Futures-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Futures-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 41 FUTURES THE FUTURES MARKET: A futures contract is a promise; the person who initially sells the contract promises to deliver a quantity of a standardize commodity to a designated delivery point during a certain month called a delivery month. The other party to the trade promises to pay a predetermined price for the goods upon delivery. The person who promises to buy is said to be long; the person who promises to deliver is short. UNDERSTANDING FUTURES MARKETS: Why Futures Markets? Physical commodities and financial instruments typically are traded in cash markets. A cash contract calls for immediate delivery and is used by those who need a commodity now (e.g., food processors). Cash contracts cannot be canceled unless both parties agree. The current cash prices of commodities and financial instruments can be found daily in such sources as The Wall Street Journal. There are two types of cash markets, spot markets and forward markets. Spot markets are markets for immediate: delivery. The spot price refers to- the current market price of an item available for immediate delivery. Forward markets are markets for deferred delivery. The forward price is the price of an item for deferred delivery. Futures Contracts: : A forward contract is an agreement between two parties that calls for delivery of a commodity (tangible or financial) as, a specified future time at a price agreed upon today. Each contract has a buyer and a seller: Forward markets have grown primarily because of the growth in swaps, which in general are similar to forward contracts.  Forward contracts involve credit risk—either party can default on their obligation. These contracts also involve liquidity risk because of the difficulties involved in getting out of the contract. On the other hand, forward contracts can be customized to the specific needs of the, parties involved. A futures contract is a standardized, transferable agreement providing for the deferred delivery of either a specified grade or quantity of a designated commodity within a specified geographical area or of a financial instrument (or its cash value). In simple language, a futures contract locks in a price for delivery, on a future date. The futures price at which this exchange will occur at contract maturity is determined today. The trading of futures contracts means only that commitments have been made by buyers and sellers; therefore,, "buying" and "selling" do not have the same meaning in futures transactions as they do in stock and bond transactions. Although these commitments are binding because futures contracts are legal contracts, a buyer or seller can eliminate the commitment simply by taking an opposite position in-the same commodity or financial instrument for the same futures month. docsity.com y g ( )  Futures contracts are standardized and easily traded. Credit risk is removed by the clearinghouse (explained below) which ensures performance on the contract. On the other hand, they cannot readily be customized to fit particular needs. Futures contracts are not securities and are not regulated by the Securities and Exchange Commission (SEC). The Commodity Futures Trading Commission (CFJC), a federal regulatory agency, is responsible for regulating trading in all domestic futures markets. In practice, the National Futures Association, a self-regulating body, has assumed some of the duties previously performed by the CFTC. In addition, each futures exchange has a supervisory body to oversee its members. Futures vs. Options: Some analogies can be made between futures contracts and options contracts. Both involved a predetermined price and contract duration. An option, however, is precisely that. The person holding the option has the right, but not the obligation, to exercise the put or the call. If an option has no value at its expiration, the option holder will allow it to expire unexercised. But with futures contract, a trade must occur if the contract is held until its delivery deadline. Futures contracts do not “expire” unexercised. One party has promised to deliver a commodity, which another party has promised to buy. An important concept keep in mind with futures is that the purpose of contracts is not to provide a means for the transfer of goods. Stated another way, property rights to real or financial assets cannot be transferred with futures contracts. Futures contracts do, however, enable people to reduce some of the risks they assume in their business. People who buy puts or calls do not usually intend to exercise them; valuable options are sold before expiration day. Similarly, an individual who is long a corn futures contract usually does not want to take delivery of the 5,000 bushels covered by the contract. Also, a farmer who has promised to deliver wheat through the futures market may prefer to sell the crop locally rather than deliver it to an approved delivery point. In either case the contract obligation can be satisfied by making an offsetting trade, or trading out of the contract. An individual with a long position sell a contract, canceling the long position. The farmer with short position would buy. Both individuals would be out of the market after these trades. Market Participants: Two types of participants are required in order for a futures market to be successful: hedgers and speculators. Without hedgers the market would not exist, and no economic function would be performed by speculators. 1. Hedgers: In the context of future market, a hedger is someone who is engaged in some type of business activity with an unacceptable level of price risk. A farmer must decide what crop to put in the ground in each spring. The welfare of the farmer’s family or business depends on the price of the chosen commodity at harvest. If the price is high the farmer will earn a nice profit in the crop. Should prices be low because of overabundance or reduced demand, and then prices may fall to such a level that operating costs cannot even be recovered. It is important to recognize that the farmer cannot eliminate the risk of a poor crop through the futures market; only price risk can be eliminated. Crop insurance may help protect against such an eventuality, but the futures market cannot. docsity.com