Futures - 1

FORWARD / FUTURES TRANSACTIONS (LONG). There are three ways in which you
can acquire a commodity (or currency or financial) asset in the future. You can:

a) buy now and hold it till later [at the current market price (SPOT) price]
b) buy it later [at an unknown future SPOT price]
c) Decide on a price today for later delivery.

 In a) and b) the underlying asset is acquired the same time that the price is paid.
 In c) the price is decided now, but paid later when the asset is delivered.

 Transactions (a) and (b) occur in a SPOT market, where cash is exchanged for an
asset either today, or at a later date.

 Acquiring the underlying asset via (c) is a forward/future market transaction. The
price is decided NOW, but is paid LATER, regardless of what the SPOT price of
the asset at that time will be.
  A transaction as in c) gives the initiator a “LONG” futures The LONG is obliged
to buy the underlying asset unless they close out their position before maturity.
This is unlike options where call buyers have the choice of whether to exercise or
not. Say long but try not to say “buy futures!”
 NOTHING is PAID now on the LONG futures. A margin account is opened, think
of it as a “good faith deposit” against future payment.

EXAMPLE: Crude Oil trades for $100 per barrel in the spot market.

a) The futures price for crude in 3 months (call it May crude) is $ 102 per barrel. This
means that those entering LONG futures positions in May crude are committing to
paying $102 per barrel in May TO TAKE DELIVERY of crude. (size 1000 bbl).
b) The SPOT price in May may be different from $102. The LONG futures will only
pay $102 in MAY for crude even if the SPOT price then is $80 or $120 or…
c) What is paid NOW? Suppose the margin is 10%. Then 10% of the $102,000 owed
later (or $10,200) is earmarked in the margin account. For some underlying assets,
collateral in the form of securities is permitted. This margin adjusts daily.
EXAMPLE: ONE WEEK LATER

Suppose that the futures price for May Crude in one week is $104 per barrel. All that
means is that other traders are willing to pay $104 for the same May crude that traded
at $102 the previous week. This could be due to supply/demand or weather changes….

THE LONG POSITION initiated at $102 last week is now sitting on a paper gain of $2
per barrel, [(104-102)*1000] = $2000.
This gain goes immediately into the LONG’s margin account at the close of each day
(mark-to-market). This long can a) realize the gain and book the profit or: b) let it ride
as May is still some time away.

Suppose the LONG decides to realize the gain, The margin account is richer by $2000,
which is nearly a 20% profit on the margin deposit of $10,200, although futures prices
only went up by 2% (102 to 104). This is due to leverage. (Discuss the leverage idea
more, with a housing example and bank example).
COMPARE WITH EQUITIES.

Think about why someone might buy INFY or DHFL. The expectation is that the stock will
go up over time, you go along for the ride and take profits along the way. People buying
INFY are also said to be LONG Infy, just like the people above were LONG May Crude.
With futures, the difference is:

a) that there is a time limit, May;

b) that crude (or INFY) is not going to the moon;
c) you commit little in terms of funds, stocks require 50% margin, the futures require 10%.

Terminating the purchase transaction requires you to reverse it with a sell.

As with publicly traded stocks, some people may have the opposite expectation, that prices
may fall in the future, rather than rise. Such people can take short futures (Revisit short
selling, if the class is not comfortable with it). Here again, terminating the short sale involves
“buying to cover”. The single stock futures market in India is one of the biggest in the world!
SHORT FUTURES POSITIONS. VIEW A SHORT FUTURES position as a bet that:

In the future, crude prices will be lower rather than higher. Continuing with the previous
set of numbers for crude, suppose that the futures trader takes a short position in May
crude.This is tantamount to agreeing to DELIVER crude in May at $102 per barrel. If a
month later, crude prices are $95 per barrel, the short futures position profits by $7 per
barrel (you buy crude in the spot market at 95 and deliver against the futures at 102)
and you realize this gain by closing out the short position.

You don’t have to own the oil to create the SHORT position, you don’t even have to
borrow it (like you would borrow shares to short). The 10% margin funds serves as your
good faith guarantee of oil delivery.

