Lecture 1 An Introduction to Futures Primary Texts Edwards and Ma: Chapter 1 CME: Chapters 1 and 2.

Lecture 1An Introduction to Futures

Primary Texts

Edwards and Ma: Chapter 1

CME: Chapters 1 and 2

An Introduction to Futures Contracts

Before the 1840s – At harvest time, farmers used to converge to a market center to sell their grains - Lack of storages

Excess Supply in the Fall – price drop Excess demand in the Winter and Spring – price surge

1848 – The Chicago Board of Trade (CBOT) Organized grain exchange Investors built huge silos to store grain for year round consumption Smoothing grain supply and stabilize grain price Didn’t eliminate all price risks

Demand and supply shocks due to natural disaster, pests, diseases, political unrests, etc.

Forward contracts – to cope with other causes of price uncertainty

An Introduction to Futures Contracts

Forward Contracts: A forward contract or cash forward sale is a private negotiation made in the present that establishes the price of a commodity to be delivered in the future.

Two parties agree to exchange a good or service in the future at a price specified now – the forward price.

The price for immediate delivery of the item is called the spot price. No money is paid in the present by either party to the other. The face value of the contract is the quantity of the item times the

forward price specified in the contract. The party who agrees to buy the specified good or service is said to

take a long position, and the party who agrees to sell the item is said to take a short position.

An Introduction to Futures Contracts

Problems with forward contracts Unable to eliminate the risk of default among the parties in the contract

Solution – A neutral third party, the exchange (e.g., CBOT) Specific to a particular seller and buyer – not standardized or

interchangeable Solution – standardization and interchangeability

Futures Contracts - standardized forward contracts that are traded on some organized exchangeA futures contract is a legally binding agreement between a seller and buyer, that calls for the seller to deliver to the buyer a standardized commodity (with specified quantity and quality) at a set price on a future date at an organized exchange.

An Introduction to Futures Contracts

Basic Features of Futures Contracts Quantity, quality and delivery date are standardized – a June CME Live

Cattle futures contract requires the delivery of 40,000 lb of live cattle with 55% Choice, 45% Select, Yield Grade 3 on the last business day of June at CME

Regulated by an organized exchange - CME, CBOT, NYMEX, etc. Interchangeability - contracts may change hands many times before their

specified delivery dates Unit price of a futures contract may change on each transaction

Both buyer and seller post a performance bond (funds) with the exchange Last Trading Day - all open positions must be closed out by this date A clearing operation – Plays the role of third party to every futures

transaction after the trade has “cleared.”

Contract Specification: CME Live Cattle Futures Contract

Contract Size 40,000 pounds

Product Description 55% Choice, 45% Select, Yield Grade 3 live steers

Pricing Unit Cents per pound

Tick Size (min. fluctuation) $.00025 per pound (=$10 per contract)

Daily Price Limits $.03 per pound above or below the previous day's settlement price

Trading Hours(All times listed are Central Time)

CME Globex (Electronic Platform)MON 9:05 a.m. - FRI 1:55 p.m. Daily trading halts 4:00 p.m. - 5:00 p.m. CTOpen Outcry (Trading Floor)MON-FRI: 9:05 a.m. -1:00 p.m.

Last Trade Date/Time Last business day of the contract month, 12:00 p.m.

Contract Months Feb, Apr, Jun, Aug, Oct, Dec

Settlement Procedure Physical Delivery

Ticker Symbol CME Globex = LE, Open Outcry = LC

An Introduction to Futures Contracts10102.D. Daily Price Limits

There shall be no trading in corn futures at a price more than $0.40 per bushel ($2,000 per contract) above or below the previous day’s settlement price.

Should two or more corn futures contract months within the first five listed non-spot contracts close at limit bid or limit offer, the daily price limits for all contract months shall increase to $0.60 per bushel the next business day.

If price limits are $0.60 per bushel and no corn futures contract month closes at limit bid or limit offer, daily price limits for all contract months shall revert back to $0.40 per bushel the next business day.

There shall be no price limits on the current month contract on or after the second business day preceding the first day of the delivery month.

An Introduction to Futures ContractsEvolution of the CME

The Chicago Mercantile Exchange 1874 – Chicago Produce Exchange

Chicago Butter and Egg Board 1919 - Chicago Mercantile Exchange

Added futures contracts on hides, onions, & potatoes 1950s – added turkeys and frozen eggs futures 1961 – added frozen pork belly futures 1972 – added financial futures, with eight currency futures 2005 – largest futures exchange in the US – trading 1.05

billion contracts

An Introduction to Futures ContractsSix Basic Types of CME Futures Contracts

CME Commodity Products: Cattle, hogs, milk, pork bellies, butter, etc. CME Foreign Exchange Products: CME Euro FX, CME British Pound,

CME Japanese Yen, CME Canadian Dollar and other FX products. CME Interest Rate Products: CME Eurodollars, CME Eurodollar FRA,

CME Swap Futures and other interest rate products. CME Equity Products: CME S&P 500, CME E-mini S&P 500, CME E-

mini NASDAQ-100, CME E-mini Russell 2000, CME S&P MidCap 400 and other equity products.

