Futures markets

Today’s price for products to be delivered in the future.

A mechanism of trading promises of future commodity deliveries among traders.

Biological nature of ag production– Prices not known when production decision is

made– Processors need year around supply

Futures Market Exchanges

12 organized exchanges Two largest

– Chicago Board of Trade (CBOT)» Grains, interest rates» http://www.cbot.com/

– Chicago Mercantile Exchange (CME)» Livestock, financial, currencies» http://www.cme.com/

– Combined for 75% of futures volume

Futures Market Exchanges

Trading pits Centralized pricing

– Buyers and sellers represented– All information represented

Perfectly competitive market– Open out-cry trading

The futures contract

A legally binding contract to make or take delivery of the commodity– Form (wt, grade, specifications)– Time (delivery date)– Place (delivery location)– Possession (seller delivers, buyer receives)

The futures contract Standardized contract No physical exchange takes place when

the contract is traded. Deliveries are made when the contract

expires (delivery time) Payment is based on the price established

when the contract was initially traded.

Standardized contract Certain delivery (contract) months Fixed size of contract

– Grains 5,000 bushels– Livestock in pounds

» Lean Hogs 40,000 lbs carcass

» Live Cattle 40,000 lbs live

» Feeder Cattle 50,000 lbs live

Specified delivery points– Relatively few delivery points

Market position

Objective: Buy low, sell high You can either buy or sell initially

– Sell a December Corn contract initially» Short the market» Buy back at a later date

– Buy a February Live Cattle contract initially» Long the market» Sell back at a later date

Margin account Highly leveraged trades

– Margin is the earnest money that must be maintained in the trader’s account

– Often 5-10% of full value Margin account settled everyday

– Must maintain account balance– Margin call

Calculate as if you had to get out of the market every day.

Margin Account

Initial margin: The amount needed to open and account.

Maintenance margin: The minimum amount needed to keep and account open.

“Mark to the Market” at the close of each trading day.

Margin Account Example

Initial margin$1,000

Maintenance margin$800

Corn contract (5000 bushels)– Day 1: Sell at 2.55

Margin Account Example

Day Price Chg G/L Margin

1 2.54 +.01 +50.00 1050.00

2 2.58 -.04 -200.00 850.00

3 2.61 -.03 -150.00 700.00

Below Maintenance Margin

must make $100 margin call 800.00

4 2.52 +.09 +450.00 1250.00

Changes reflect the initial “sell” of the contract

Margin Account Example

Note that you can calculate your margin account if you know the initial margin, any additions or removals and the current closing price.

Market participants

Hedgers are willing to make or take physical delivery because they are producers or users of commodity.

Speculators buy or sell in an attempt to profit from price movements.

Hedgers

Producers with a commodity to sell at some point in the future

Short hedgers1 Sell the futures contract first2 Buy the futures contract (offset) when they

sell the physical commodity

Hedgers

Processors or feeders that plan to buy a commodity in the future

Long hedgers1 Buy the futures first2 Sell the futures contract (offset) when they

buy the physical commodity

Futures Speculators

Do not have the commodity nor need the commodity

They try to profit from price change

Price discovery

Must be a buyer and seller for every transaction

Supply and demand still works– more sellers than buyers price falls– more buyers than sellers price rises

Futures trade on information

Why would buyers buy?– They think that the price at delivery will be

higher than it is currently. Why would sellers sell?

– They think that the price at delivery will be lower than it is currently.

Futures Trade Example

Day 1: Think that the new crop (Dec) corn price is going to declineStep 1: Decide to Sell a December corn futures contract by calculating

expected price from hedgingFutures bid $2.34Adjust for basis -.31Subtract commission -.01Expected hedge price $2.02

Futures Trade Example

Step 2: Call your broker and place order to sell Dec corn at the market

Step 3: Broker forwards order to CBOT where the broker's representative runs the order to the pit and tries to fill the order.

Futures Trade Example

Step 4: The order is filled at $2.34

Step 5: Broker calls to confirm fill

Step 6: Send margin money to broker Initial margin account level is $750 Must maintain at least $600 in margin

account at end of each day

Futures Trade Example

Day 2: Closing price is $2.38

We sold at $2.34

Market is $2.38

We are behind by -$0.04

On 5,000 bushels = $200

Send broker $200 on Day 2

Futures trade example

At some later date we decide to offset our position

Last Day: Call broker and place order to buy Dec corn at the market

Two things could have happened

Prices are higher than initially

Prices are lower than initially

Futures trade example Case 1: Prices are higher => $2.56 Calculate returns per bushelsSold on Day 1@ $2.34Bought back later @ $2.56Gross future return -$0.22Commission @ $50/contract -$0.01Net return per bushel -$0.23Local cash price $2.25Net price $2.25-.23=$2.02

Futures trade example Convert to contract returns

Gross returns -$0.23

Contract = 5,000 bushels -$1,150

Because we settled the margin account every day the broker has this amount plus at least $600 minimum margin. The remaining margin balance is returned.

Futures trade example Case 2: Prices are lower => $2.20 Calculate returns per bushelsSold Day 1 @ $2.34Bought back later @ $2.20Gross return +$0.14Commission @ $50/contract -$0.01Net return per bushel +$0.13Local cash price $1.89Net price $1.89+.13= $2.02

Futures trade example

Convert to contract returns

Gross returns +$0.13

Contract = 5,000 bushels +$650

Because the margin account is settled every day the broker has this amount plus the $750 initial margin. We are returned the $1,400.

Relationship between futures and cash prices

Difference is call basisBasis = Cash - Futures

GrainTypically quote the absolute value

“30 cents under” = $.30 basis

Cash is $.30 less than futures Livestock

The sign is important

Basis

Reflects local conditions– Supply and demand

» Yields, storage availability, processing capacity, rail cars, local usage

Individual basis impacted by factors that effect the local cash price relative to the delivery point price.

Basis

Differs by market– Time, place, and form

Basis includes – Storage to maturity – Transportation to delivery point– Grade differences

Basis generalities

Cash and futures move together Basis narrows at contact maturity

– Cash and futures converge– Arbitrage of delivery

Basis is more predictable than price Basis generally follows a pattern

– Seasonal patterns

Live Cattle Basis 1997-2001

-3.00

-2.50

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

Jan 1

-15

Feb 1

-15

Mar

1-1

5

Apr 1-1

5

May

1-1

5

Jun 1

-15

Jul 1

-15

Aug 1-1

5

Sep 1

-15

Oct 1

-15

Nov 1-

15

Dec 1

-15

Position Diagram Graph of expected payoff at alternative

futures prices at contract expiration

1. Futures prices on horizontal axis

2. Expected net price on vertical axisAdjust for basis and commission if needed

3. Start with current futures price

4. Identify one other futures priceFutures, cash, and hedge are linear

Futures

Net Price

Current

Long Cash

Adjust for basis

Long Futures = 45oShort Futures = 45o

HedgeAdjust for basis