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CHAPTER 14

Chapter Sections:Futures Contracts BasicsWhy Futures?Futures Trading AccountsCash Prices versus Futures PricesStock Index Futures

Futures Contracts

“There are two times in a man’s life when he should not speculate; when he can’t afford it and when he can.”

– Mark Twain

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What are Futures? Futures contract

A commitment to deliver a certain amount of some specified item at some specified date in the future

A buyer and a seller specify a commodity or financial instrument to be delivered and paid when the contract matures The futures price is guaranteed by the contract

Futures started with commodities… a.k.a. hard assets, real assets Examples: wheat, soybeans, cattle, pork bellies,

gold, oil, etc. But have since moved to financial assets

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What is the Purpose of Futures? Producers of commodities use futures

contracts extensively Example: A wheat farmer in Iowa plants 1,000 acres

of wheat in April. He knows that if all goes well, Lord Willing, come September he will have 500,000 bushels of wheat. September wheat futures are currently (in April) selling for $6 per bushel

Our farmer can “sell” his wheat (via a wheat futures contract) while it is still in ground. He can guarantee a price that he is happy with and will result in a profit

The contract states he will deliver the wheat in September and receive $6 per bushel no matter what happens to wheat prices

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What is the Purpose of Futures? Consumers of commodities also use them

Example: Kellogg’s and General Mills and Post Cereal need tons and tons of wheat each year to make cereal and other foodstuffs

Via futures contracts, in April, they can purchase the wheat to be delivered in September and pay $6 per bushel no matter what happens to wheat prices

(continued)

What are the advantages and disadvantages of using futures contracts when you are the producer

and when you are the consumer?

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What is the Purpose of Futures? Futures contracts allow producers and

consumers of commodities to hedge Hedging: Taking a futures position opposite to an

existing position in the underlying commodity or financial instrument

(continued)

“Hedge your bet!” Have you ever heard this saying? The farmer is protecting himself from wheat prices

falling. The cereal companies are protecting themselves from wheat prices rising.

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Major Classes of Commodities

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What are Financial Futures? The financial world adopted the technique of

futures contracts to financial assets, treating financial assets like commodities Examples: currencies, interest rates, stock and

bond indexes, etc. “I will deliver $25,000 worth of British Pounds to

you next April” “I will purchase $10,000 worth of the S&P 500

stock index from you next August”

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Purpose of Financial Futures? For those working in the World of Finance

and especially, the World of International Business, they can be very useful tools Example: A car manufacturer knows it will need

to purchase 50,000 engines from Japan next October

The manufacturer can buy a currency future for $20,000,000 worth of Japanese Yen payable in October

This protects the manufacturer from adverse currency fluctuations Example: The dollar falls relative to the yen

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Can Anyone Purchase Futures? Lucky You! You do not have to work in either

the commodities world or the finance world to buy and sell futures contracts You can be a speculator! You simply buy and sell the futures contracts You never actually deliver or take delivery of the

commodity nor the financial asset You could buy the 500,000 bushels to be delivered

in September even though you live in a condo in West Los Angeles and have never even seen a farm!

What do you think of this strategy? What is the limit of your losses?

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Speculating with Futures Speculating – Accepting the futures price risk

without having a position opposite to an existing position in the underlying commodity or financial instrument It is the opposite of hedging “… futures speculation is risky, but it is potentially

rewarding if you can accurately forecast the direction of future commodity price movements.” – page 456, 4th edition

Can anyone accurately forecast the future? If our LA speculator sitting in her condo had purchased the futures

contract for 500,000 bushels of wheat to be delivered in September and wheat prices plummeted, she could potentially lose hundreds of thousands of dollars!

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Trading Futures Chicago Board of Trade

Largest, most active futures exchange Many other exchanges

Long position The buyer of the futures contract

Protected from futures price increases Wheat Example: Kellogg’s, Post Cereal

Short position The seller of the futures contract

Protected from futures price decreases Wheat Example: Our farmer

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Futures Seem Like Options In fact, the two are very similar

Financial futures work very much like options There is the potential for great rewards But there is also much more of the likelihood of

sustaining great losses In fact, the potential losses from futures contracts

are staggering! And, just like options, they are a tremendous

source of commissions for your broker

By the way, you can purchase options on futures contracts. What do you think about that?

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Final Comments on Futures?

They are even more potentially dangerous than options.

STAY AWAY FROM THEM!

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CHAPTER 14 – REVIEW

Futures Contracts

Next: Brokerage Accounts, Buying on Margin, and Selling Shorting

Chapter Sections:Futures Contracts BasicsWhy Futures?Futures Trading AccountsCash Prices versus Futures PricesStock Index Futures