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sonally renegotiated with the other party to the contract. Because the exchange guarantees the
performance of each party to the contract, costly credit checks on other traders are not neces-
sary. Instead, each trader simply posts a good faith deposit, called the margin, in order to guar-
antee contract performance.

The Basics of Futures Contracts
The futures contract calls for delivery of a commodity at a specified delivery or maturity date,
for an agreed-upon price, called the futures price, to be paid at contract maturity. The contract futures price
specifies precise requirements for the commodity. For agricultural commodities, the exchange The agreed-upon
sets allowable grades (e.g., No. 2 hard winter wheat or No. 1 soft red wheat). The place or price to be paid on a
means of delivery of the commodity is specified as well. Delivery of agricultural commodities futures contract at
maturity.
is made by transfer of warehouse receipts issued by approved warehouses. In the case of fi-
nancial futures, delivery may be made by wire transfer; in the case of index futures, delivery
may be accomplished by a cash settlement procedure such as those used for index options.
(Although the futures contract technically calls for delivery of an asset, delivery rarely occurs.
Instead, parties to the contract much more commonly close out their positions before contract
maturity, taking gains or losses in cash.)1
Because the futures exchange specifies all the terms of the contract, the traders need bar-
gain only over the futures price. The trader taking the long position commits to purchasing the long position
commodity on the delivery date. The trader who takes the short position commits to deliver- The futures trader
ing the commodity at contract maturity. The trader in the long position is said to “buy” a con- who commits to
tract; the short-side trader “sells” a contract. The words buy and sell are figurative only, purchasing the asset.
because a contract is not really bought or sold like a stock or bond; it is entered into by mutual
agreement. At the time the contract is entered into, no money changes hands. short position
Figure 16.2 shows prices for futures contracts as they appear in The Wall Street Journal. The The futures trader
boldface heading lists in each case the commodity, the exchange where the futures contract is who commits to
traded in parentheses, the contract size, and the pricing unit. For example, the first contract listed delivering the asset.
under “Grains and Oilseeds” is for corn, traded on the Chicago Board of Trade (CBT). Each con-
tract calls for delivery of 5,000 bushels, and prices in the entry are quoted in cents per bushel.
The next several rows detail price data for contracts expiring on various dates. The March
2002 maturity corn contract, for example, opened during the day at a futures price of 211 cents
per bushel. The highest futures price during the day was 214, the lowest was 210, and the



1
We will show you how this is done later in the chapter.
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




568 Part FIVE Derivative Markets




F I G U R E 16.2
Futures listings
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




569
16 Futures Markets




F I G U R E 16.2
(Continued)
Source: From The Wall Street Journal, January 16, 2002, Reprinted by permission of Dow Jones & Company, Inc., via Copyright Clearance Center, Inc.
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




570 Part FIVE Derivative Markets


settlement price (a representative trading price during the last few minutes of trading) was
2123„4. The settlement price increased by 13„4 cents from the previous trading day. The highest
futures price over the contract™s life to date was 270, the lowest 205 cents. Finally, open inter-
est, or the number of outstanding contracts, was 255,712. Similar information is given for each
maturity date.
The trader holding the long position, that is, the person who will purchase the good, profits
from price increases. Suppose that when the contract matures in March, the price of corn turns
out to be 2173„4 cents per bushel. The long position trader who entered the contract at the futures
price of 2123„4 cents on January 15 (the date of the Wall Street Journal listing) earns a profit of 5
cents per bushel: The eventual price is 5 cents higher than the originally agreed-upon futures
price. As each contract calls for delivery of 5,000 bushels (ignoring brokerage fees), the profit to
the long position equals 5,000 $0.05 $250 per contract. Conversely, the short position loses
5 cents per bushel. The short position™s loss equals the long position™s gain.
To summarize, at maturity
Profit to long Spot price at maturity Original futures price
Profit to short Original futures price Spot price at maturity
where the spot price is the actual market price of the commodity at the time of the delivery.
The futures contract is, therefore, a zero sum game, with losses and gains to all positions
netting out to zero. Every long position is offset by a short position. The aggregate profits to
futures trading, summing over all investors, also must be zero, as is the net exposure to
changes in the commodity price.
Figure 16.3, panel A, is a plot of the profits realized by an investor who enters the long side
of a futures contract as a function of the price of the asset on the maturity date. Notice that
profit is zero when the ultimate spot price, PT , equals the initial futures price, F0 . Profit per
unit of the underlying asset rises or falls one-for-one with changes in the final spot price. Un-
like the payoff of a call option, the payoff of the long futures position can be negative: This
will be the case if the spot price falls below the original futures price. Unlike the holder of a
call, who has an option to buy, the long futures position trader cannot simply walk away from
the contract. Also unlike options, in the case of futures there is no need to distinguish gross
payoffs from net profits. This is because the futures contract is not purchased; it is simply a
contract that is agreed to by two parties. The futures price adjusts to make the present value of
either side of the contract equal to zero.
The distinction between futures and options is highlighted by comparing panel A of Figure
16.3 to the payoff and profit diagrams for an investor in a call option with exercise price, X,
chosen equal to the futures price F0 (see panel C). The futures investor is exposed to consid-
erable losses if the asset price falls. In contrast, the investor in the call cannot lose more than
the cost of the option.
Figure 16.3, panel B, is a plot of the profits realized by an investor who enters the short side
of a futures contract. It is the mirror image of the profit diagram for the long position.


