FIN 355 (21) - Introduction to Futures, Forwards, and Commodities (module 6).pptx
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FIN 355 Principles of Investments Futures and Forwards Lecture Preview Big-Picture Motivation: Traditional portfolios tend to focus on stocks and bonds. Many mutual funds are also focused on stock and bonds. This type of ownership tends not to use leverage and tends to move up and down in straigh...
FIN 355 Principles of Investments Futures and Forwards Lecture Preview Big-Picture Motivation: Traditional portfolios tend to focus on stocks and bonds. Many mutual funds are also focused on stock and bonds. This type of ownership tends not to use leverage and tends to move up and down in straightforward ways with the value of the stocks and/or bonds. The derivatives market is huge and offers new payoff relationships with the value of the underlying assets that can be customized and are often leveraged. Discussion Outline: • What are futures and forward contracts? • How do futures markets work? • Parity condition Futures and forwards “Futures and forward contracts are like options in that they specify purchase or sale of some underlying security at some future date. The key difference is that the holder of an option is not compelled to buy or sell and will not do so unless the trade is advantageous. A futures or forward contract, however, carries the obligation to go through with the agreed-upon transaction” -Introduction to Chapter 22 of the graduate version of your textbook (bold added) Note – futures contracts can be exited by buying/selling a contract with opposite terms. This point is important because in the vast majority of cases the contract is not held to maturity. Forwards vs futures • Both forward and futures contracts are agreements to trade something at a future date for a specified price. • Forward contracts are often customized for specific trade partners. • Futures contracts, in contrast, are standardized. Both the “buyer” and “seller” enter into these contracts by transacting with a centralized futures exchange. Using standardized contracts that trade on an exchange… • Reduces customization in contracts (+/-) • Increases liquidity • Removes the need to verify creditworthiness of trade partners (everything is done via the exchange, daily marking to market and margins) • Allows speculators and hedgers (not just the producers and buyers) to gain financial exposure to interesting assets (e.g., commodities, minerals, metals, energy, interest rates, indexes, currencies, etc.) To get a sense for why some investors participate in the futures market consider the producer of wheat and the buyer of wheat. The farmer: • Incurs upfront costs to plant wheat. • Spends significant money, time, and effort over several months to produce the crop. • Faces uncertain prices and market conditions at harvest. All of the efforts and resources committed might end with a negative outcome! The miller: • Incurs upfront costs to have the equipment, transport, etc. ready to process wheat • Faces uncertain prices and market conditions at harvest. All of the efforts and resources committed might end with a negative outcome! Futures and forward contracts allow both the farmer and miller to plan for the future. This allows them to commit resources today. • Both the farmer and the miller can enter into an agreement now (at the start of the wheat growing season) and decide on a price and quantity of wheat to trade at the end of the season. • This agreement allows both parties to reduce the uncertainty of future markets. • Note that this arrangement is not an “option” because the agreement calls for the actual delivery of goods at a pre-specified price. • The price that is agreed to in advance is the futures price. The agreement is the futures contract. Speculation and hedging in the futures market Speculation Seek to profit from price movement •Long — believe price will rise •Short — believe price will fall Hedging Seek protection from price movement •Long hedge — protecting against a rise in purchase price •Short hedge — protecting against a fall in selling price • Futures are traded on margin • At the time the contract is entered into, no money changes hands “Hedgers and speculators go hand in hand – if you took one away, there simply would be no market.” (1/2) -https://www.futuresfundamentals.org/ “All kinds of people come to futures exchanges, to buy and sell futures and options contracts. They may work for banks, corporations or governments. They may be livestock ranchers, investment managers, construction planners, farmers or food manufacturers…futures trading involves…anyone in the world who wants either to manage the risk of fluctuating prices or profit from those fluctuations. But whoever they are, and wherever they came from, these traders are interested in two types of trading: hedging and speculating. Hedgers and speculators go hand in hand – if you took one away, there simply would be no market. Hedgers transfer risk, and speculators absorb that risk. It takes both types of traders to bring balance to the market and keep trades moving back and forth.” “Hedgers and speculators go hand in hand – if you took one away, there simply would be no market.” (2/2) -https://www.futuresfundamentals.org/ … “Meet the