Transcript Introduction

Lecture 1
An Introduction to Futures
Primary Texts
Edwards and Ma: Chapter 1
CME: Chapters 1 and 2
An Introduction to Futures Contracts
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Before the 1840s – At harvest time, farmers used to converge to a
market center to sell their grains - Lack of storages
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1848 – The Chicago Board of Trade (CBOT)
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Excess Supply in the Fall – price drop
Excess demand in the Winter and Spring – price surge
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
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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.
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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
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Problems with forward contracts
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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 exchange
A 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
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Basic Features of Futures Contracts
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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. CT
Open 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 Contracts
10102.D. Daily Price Limits
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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.
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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.
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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.
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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 Contracts
Evolution of the CME
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The Chicago Mercantile Exchange
 1874 – Chicago Produce Exchange
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1919 - Chicago Mercantile Exchange
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Chicago Butter and Egg Board
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 Contracts
Six Basic Types of CME Futures Contracts
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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 Emini 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
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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 Contracts
Differences between Futures and Stocks
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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.
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Futures contracts have time limits (fixed maturity date), while
stocks don’t (no maturity date).
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Futures traders can sell short as easily as they can buy long, while
selling short of stocks is permitted under special circumstances.
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Stock holders may receive dividends, while futures contract holders
don’t.
An Introduction to Futures Contracts
Who Trades Futures Contracts and Why?
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Speculators – Buy and sell futures contracts with the
expectation of profiting from changes in the price of the
underlying commodity – predominantly, individuals.
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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.
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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 Contracts
The Economic Functions of Futures markets
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Reallocation of exposure to price risk – without futures
markets, the cost of risk to the society would be higher
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Price discovery – more accurate equilibrium price
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Hedgers eliminate (or reduce) price risk
Speculators assume price risk
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 Contracts
Terminology
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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.
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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 Contracts
Terminology
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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.
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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.
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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 Contracts
Terminology
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Last Day of Trading: Each futures contract has a specified last
day of trading.
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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.