Trade (CBT) began in 1848
- More than a dozen U.S. commodities exchanges *Chicago Mercantile Exchange (CME) is largest *Chicago Board of Trade (CBOT) and New York *Mercantile Exchange (NYMEX) also active 95% of U.S. commodities trade on these three exchanges *Although still operating independently, the CME, CBOT, and NYMEX have all been merged to form the CME Group Most exchanges use a combination of electronic trading and open-outcry auction |
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Players in the Futures Markets
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- Hedgers:
*Producers and processors *Protecting their interests in underlying commodity or financial instrument *Provide the actual products being sold - Speculators: *Investors *Trying to earn profit on expected swings in prices of futures contracts *Provide liquidity |
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Trading Mechanics
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- Contracts are easily traded on futures markets
- Bought and sold through brokerage offices - Same types of orders are used as stocks *Market *Limit - Long position—buying a contract *Investor wants contract price to go up - Short position—selling a contract *Investor wants contract price to go down - Long and short positions can be liquidated by executing an offsetting transaction *About 1% of futures contracts are settled by delivery |
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Margin Trading
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- All futures contracts are traded on margin
- No borrowing is required - Initial margin deposit *Amount deposited with broker at time of commodity transaction to cover any loss in market value of futures contract due to price movements *Margin requirements range from 2% to 10% - Maintenance deposit *Minimum amount of deposit required at all times *Margin call occurs if value drops below allowed amount - Mark-to-the-market occurs daily |
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Components of Commodity Contract
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- Type of product
- Exchange where contract is traded - Size of contract (in bushels, pounds, tons) - Method of valuing contract (e.g., cents per pound, dollars per ton) - Delivery month - Open Interest: the number of contracts currently outstanding on a commodity or financial future |
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Factors in Commodity Price Behavior
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- Weather and crop forecasts
- Economic factors - Political factors - International pressures - Settle Price: the closing price (last price of the day) for commodities and financial futures |
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Commodity Price Behavior
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- Prices change daily
- Changes can be sizable - Because of leverage, small unit price changes can cause large total dollar changes in contract price - To protect investors, daily price change limits are set: *Daily price limit: restriction on the day-to-day change in price *Maximum daily price range: the amount a commodity price can change during the day; usually equal to twice the daily price limit |
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Return on Invested Capital
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- Commodities allow use of leverage for potentially high returns
- Return to investors is based upon amount of money actually invested = Selling price of commodity contract - purchase price of commodity contract / amount of margin deposit |
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Trading Strategies with Commodities
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- Speculating
*Capitalizing on wide swings that are characteristic of many commodities - Spreading *Used by producers and processors to protect a position in a product or commodity *Producer or grower attempts to hedge as high a price as possible *Processor or manufacturer attempts to hedge as low a price as possible *No limit to the amount of loss that can occur with a futures contract |
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Financial Futures:
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future contract in which the commodity is a financial asset, such as debt securities, foreign currencies or market baskets of common stocks
- Often used by large institutional investors to hedge specific types of risk: *Offset interest rate risk on debt instruments *Minimize foreign currency rate risk on overseas business transactions *Minimize market risk on common stock investments |
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Examples of Financial Futures:Foreign Currency
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British pound
Swiss franc Canadian dollar Japanese yen Euro Other currencies |
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Examples of Financial Futures: Interest Rates
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U.S. Treasury securities
Federal Funds Interest rate swaps Euromarket deposits Foreign government bonds |
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Examples of Financial Futures: Stock-Indexes
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Dow Jones Industrial Average
S&P 500 Index Nasdaq 100 Index Russell 2000 Index |
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Financial Futures Contract Specifications
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- Similar to commodities contracts
- Control large sums of underlying financial instruments - Have varying delivery dates - Stock-index futures are settled in cash rather than underlying stocks of the specific stock index. |
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Speculating in Financial Futures
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Allows large quantities of financial instruments to be controlled through future contract
- Leverage can provide high returns (or losses) - “Long” positions are used if investor speculates values will go up - “Short” positions are used if investor speculates values will go down |
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Hedging with Financial Futures
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- Effective way of protecting stock or other securities holdings in a declining market
- Stock-index futures used to hedge stock portfolios - Interest rate futures used to hedge bond portfolios - Foreign currency futures used to hedge significant exposure to foreign exchange rate risk |
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Combining Futures and Options - Futures Options:
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- options that give the holders the right to buy or sell a single standardized futures contract for a specified period of time at a specified strike price
- A significant advantage that a futures option has over a futures contract is that the option limits the buyer’s loss exposure to the price of the option. |