>
1. a. Compare the profit diagram in Figure 16.3B to the payoff diagram for a long
Concept
position in a put option. Assume the exercise price of the option equals the ini-
CHECK tial futures price.
b. Compare the profit diagram in Figure 16.3B to the payoff diagram for an in-
vestor who writes a call option.


Existing Contracts
Futures and forward contracts are traded on a wide variety of goods in four broad categories:
agricultural commodities, metals and minerals (including energy commodities), foreign
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




571
16 Futures Markets




Profit Profit



Payoff


Profit

X PT
PT PT
F0 F0


C. Buy a call option
B. Short futures profit = F0 “ PT
A. Long futures profit = PT “ F0




F I G U R E 16.3
Profits to buyers and sellers of futures and options contracts
A: Long futures position (buyer)
B: Short futures position (seller)
C: Buy call option



currencies, and financial futures (fixed-income securities and stock market indexes). The fi-
nancial futures contracts are a relatively recent innovation, for which trading was introduced
in 1975. Innovation in financial futures has been rapid and is ongoing. Table 16.1 lists various
contracts trading in the United States in 2002.
Contracts now trade on items that would not have been considered possible only a few
years ago. For example, there are now electricity as well as weather futures and options con-
tracts. Weather derivatives (which trade on the Chicago Mercantile Exchange), have payoffs
that depend on the number of degree-days by which the temperature in a region exceeds or
falls short of 65 degrees Fahrenheit. The potential use of these derivatives in managing the risk
surrounding electricity or oil and natural gas use should be evident.
Outside the futures markets, a well-developed network of banks and brokers has established
a forward market in foreign exchange. This forward market is not a formal exchange in the sense
that the exchange specifies the terms of the traded contract. Instead, participants in a forward
contract may negotiate for delivery of any quantity of goods at any time, whereas, in the formal
futures markets, contract size and delivery dates are set by the exchange. In forward arrange-
ments, banks and brokers simply negotiate contracts for clients (or themselves) as needed.


16.2 MECHANICS OF TRADING IN FUTURES MARKETS
The Clearinghouse and Open Interest
Trading in futures contracts is more complex than making ordinary stock transactions. If you
want to make a stock purchase, your broker simply acts as an intermediary to enable you to
buy shares from or sell shares to another individual through the stock exchange. In futures
trading, however, the clearinghouse plays a more active role.
When an investor contacts a broker to establish a futures position, the brokerage firm wires
the order to the firm™s trader on the floor of the futures exchange. In contrast to stock trading,
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




572 Part FIVE Derivative Markets



TA B L E 16.1
Sample of futures contracts

Foreign Currencies Agricultural Metals and Energy Interest Rate Futures Equity Indexes

British pound Corn Copper Eurodollars Dow Jones Industrials
Aluminum
Canadian dollar Oats Euroyen S&P Midcap 400
Japanese yen Soybeans Gold Euro-denominated Nasdaq 100
Euro Soybean meal Platinum bond NYSE index
Soybean oil Palladium
Swiss franc Euroswiss Russell 2000 index
Australian dollar Wheat Silver Sterling Nikkei 225 (Japanese)
Gilt†
Mexican peso Barley Crude oil FTSE index (British)
Brazilian real Flaxseed Heating oil CAC index (French)
German government
Canola Gas oil DAX index (German)
bond
Rye Natural gas All ordinary (Australian)
Italian government
Cattle Gasoline Toronto 35 (Canadian)
bond
Milk Propane Dow Jones Euro STOXX 50
Canadian
CRB index*
Hogs government bond
Pork bellies Electricity Treasury bonds
Cocoa Weather Treasury notes
Coffee Treasury bills
Cotton LIBOR
Orange juice EURIBOR
Sugar Municipal bond index
Lumber Federal funds rate
Rice Bankers™ acceptance
S&P 500 index

*
The Commodity Research Bureau™s index of futures prices of agricultural as well as metal and energy prices.

Gilts are British government bonds.




which involves specialists or market makers in each security, most futures trades in the United
States occur among floor traders in the “trading pit” for each contract. Traders use voice or
hand signals to signify their desire to buy or sell. Once a trader willing to accept the opposite
side of a trade is located, the trade is recorded and the investor is notified.
At this point, just as is true for options contracts, the clearinghouse enters the picture.
clearinghouse
Rather than having the long and short traders hold contracts with each other, the clearinghouse
Established by
becomes the seller of the contract for the long position and the buyer of the contract for the
exchanges to
short position. The clearinghouse is obligated to deliver the commodity to the long position
facilitate trading. The
clearinghouse may and to pay for delivery from the short; consequently, the clearinghouse™s position nets to zero.
interpose itself as an This arrangement makes the clearinghouse the trading partner of each trader, both long and
intermediary between

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