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Chapter 16

Chapter 16 Detailed Note.docx

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Department
Administrative Studies
Course Code
ADMS 3531
Professor
Dale Domian

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Chapter 16: Future Contracts 16.1 Futures Contracts Basics - A forward contract is an agreement made today between a buyer and a seller who are obligated to complete a transaction with one another at a set date in the future. - It allows a producer to sell a product to a willing buyer before it is actually produced. - The buyer and the seller know each other, and they negotiate the terms of the contract. - The terms of a forward contract are customized. > What to trade; Where to trade; When to trade; How much to trade; What quality of good to trade—all customized under the terms of the forward contract. - Important: The price at which the trade will occur is also determined when the agreement is made. > This price is known as the forward price. > Generally, no cash changes hands until the trade is made. - One party faces default risk, because the other party might have an incentive to default on the contract. - To cancel the contract, both parties must agree. - One side might have to make a dollar payment to the other to get the other side to agree to cancel the contract. - A futures contract is an agreement made today between a buyer and a seller who are obligated to complete a transaction at a set date in the future. - The buyer and the seller do not know each other. > The "negotiation" occurs in the fast-paced frenzy of a futures pit. - The terms of a futures contract are standardized. > What to trade; Where to trade; When to trade; How much to trade; What quality of good to trade—all standardized under the terms of the futures contract. - The price at which the trade will occur is determined “in the pit” or, increasingly, “in the electronic market.” > This price is known as the futures price. > There are daily “marked to market” cash flows. - No one faces default risk, even if the other party has an incentive to default on the contract. - The Futures Exchange where the contract is traded guarantees each trade—no default is possible. -To cancel the contract, an offsetting trade is made, either “in the pit” or “in the electronic market”. Modern History of Futures Trading - Established in 1848, the Chicago Board of Trade (CBOT) was the first organized futures exchange in the United States. - Other major exchanges include: > New York Mercantile Exchange (1872) > Chicago Mercantile Exchange (1874) - Canadian financial futures are traded on the Montreal Exchange. Agricultural futures are traded on the Ice Canada Exchange. - Early in their history, these exchanges only traded contracts in storable agricultural commodities (e.g., soybeans, corn, wheat). - Agricultural futures contracts are still important to organized futures exchanges. - During 2007, there were several important events for organized futures exchanges. > The Intercontinental Exchange (ICE) purchased the New York Board of Trade (NYBOT) > The Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) - Financial futures are also important to organized futures exchanges. - Some important milestones: > Currency futures trading, 1972. > Gold futures trading, 1974.  Actually, on December 31, 1974.  The very day that ownership of gold by U.S. citizens was legalized. > U.S. Treasury bill futures, 1976. > U.S. Treasury bond futures, 1977. > Eurodollar futures, 1981. > Stock Index futures, 1982. - Today, financial futures are so successful that they constitute the bulk of all futures trading. Futures Contract Features - In general, futures contracts must stipulate at least the following five terms: 1) The identity of the underlying commodity or financial instrument. 2) The futures contract size. 3) The futures maturity date, also called the expiration date. 4) The delivery or settlement procedure. 5) The futures price. 16.2 Why Futures? - A futures contract represents a zero-sum game between a buyer and a seller. > Gains realized by the buyer are offset by losses realized by the seller (and vice-versa). > The futures exchanges keep track of the gains and losses every day. - Futures contracts are used for hedging and speculation. > Hedging and speculating are complementary activities. > Hedgers shift price risk to speculators. > Speculators absorb price risk. Speculating with Futures, Long - Buying a futures contract (today) is often referred to as “going long,” or establishing a long position. - Recall: Each futures contract has an expiration date. > Every day before expiration, a new futures price is established. > If this new price is higher than the previous day’s price, the holder of a long futures contract position profits from this futures price increase. > If this new price is lower than the previous day’s price, the holder of a long futures contract position loses from this futures price decrease. Example of Speculating in Gold Futures: - You believe the price of gold will go up. So, > You