Another way to think about is that when you reach May, if the spot price is even lower
say $90, you can buy oil at $90 in the SPOT market and DELIVER it for $102.
TO MOTIVATE FROM OPTIONS– CONSIDER BUYING A CALL AND SELLING
A PUT AT THE SAME STRIKE. THINK OF EXERCISE AT EXPIRATION.

Value of the underlying > strike price at expiration.

Exercise of the call lets you buy the stock at strike (in the future).

Value of the underlying < the strike price at expiration.

Exercise of the put implies stock is sold to you at strike, you again end up buying stock
at strike in the future.
This is like a long futures position.

REVERSE IT: SELL A CALL AND BUY A PUT (SAME STRIKE).

WOULD BE LIKE A SHORT FUTURES CONTRACT WOULD IT NOT?
THINK THIS WORKS IN INDIA? IT MUST. GO CHECK?
TERMINATING FUTURES TRANSACTIONS
The notion of OPENING and CLOSING positions is important. If you OPEN a LONG
position and you don’t really want to TAKE DELIVERY of crude, then you realize your
profit or loss by reversing the transaction, which is CLOSE SHORT. For the May crude
example, you OPEN LONG at $102 and realize your gain by CLOSING SHORT at $104.
Beware that if you OPEN SHORT instead of CLOSING, you would be initiating a second
futures position, i.e SHORT at $104.

In India, the notion is simply one of “squaring off” the initial position. In other locations,
gains and losses on reversing transactions are calculated based upon the “settlement” price,
which is typically the average of the last few trades in the futures contract on that day (to
prevent gaming). Closing short or long is only ONE way to TERMINATE a transaction,
although the most common and the easiest way to illustrate how futures work. After all,
most speculators don’t really want to TAKE DELIVERY or MAKE DELIVERY of crude. In
fact, when the May futures start trading, people start taking positions (long or short) and the
“open interest” in the contract begins to rise. As May gets closer, these positions are closed
out and “open interest” begins to decline.
 DELIVERY. Some market players may actually want to take delivery of the
underlying oil via the futures, and keep the LONG position OPEN till maturity. The
short side would then DELIVER at the futures price according to a delivery schedule
(location can vary). Although not common with commodities, delivery is common in
interest-rate futures contracts. The T-bond futures contract has an extremely
complicated delivery process.

CASH SETTLEMENT. Some futures contracts are “cash-settled.” Think about what it
would mean to deliver the NIFTY index on an index futures contract. A share of INFY,
two of Reddy etc, which makes no sense, hence and the gain/loss is exchanged in cash.

EXCHANGE FOR PHYSICALS. There is also a rare notion of “exchange for physicals”
where the two parties might arrange delivery outside of the normal procedures specified by
the exchange.
CONVERGENCE.
The Figure below represents possible paths of the hypothetical May crude futures
contract. Also plotted is the path of spot crude. Notice how the two are different but
related. We see that today’s price of crude is $100, and todays price for May crude is
$102. We don’t know what either of them will be in May, BUT we know that they
will be the same. Ten seconds before maturity in May, we know that the price for
May crude futures should be equal to the May spot price. Thisi property is
CONVERGENCE. NOW s
MAT
C
O 108
104 N This property
V
F=102 E

S=100
95
90
 COST OF CARRY

Recall from the first page, that someone who needs crude in May could always buy and
hold it (incurring a cost, storage, insurance, spoilage etc), rather than enter the futures
market. Shouldn’t today’s difference of $2 between spot crude and May crude reflect that
cost. This is known as the cost of “carrying” crude for these few months. (SPOT-
FUTURES PARITY).

Since cost of carry is generally positive, one would expect futures prices to normally be
higher than spot prices, with some additional relationship with the time frame of that
futures contract.

However in some commodity markets, especially oil, seasonalities (heating oil in the
winter time gets hoarded) causing spot prices higher than the futures. Think of this as a
“convenience yield) for holding the underlying. Likewise think of dividends for stocks.

HENCE NORMAL (CONTANGO) markets and INVERTED (backwardation).

