Chapter 15

Commodities and Financial Futures

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Commodities and Financial Futures Learning Goals

1. Describe the essential features of a futures contract, and explain how the futures market operates.
2. Explain the role that hedgers and speculators play in the futures market, including how profits are made and lost. 3. Describe the commodities segment of the futures market and the basic characteristics of these investment vehicles.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

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Commodities and Financial Futures

Learning Goals (contd)

4. Discuss the trading strategies investors can use with commodities, and explain how investment returns are measured.
5. Explain the difference between a physical commodity and a financial future, and discuss the growing role of financial futures in the market today. 6. Discuss the trading techniques that can be used with financial futures and note how these securities can be used in conjunction with other investment vehicles.

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The Futures Market

Cash Market: a market where a product or commodity changes hands in exchange for a cash price paid when the transaction is completed

Futures Market: the organized market for the trading of futures contracts
Futures Contract: a commitment to deliver a certain amount of some specified item at some specified date in the future
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Table 15.1 Futures Contract Dimensions

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Characteristics of Futures Contracts

Transaction will not be completed until some agreedupon 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 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

Dont 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 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

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
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

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
Contracts are easily traded on futures markets Bought and sold through brokerage offices Same types of orders are used as stocks
Market Limit

Long positionbuying a contract

Investor wants contract price to go up

Short positionselling 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
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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Table 15.3 Major Classes of Commodities

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Components of Commodity Contract 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 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

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

Commodities allow use of leverage for potentially high returns Return to investors is based upon amount of money actually invested
Selling price of Purchase price of commodity contract commodity contract Amount of margin deposit

Return on invested capital

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Trading Strategies with Commodities

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
Financial Futures: 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 Examples of Currency Futures

British pound
Swiss franc Canadian dollar Japanese yen Euro Other currencies

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Examples of Financial Futures: Interest Rates Examples of Interest Rate Futures

U.S. Treasury securities
Federal Funds Interest rate swaps Euromarket deposits Foreign government bonds

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Examples of Financial Futures: Stock-Indexes Examples of Stock-Index Futures

Dow Jones Industrial Average
S&P 500 Index Nasdaq 100 Index Russell 2000 Index

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Financial Futures Contract Specifications 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

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

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: 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 buyers loss exposure to the price of the option.

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Chapter 15 Review
Learning Goals

1. Describe the essential features of a futures contract, and explain how the futures market operates.
2. Explain the role that hedgers and speculators play in the futures market, including how profits are made and lost. 3. Describe the commodities segment of the futures market and the basic characteristics of these investment vehicles.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

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Chapter 15 Review (contd)

Learning Goals (contd)
4. Discuss the trading strategies investors can use with commodities, and explain how investment returns are measured.
5. Explain the difference between a physical commodity and a financial future, and discuss the growing role of financial futures in the market today. 6. Discuss the trading techniques that can be used with financial futures and note how these securities can be used in conjunction with other investment vehicles.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

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Chapter 15

Additional Chapter Art

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Figure 15.1
Source: Copyright 2003 Board of Trade of the City of Chicago, Inc. All Rights Reserved. Used with permission.)

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Table 15.2 Margin Requirements for a Sample of Commodities and Financial Futures

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Figure 15.2 Quotations on Actively Traded Commodity Futures Contracts

Source: Wall Street Journal Online, September 15, 2009, wsj.com.

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Figure 15.3 Quotations on Selected Actively Traded Financial Futures

Source: Wall Street Journal Online, September 15, 2009, wsj.com.

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Table 15.4 Futures Options: Puts and Calls on Futures Contracts

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