CME Alternative Investment Products: CME Weather, CME Energy, CME Economic Derivatives and CME Housing Index products.

TRAKRS (Total Return Asset Contracts): Commodity TRAKRS, Euro Currency TRAKRS, Gold TRAKRS, LMC TRAKRS, Rogers International Commodity TRAKRS.

An Introduction to Futures Contracts

Some futures contracts, such as the CME Live Cattle and CME British Pound contracts, call for physical delivery of the commodity. Other futures contracts, such as the CME S&P 500 and CME Eurodollar contracts, are cash-settled and do not have a physical delivery provision.

For a physical delivery contract like CME Live Cattle, the open positions can be closed out by making an offsetting futures trade or by making/taking physical delivery of the cattle.

For cash-settled futures contracts, positions can be closed out by making an offsetting futures trade or by leaving the position alone and having it closed out by one final mark-to-market settlement adjustment.

An Introduction to Futures ContractsDifferences between Futures and Stocks

A Futures contract represents an obligation to deliver or receive a commodity at a future date, while a stock represent ownership in a corporation.

Futures contracts require an initial performance bond in an amount set by the exchange, while stock requires a partial deposit (margin) to put up with the broker while borrowing the remaining amount from the broker.

Futures contracts have time limits (fixed maturity date), while stocks don’t (no maturity date).

Futures traders can sell short as easily as they can buy long, while selling short of stocks is permitted under special circumstances.

Stock holders may receive dividends, while futures contract holders don’t.

An Introduction to Futures ContractsWho Trades Futures Contracts and Why?

Speculators – Buy and sell futures contracts with the expectation of profiting from changes in the price of the underlying commodity – predominantly, individuals.

Willing to take additional risks with the profit objective Buy (long) a futures contract if cash price is expected to rise in the future Sell (short) a futures contract if cash price is expected to fall in the future

Hedgers – Buy and sell futures contracts to eliminate their risk exposure due to changes in the price of the underlying commodity – predominantly, businesses.

If price is expected to fall during the harvest, sell (short) futures contract now, offset (buy back) the futures position in future, and sell the harvest at the spot market

An Introduction to Futures ContractsThe Economic Functions of Futures markets

Reallocation of exposure to price risk – without futures markets, the cost of risk to the society would be higher

Hedgers eliminate (or reduce) price risk Speculators assume price risk

Price discovery – more accurate equilibrium price Futures market provides centralized trading where information about

fundamental supply and demand conditions for a commodity is efficiently assimilated and acted on, as a consequence equilibrium price is discovered

Improve economic efficiency - By providing a means to hedge price risk associated with storing a

commodity, futures market makes it possible to separate the decision of whether to physically store a commodity from the decision to have financial exposure to its price change

An Introduction to Futures ContractsTerminology

Bull Market: A bull market is a market in which prices are rising. When someone is referred to as being bullish, that person has an optimistic outlook that prices will be rising.

Bear Market: A bear market is one in which prices are falling. When someone is referred to as being bearish, that person has a pessimistic outlook that prices will be falling.

Going Long: If a trader initiates a position by buying a futures contract, the trader has gone long. A trader who has purchased 10 pork belly futures contracts is long 10 pork belly contracts.

A speculator, who is long in the market expect prices to rise and make money by later selling the contracts at a higher price

An Introduction to Futures ContractsTerminology

Going Short: If a trader initiates a position by selling a futures contract, the trader has gone short. A trader who has sold 10 pork belly futures contracts is short 10 pork belly contracts.

A speculator, who is short in the market expect prices to fall and make money by later buying the contracts at a lower price

Contract Maturity: Futures contracts have limited lives, known as contract maturities.

Contract maturity is expressed in terms of contract months, e.g., August, October, December.

The contract maturity designates the time at which deliveries are to be made or taken, unless the trader has offset the contract by an equal, opposite transaction prior to maturity.

An Introduction to Futures ContractsTerminology

Last Day of Trading: Each futures contract has a specified last day of trading.

For CME Live Cattle futures contracts, the last business day of the contract month is the last day of trading.

For CME Canadian Dollar futures contract, the last day of trading would be the business day immediately preceding the third Wednesday of the contract month.

Last Delivery Date: Each futures contract has a specified last day of trading.