MARKET PARTICIPANTS

The market player in the above setting is a SPECULATOR who bets on the
future price of a commodity rising (long) or falling (short). Typically, they

 do not take (long) or make (short) delivery.

 close out positions with a reversing trade.
 operate only in one market (futures), can do spreads and such.
HEDGERS—The more common player in these markets is a HEDGER, whose nature
of business creates future spot exposure to a commodity. An oil drilling firm will have
oil extracted at different points in time and will be concerned about the risk of oil
prices falling. An oil refining firm purchasing crude for converting to gasoline is
likewise concerned about rising crude prices. (Coffee chain and coffee producer.)

These entities are not looking for speculative profits. They are looking to futures to
hedge their future spot exposure. So they effectively operate in both markets.

 A hedger who is long futures looks to profit from a possible price increase (like the
speculator). But this gain, if it occurs, will offset the higher future spot price at
which the commodity may have to be purchased in that spot market.

 A hedger who is short futures looks to profit from a possible price decrease (like a
speculator). But this gain, if it occurs, will offset the lower future spot price receipts
from delivery in that spot market.
Go back to Figure 1. The oil refining firm will be long May crude futures @ $102. If May
prices are $108, they have a $6 per barrel gain on the futures and will have to pay $108 for
crude in the spot market. Their out-of-pocket cost is $108 – $6 = $102. Again, if May prices
are $90, they have a loss of $12 on the long futures, but they pay $90 for crude. Their out-
of-pocket cost is $90 + $12 = $102. In other words, the hedger has locked in price of $102
to purchase crude in May. They are not happy with the hedge if prices fall (as they could
have got the crude cheaper), but that was not their concern. The risk is of prices rising and
eroding profit margins on their core refining business.

Likewise, consider the oil driller who is concerned about falling prices when they have to
MAKE DELIVERY in May. They are short May crude futures at $102 as well. If May
prices are $108, they can sell their crude for $108, but have a loss of $6 ($102-$108) on the
short futures (as prices went up). Their revenue per barrel is 108-6 = $102. Again, if May
prices are $90, they only get $90 from selling spot crude, but make $12 on the short futures
(102-90). Their revenue per barrel is $102. These guys are locked into $102 to deliver crude.
They are not happy if crude prices went up (they could have sold it for more), but they were
more worried about getting less (if crude prices fell).
ARBITRAGEURS: bet on mispricing by taking positions in BOTH markets!

Go back to Figure 1 and assume that this entity is able to carry crude till May for $1
instead of the $2 reflected in (spot – May crude). What would this individual do?

Obviously, buy spot crude for $100, hold it till May for $1, incurring a TOTAL
COST of $101. But what if May prices are down to $90? She would be out $11.
So, she would ADDITIONALLY also SHORT May futures at $102.

If May prices are $90, she sells the crude in the spot market and makes $12 on the
short futures position. Net profit ($90 + $12 - $101) = $1 per barrel.
If May prices are $108, net profit is $108 – $6 - $101) = $1 per barrel.

Pick any May price, the net profit will always be $1. Market efficiency means that
such an arbitrage will not persist. The motivation of this arbitrage is the mispricing
of $1 in the cost-of-carry an is quite different from the speculator or the hedger.
TYPES OF FUTURES CONTRACTS

a) Commodities,
“soft” commodities are grown – corn, wheat, sugar, coffee, cocoa, grains, cattle.
 “hard” commodities are extracted – gold, oil, industrial metals…
 In both, the basic products are often “refined” – corn + sugar to ethanol, crude oil
to gasoline. “Hard” commodities dominate.
 Many commodities do not have futures markets, in some cases, they are emerging –
water rights, pollution rights, carbon…
 Interest in them as an asset class extremely popular as they have historically shown
negative correlations with financials. NO LONGER?
 CCI = Continuous Commodity Index and other commodity indexes exist as well
(think large institutional money wanting commodity exposure).

b) financials- currencies, interest rates, equity indexes, single-stock futures, Markets

here are bigger still.
MARGINS IN FUTURES

Coffee futures have a contract size of 37,500 lbs. Say, coffee futures are 67.00 per lb.
AND, you are long TWO coffee futures contracts.
=> You agree to pay 2*0.67*37500 = 50,250 in 1 week for delivery

If, 1 week later, coffee spot prices are 70/lb. You can take delivery of the coffee at 6 or
just close out at a gain of: (0.70 – 0.67) * 2 * 37500 = $2,250

Typically, you post margin of 10%, OR 0.10 (50250) = $5025

RATE OF RETURN IS 2250/5025 = 44.8%, PRICE INCREASE IS (70-67)/67 =

4.48%. SO, leveraged by a factor of 10 !!

