Future Contracts

Future contracts characteristics submitted by : vishal alluri manik reddy karthik agarwal k jeevan

Topics covered………… future contracts

features of futures contracts

What is a derivative? Options

Futures

The value of the derivative instrument is DERIVED from the underlying security

Forwards

Swaps Underlying instrument such as a commodity, a stock, a stock index, an exchange rate, a bond, another derivative etc..

Introduction In

the

financial

marketplace

some

instruments

are

regarded as fundamentals, while others are regarded as derivatives. Financial Marketplace

Derivatives

Fundamentals

Simply another way to catagorize the diversity in the FM*. *Financial

Introduction (II) Financial Marketplace

Derivatives • • • •

Futures Forwards Options Swaps

Fundamentals • Stocks • Bonds • Etc.

Introduction to futures …….. A futures contract is just what it's called – a contract. It is not equity in a stock or commodity. It is a contract – a contract to make or take delivery of a product in the future, at a price set in the present. A standardized, transferable, exchange-traded contract that requires delivery of a commodity , bond , currency, or stock index, at a specified price , on a specified future date The futures contract is a “paper” asset that is only converted to a commodity if the “paper” is held to maturity and “delivery” takes place. This “paper” is traded (auctioned) only at government regulated exchanges .

What can be traded in future contracts :•Agricultural commodities (e.g. grains, livestock, meat, food and

fiber)

•Metals and minerals (e.g. gold, platinum, crude oil, and electricity) •Foreign currencies •Financial futures Interest rate futures Stock index futures

Spot, Forward, and Futures Contracts •

A spot contract is an agreement (at time 0) when the seller agrees to deliver an asset and the buyer agrees to pay for the asset immediately (now)

•

A forward contract is an agreement (at time 0) between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now

•

A futures contract is similar to a forward contract and is normally arranged through an organized exchange (i.e., ME, CBT) The main difference between a futures and a forward contract is that the price of a forward contract is fixed over the life of the contract, whereas futures contracts are marked-to-market daily. 8

Advantages of futures contracts If price moves are favourable, the producer realizes the greatest return with this marketing alternative. No premium charge is associated with futures market contracts.

Disadvantages of future contracts Subject to margin calls Unable to take advantage of favourable price moves Net price is subject to Basis change

Who uses futures markets ………

Participants in the futures markets are commercial or institutional users of the commodities they trade. These users, most of whom are called "hedgers," want the value of their assets to increase and want to limit, if possible, any loss in value. Hedgers may use the commodity markets to take a position that will reduce the risk of financial loss in their assets due to a change in price. Other participants are "speculators" who hope to profit from changes in the price of the futures or option contract.

Purposes of futures markets……….. Meets the needs of three groups of futures market users: 2. Those who wish to discover information about future prices of commodities (suppliers) 3. Those who wish to speculate (speculators) 4. Those who wish to transfer risk to some other party (hedgers)

Reading Futures Prices (Prices)

1. Opening 2. High 3. Low

4. Settlement  Price at which the contracts are settled at the close of trading for the day  Typically the last trading price for the day

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Future Contracts (I) Futures

The owner of a future contract has the OBLIGATION to sell or buy something in the future at a predetermined price.

Scenario: You are a farmer and you know that you will harvest corn in three months from today on. How can you protect yourself from loosing if corn price happens to drop until March by using corn forward contracts?

t 1/1

3/1 Harvest

Future Contracts You lock into a price by holding a short position in a corn future contract with a maturity date a little bit longer than the harvest date.

Suppose the price drops...

You either take delivery and lock in a price.

You close out the corn contract and the gain in the futures market will offset the loss in the sport market

“A futures contract makes unfavourable price movements less unfavourable and a favourable price movements less favourable“!

Trading Strategies

Speculation

Short - believe price will fall Long - believe price will rise Hedging For someone who needs to buy or sell the underlying asset in the future

Long hedge - protecting against a rise in price go long in the futures contract and you effectively lock in the future purchase price today Short hedge - protecting against a fall in price go short in thefutures contract and you effectively lock in the future sale price today

Key terms …

 Initial margin  Maintenance margin  Margin call  Going long  Going short  Spreads

Notes :Initial margin of $1,000 Maintenance margin level is $500 Losses dropped the value of your account to $400 Broker makes a margin call to you, requesting a deposit of additional $600 Bringing the account back up to the initial margin level of $1,000.

When a margin call is made, the funds usually have to be delivered immediately. If they are not, the brokerage can have the right to liquidate your position completely in order to make up for any losses it may have incurred on your behalf.

Going long When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase. Example : Speculator buys one September contract of gold at 1400/gm Total worth = 1400*1,000 gms or 14 lakhs By buying in June is going long, with the expectation that the price of gold will rise by the time the contract expires in September. By August, the price of gold increases by 200 rs to 1600/gm Contract becomes worth 1600*1000=16 lakhs Profit would be 2 lakhs Given the very high leverage (remember the initial margin was $2,000), 100% profit!

Going Short A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. Initial margin deposit of 3000$ Mr. X sold one May crude oil contract ( 25 $/barrel *1000) Total value of $25,000. By March, the price $20/barrel Mr. X bought back the contract which was valued at $20,000. By going short, Mr. x made a profit of $5,000

Risks with futures qThe futures market was founded on the principle of risk transfer. qAny transaction can result in a loss that exceeds the amount of the initial margin, and could potentially be an almost unlimited amount qThere may be no party willing to sell or buy the offsetting contract you need to prevent further losses.

Features of futures …  Trading is conducted through an association /exchange  It is entered into a standard variety known as basis variety .  The delivery periods are specified .  Seller has the choice to decide whether to deliver goods against

outstanding sale contracts  Standardised contracts in terms of Quantity ,Quality ,Date of Delivery  Exchange gaurantees the settlement hence no default risk .  Contracts can be closed anytime before the expiry of contract hence no

liquidity risk  Every transaction through memebers/broking .  Price of the contract is available to public domain through media .

WHAT IS BASIS ?????

Basis is the current cash price of a particular commodity minus the price of a futures contract for the same commodity. BASIS = CURRENT CASH PRICE – FUTURES PRICE

The Basis (continued)…… Price s Cash Basis

Presen t

Future s

Maturit y

Time

The Basis (continued)

Example: Gold Prices and the Basis: MONTH

PRICE

$441.00

BASIS

DEC

441.50

-.50

MAR ‘04

449.20

- $7.70

JUN

459.40

-$17.90

SEP

469.90

-$28.40

DEC

480.70

-$39.20

MAR ‘05

491.80

-$50.30

12/16/03

Word s of wisdoms future contracts • If you are going to sell something in the near future but want to lock in a secured price, you take a short position. • If you are going to receive/buy something in the future but want to lock in a secured price, you take a long position.