hedger: The hedger buys futures contracts because he wants to protect himself from price swings in the future. By using futures to lock in a future price for a product, he makes his costs – and his profits – more predictable. In other words, he trades futures to drive risk out of his business. But that risk doesn’t just disappear into thin air – it gets transferred to the speculator. Meet the speculator: The speculator accepts price risk in pursuit of profit. Speculators have no interest in owning the product being traded, but they are interested in the contracts for those products. Think of it like investing – buying and selling futures contracts in order to make a profit when prices move in the right direction.” Examples of some of major categories of futures contracts (Table 22.1) Figure 22.3 Panel B - The net position of the clearing house is zero. At the start of the futures position only margin is needed. • Futures are traded on several different exchanges. On these exchanges both the “buyer” and “seller” are interacting directly with the exchange/clearinghouse not directly with each other. • The exchange requires margin to be posted and maintained throughout the life of the contract. • You can enter into a futures contract for a fraction of the value (often between 3 and 15% depending on the volatility in the asset’s prices) • Required to mark to market on a daily basis. Initial margin, marking to market, daily settlement • Before trading futures the exchange requires both long and short sides of the trade to place some funds at the exchange. The deposits are typically between 3 and 15% of the total futures contract value but the initial margin rates can vary depending on asset price and market volatility. • These deposits can be invested in liquid investments that earn some interest while at the exchange. • The margin deposits are not “ownership” they are the funds that will be drawn from (or added to) over time as the futures contracts are marked to market. They are there to ensure both parties can meet their financial obligations as prices change. • If one of the people loses enough money such that the margin account drops below the maintenance margin then the person will be required to add additional funds. How do investors make or lose money with daily marking to market? Example – Assume the 5-day maturity futures price for silver is currently$20.10 per ounce. 1 contract is for 5,000 ounces. Assume the futures price evolves over the next 5 days: Day 0 (today) 1 2 3 4 5 (maturity) Futures Price Over Time 20.10 (F0= futures price at 0) 20.20 20.25 20.18 20.18 20.21 (FT = futures price at T) Daily proceeds .10 * 5000 = $500 .05 * 5000 = 250 -.07 * 5000 = -350 0 * 5000 = 0 .03 * 5000 = 150 The profit on day 1 is the increase in the futures price from the previous day, or ($20.20 - 20.10) per ounce. Because each silver contract on the exchange calls for purchase and delivery of 5,000 ounces, the total profit per contract is 5000 times .10, or $500. Example – Assume the 5-day maturity futures price for silver is currently$20.10 per ounce. 1 contract is for 5,000 ounces. Assume the futures price evolves over the next 5 days: Day 0 (today) 1 2 3 4 5 (maturity) Futures Price Over Time 20.10 (F0= futures price at 0) 20.20 20.25 20.18 20.18 20.21 (FT = futures price at T) Profit = (20.21 – 20.10) * 5000 = 550 Daily proceeds .10 * 5000 = $500 .05 * 5000 = 250 -.07 * 5000 = -350 0 * 5000 = 0 .03 * 5000 = 150 Sum = 550 Because of the convergence property the final futures price for a commodity must equal the spot price at that time. So we can write the profit as (FT - F0) or (PT - F0) Profit with futures contracts Profit to long position at maturity = Spot price at maturity - Original futures price Profit to short position at maturity = Original futures price - Spot price at maturity The futures contract is a zero-sum game, which means the gains and losses across both sides of the trade net out to zero Important intuition: The profit for long and short positions is zero when the ultimate spot price, PT equals the initial futures price, F0 The link below provides an example of how futures are used by groups involved with the production of cereal. Link: https://www.futuresfundamentals.org/get-the-basics/heres-why-futures-matter-to-you/#cereal_infographic Futures are used by many different groups. As another example… Linda Whiteside is responsible for dairy and frozen food products at Associated Wholesale Grocers (AWG), a member-owned co-op serving more than 2,900 stores in 24 states. “Our concern is controlling our costs,” Whiteside says. “Our goal is to keep our stores very competitive in their markets.” To control costs, AWG works with vendors to ensure price points. For example, she works with cheese vendors to hedge their needs over a certain period of time, generally via CME Group Class III milk futures or cheese futures contracts. “Where we can, we will work with vendors to establish a hedge that they might choose,” she says, “but every vendor is different, and we work with multiple vendors to ensure consistent supply.” impact/agriculture-futures/ -- https://www.futuresfundamentals.org/see-the- Futures are used extensively in many different markets/scenarios Common Examples Agricultural markets • Wheat, corn, soybeans, pork, cattle, etc. Energy