In futures markets, this gain of $ 2250 accrues in daily increments via mark-to-market.
In forward markets, this gain accrues at maturity (or when trade is closed).
MARK-TO-MARKET (DAILY SETTLEMENT)

Say, for coffee futures contract above, you see this pattern of daily futures prices

1___________2_________3_________4__________5__
/ / / / /
67.0 67.9 66.0 69 70

From day 1 to 2, price increase of $.009 per pound (0.009 x 2 x 37500) per trade

= $675 -1425 +2250 +750

Or $ 675 was deposited in the margin account of the long. Likewise, on day 3, $ 1425 is
transferred from margin account of long position to the margin account of short position.

These amounts are deposited (withdrawn) from margin accounts daily. Over the entire
period a NET TOTAL OF $2250 is deposited.
 SOME SIMPLE HEDGING ILLUSTRATIONS

1. COFFEE GROWER IN S. AMERICA : EXPECTS BUMPER HARVEST IN 3 MONTHS

RISK: COFFEE PRICES FALL (OVERSUPPLY)
ACTION: SHORT COFFEE FUTURES

2. STARBUCKS -- EXPECTS TROPICAL STORMS

RISK: COFFEE PRICES WILL RISE
ACTION: LONG COFFEE FUTURES

3. OIL REFINING CO. AGREES TO BUY CRUDE OIL AT FIXED PRICES FOR 2 YRS
RISK: CRUDE PRICES WILL FALL COULD HAVE BOUGHT CHEAPER SPOT)
ACTION: SHORT CRUDE OIL FUTURES

4. US MFG CO ORDERS HIGH-PRECISION TOOLS FROM GERMANY, TO PAY IN 6

MONTHS
RISK: EURO APPRECIATION
ACTION: LONG EURO FORWARD

 
 
 
5. US FIRMS HAS YEN ACCOUNTS RECEIVABLE
RISK: YEN DEPRECIATES
ACTION: SHORT YEN FORWARD

6. EQUITY FUND MANAGER

RISK: STOCK MARKET WILL DECLINE
ACTION: SHORT INDEX FUTURES

7. MONEY-MARKET FUND WANTS FUTURE T-BILL PURCHASE

RISK: RATES WILL FALL (will pay higher price later)

ACTION: LONG T-BILL FUTURES

8.TREASURER WANTS TO ISSUE COMMERCIAL PAPER IN 3 MONTHS

RISK: RATES WILL RISE (receive less at issue)

ACTION: SHORT T-BILL FUTURES
 
 
9. US CONSTRUCTION COMPANY BIDS ON A PROJECT TO BUILD A SPORTS FACILITY
IN U.K.

---- IF BID WINS, GET PAYMENT IN POUNDS

---- IF BID LOSES, GET NOTHING

RISK: BID WINS AND POUND LOSES VALUE

ACTION: SHORT POUND FORWARD IF BID WINS

SO: OPTION ON POUNDS FORWARD

(lose option premium if bid fails)

BASIS HEDGING.
Hedging focuses on changing spot prices over time, with the futures price being locked in
(to make or take delivery). Hedging is a response to volatility in commodity spot prices.

 Such hedges are clean if you can match futures contract maturities identically with the
time you want the hedge to operate. IF not, then you are exposed to calendar basis risk.

 Alternatively, suppose you operate in one location and futures contracts are for delivery
at another location, then you may be exposed to locational basis risk.

 Still alternatively, you may want to hedge one commodity but can only find futures on a
similar (but not identical) commodity. Then you are exposed to product or quality basis
risk (aluminium futures versus bauxite, corporate bonds versus Treasury futures, equity
portfolio with stock index futures. These are also called cross-hedges.