go long 100 futures contracts that expire in 3 months. > The futures price today is $1,300 per ounce. > There are 100 ounces of gold in each futures contract. - Your "position value" is: $1,300 ×100 × 100 = $13,000,000 - Suppose your belief is correct, and the price of gold is $1,320 when the futures contract expires. - Your "position value" is now: $1,320 × 100 × 100 = $13,200,000 Your "long" speculation has resulted in a gain of $200,000 Speculating with Futures, Short - Selling a futures contract (today) is often called “going short,” or establishing a short position. - Recall: Each futures contract has an expiration date. > Every day before expiration, a new futures price is established. > If this new price is higher than the previous day’s price, the holder of a short futures contract position loses from this futures price increase. > If this new price is lower than the previous day’s price, the holder of a short futures contract position profits from this futures price decrease. Example of Speculating in Gold Futures: - You believe the price of gold will go down. > So, You go short 100 futures contracts that expire in 3 months. > The futures price today is $1,300 per ounce. > There are 100 ounces of gold in each futures contract. - Your "position value" is: $1,300 × 100 × 100 = $13,000,000 - Suppose your belief is correct, and the price of gold is $1,270 when the futures contract expires. - Your “position value” is now: $1,270 × 100 × 100 = $12,700,000 Your "short" speculation has resulted in a gain of $300,000 Hedging with Futures - A hedger trades futures contracts to transfer price risk. - Hedgers transfer price risk by adding a futures contract position that is opposite of an existing position in the commodity or financial instrument. - When the hedge is in place: > The futures contract “throws off” cash when cash is needed. > The futures contract “absorbs” cash when cash is available. Hedging with Futures, Short Hedge - A company has a large inventory that will be sold at a future date. - So, the company will suffer losses if the value of the inventory falls. - Suppose the company wants to protect the value of their inventory. > Selling futures contracts today offsets potential declines in the value of the inventory > The act of selling futures contracts to protect from falling prices is called short hedging. Example of Short Hedging with Future Contracts: - Suppose Starbucks has an inventory of about 950,000 pounds of coffee, valued at $1.22 per pound. - Starbucks fears that the price of coffee will fall in the short run and wants to protect the value of its inventory. - How best to do this? You know the following: > There is a coffee futures contract at the New York Board of Trade. > Each contract is for 37,500 pounds of coffee. > Coffee futures price with three month expiration is $1.30 per pound. > Selling futures contracts provides current inventory price protection. - 25 futures contracts covers 937,500 pounds. - 26 futures contracts covers 975,000 pounds. - Starbucks decides to sell 25 near-term futures contracts. - Over the next month, the price of coffee falls. Starbucks sells its inventory for $1.16 per pound. - The futures price also falls, to $1.24. (There are two months left in the futures contract) - How did this short hedge perform? - That is, how much protection did selling futures contracts provide to Starbucks? - The hedge was not perfect. - But, the short hedge “threw-off” cash ($56,250) when Starbucks needed some cash to offset the decline in the value of their inventory ($57,000). Hedging with Futures, Long Hedge - A company needs to buy a commodity at a future date. - The company will suffer “losses” if the price of the commodity increases before then. (That is, they paid more than they could have) - Suppose the company wants to "fix" the price that they will pay for the commodity. > Buying futures contracts today offsets potential increases in the price of the commodity. - The act of buying futures contracts to protect from rising prices is called long hedging. Example of Long Hedging with Futures Contracts: - Suppose Nestles plans to purchase 750 metric tons of cocoa next month. - Nestles fears that the price of cocoa (which is $3,700 per ton) will increase before they acquire the cocoa. - Nestles wants to “set” the price it will pay for cocoa. - How best to do this? You know the following: > There is a cocoa futures contract at the New York Board of Trade. > Each contract is for 10 metric tons of cocoa. > Cocoa futures price with three months to expiration is $3,740 per ton. > Buying futures contracts provides inventory “acquisition” price protection. - 75 futures contracts covers 750 metric tons. - Nestles decides to buy 75 near-term futures contracts. - Over the next month, the price of cocoa increases, and Nestles pays $3,790 per ton for its cocoa. - The futures price also increases, to $3,825. (There are two months left on the futures contract) - How did this long hedge perform? - That is, how much protection did buying futures
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