markets • crude oil, natural gas, electric power, coal Financial markets • Interest rate, currency exchange, S&P500,VIX “Banks, hedge funds, commodity trading advisors, and other money managers-who often do not have interests in trading physical oil-are also active in the market for energy derivatives to try to profit from changes in prices. In recent years, investors have also shown interest in adding energy and other commodities as alternatives to equity and bond investments to diversify their portfolios or to hedge inflation risks.” --www.eia.gov “During the world financial crisis that occurred in the latter half of 2008 and 2009, markets saw a dramatic increase in the correlation between crude oil and other commodities as demand decreased for raw materials. However, both before and after the world economic slowdown, there were observable increases in the correlations between commodity prices.” - www.eia.gov Futures are also used to trade on the VIX. What is the VIX Index? “The Cboe Volatility Index (VIX) is a real-time index that represents the market's expectations for the relative strength of near-term price changes of the S&P 500 index (SPX). Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility. Volatility, or how fast prices change, is often seen as a way to gauge market sentiment, and in particular the degree of fear among market participants. The index is more commonly known by its ticker symbol and is often referred to simply as ‘the VIX.’ ” Using the Federal Reserve “FRED” website we can graph the VIX and the S&P500 over time. VIX-based futures contracts have exploded in recent years. Many people also trade on volatility using ETPs instead of futures. “Some people have argued that the creation and active trading of securities that derive their value from volatility measures creates a massive feedback loop where the monetary impact of changes in underlying prices can be magnified via the VIXrelated trading.” Profits to buyers and sellers of futures and option contracts Trading mechanics • Open interest is the number of contracts outstanding • If you are currently long, then you instruct your broker to enter the short side of a contract to close out your position • Most futures contracts are closed out by reversing trades • Only 1-3% of contracts result in actual delivery of the underlying commodity Basis and basis risk • Basis - the difference between the futures price and the spot price, FT – PT • The convergence property says FT - PT = 0 at maturity • Before maturity, FT may differ substantially from the current spot price • Basis Risk - variability in the basis means that gains and losses on the contract and the asset may not perfectly offset if liquidated before maturity. Contango and Backwardation • If the futures curve is upward sloping then the futures price is higher than the spot price and the curve is in “contango”. The roll yield will be negative when there is contango. The futures contracts are trading at a premium to the spot price. • If the futures curve is downward sloping then the futures price is lower than the spot price and the curve is in “backwardation”. The roll yield will be positive when there is backwardation. Futures pricing intuition There are two ways to acquire an asset for some date in the future: 1. Purchase it now and store it, or 2. Take a long position in futures on that asset Spot-futures parity theorem - These two strategies must, on average, have the same market determined costs over time otherwise there is an arbitrage opportunity. Arbitrage possibilities If spot-futures parity is not observed, then arbitrage is (temporarily) possible • If the futures price is too high, short the futures and acquire the stock by borrowing the money at the risk-free rate • If the futures price is too low, go long futures, short the stock and invest the proceeds at the risk-free rate Example of hedging with futures Current financial position: • Assume an investor holds $1000 in a mutual fund indexed to the S&P 500. Assume dividends of $20 will be paid on the index fund at the end of the year. Futures contract: • A futures contract based on the S&P500 is available with delivery in one year for $1,010 The hedge: • The investors will lose money from the mutual fund if the S&P500 goes down. The way to hedge this is to short one futures contract Hedging example, cont. Final value of stock portfolio, ST: Payoff on Short Position (1,010 - ST) Dividend Income Total 990 1,010 1,030 20 0 -20 20 1,030 20 1,030 20 1,030 ( 𝐹 0 + 𝐷)− 𝑆0 (1,010+20) − 1,000 = =3 % 𝑆0 1,000 For next time.. Review the concepts and terminology introduced in today’s lecture. Be sure to look at the online schedule for the assigned reading and the upcoming assignments. Terminology You should be able to give a 1-2 sentence description of each of these terms. • • • • • • • • • Spot price Futures price Futures contract Forward contract Exchanges Initial margin Maintenance margin Margin call Payoff diagrams for futures • Types of futures • • • • • • • • • • spot-futures parity Convergence theorem Delivery Marking to market “cash settlement” Roll yield Contango vs backwardation Who invests in futures? How can futures be used to hedge? What does it mean to say that “futures are purchased on margin”? Thank You