 Keeping it simple, define the basis as (spot – futures) (TEXTBOOK DOES IT THE
OTHER WAY!)
The example below illustrates what happens. Consider someone who needs 50,000
ounces of silver by July. It is now April. Silver futures (5000 troy oz, cents per oz).
Spot 446.0
July 450.8
Buy the silver now and hold it in case prices rise? Too costly. So, enter into 10 long July
futures contracts, expecting to pay about $4.508 per ounce in July. Think of this as a long
hedge.

Now (Apr) July

|--------------------------------------------|
Spot = 4.460 Case (a) 4.60
July Futures = 4.508 Case (b) 4.30

Hedge is convenient, July contract available, spot and futures converge at maturity, or
basis is zero, no basis risk.
I. LONG-HEDGER: Film maker needs silver in July. Risk of price increase. Action
Now: Open long futures position 50K oz @ 4.508.

Case (a) July spot price = $4.60 (also July futures - convergence).
July: buy spot silver @ cost of 4.60 * 50000 = - $230,000
Close Short futures @ 4.60 (gain) = $4,600
(0.092*50000) - $225,400
Out-of-pocket cost = - $ 225,400/50000 = $4.508
Notice that with the futures, the hedger effectively has obligation to pay $4.508 at
delivery (delivery is via the spot market since the short futures side picks location).

Case (b) July spot price = $4.30 (also July futures - convergence)
July: buy silver @ cost of 4.30 * 50000 = - $215,000
Close Short futures @ 4.30 (loss) = - $ 10,400
(-0.208*50000) - $225,400
Out-of-pocket cost = - $ 225,400/50000 = $4.508
Again, the $4.508 obligation results. PICK ANY JULY PRICE and the same happens.
II. SHORT HEDGER: Silver miner wishes to deliver silver in July. Risk of price drop.
Action Now: Open short futures position 50K oz @ 4.508.

Case (a) July spot price = $4.60

July: sell silver @ 4.60 for 4.60 * 50000 = + $230,000
Close Long futures @ 4.60 (loss) = - $4,600
Total cash flow = + $ 225,400 (225,400/50000 = $4.508).
Note with the futures, the short hedger effectively receives $4.508.

Case (b) July spot price = $4.30

July: sell silver @ 4.30 for 4.30 * 50000 = + $215,000
Close Long futures @ 4.30 (gain) = + $ 10,400
Total cash flow = + $ 225,400

And again, 225,400/50000 = $4.508, per unit.

Introduce basis risk: same example except the month is JUNE (before maturity).
Now (Apr) June July
|--------------------------------------------|
Spot = 4.460 4.50 could be anywhere
July Futures = 4.508 5.00 but converges
BASIS = -0.048 = - 0.50

LONG-HEDGER: Now: Open long futures, 50K oz @ 4.508.

June: buy silver @ cost of 4.50 * 50000 = - $225,000
Close Short futures @ 5.00 (gain) = $ 24,600
(0.492*50000) - $200,400
Out-of-pocket cost = - $ 200,400/50000 = $4.008
Notice that the long hedger effectively pays less than $4.508 since the futures gained
(0.492) more than the loss from an increase in the spot price (0.04).
Basis was 4.5 – 5 = 0.5 and the cost to the hedger is original futures price + basis =
4.508 – 0.5 = 4.008. The hedge was advantageous to the long hedger.
Another way to think of this is that the long hedger was “short” the basis, and the
basis got more negative!

The short hedger’s perspective is a mirror image. This hedger will effectively receive
$4.008 from selling silver, less than what he would have obtained without the hedge.
Note that for the short hedger, the futures trade is open short and close long and this
trade loses money.

IMP: what started off as a hedge against price risk, ended up becoming exposure to
basis risk. Still, basis risk is a lot less volatile than price risk, so hedgers are still better
off.

Try a case where the June spot price is 5.00 and the futures price is 4.80.
HEDGING COMPLICATIONS.

1. Should you hedge at all?

2. Should you hedge the entire amount?
3. Should you hedge to minimize basis risk?
4. Stack and Roll Hedges

AND SO IT GOES….