1 chapter 21 principles of the futures market. 2 as near as i can learn, and from the best...
TRANSCRIPT
![Page 1: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/1.jpg)
1
Chapter 21
Principles of the Futures Market
![Page 2: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/2.jpg)
2
As near as I can learn, and from the best information I have been able to obtain on the Chicago Board of Trade, at least
95% of the sales of that Board are of this fictitious character, where no property is actually owned, no
property sold or delivered, r expected to be delivered but simply wagers or bets as to what that property may be
worth at a designated time in the future….wheat and cotton have become as much gambling tools as chips on the
farobank table.
- Senator William D. Washburn
![Page 3: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/3.jpg)
3
Outline Introduction Futures contracts Market mechanics The clearing process Principles of futures contract pricing Foreign currency futures
![Page 4: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/4.jpg)
4
Introduction Futures contracts can lessen price risk for:
• Businesses
• Financial institutions
• Farmers
![Page 5: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/5.jpg)
5
Introduction (cont’d) The two major groups of futures market
participants are:• Hedgers
• Speculators
![Page 6: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/6.jpg)
6
Futures Contracts What futures contracts are Why we have futures contracts How to fulfill the futures contract promise
![Page 7: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/7.jpg)
7
What Futures Contracts Are Futures contracts are promises:
• The futures seller promises to deliver a quantity of a standardized commodity to a designated delivery point during the delivery month
• The futures buyer promises to pay a predetermined price for the goods upon delivery
![Page 8: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/8.jpg)
8
What Futures Contracts Are (cont’d)
With futures contracts, a trade must occur if someone holds the contract until its delivery date
Most futures contracts are eliminated before the delivery month• The contract obligation can be satisfied by
making an offsetting trade• Only 2% of futures contracts actually result in
delivery
![Page 9: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/9.jpg)
9
Why We Have Futures Contracts
If suppliers and future buyers of a commodity could not agree on the future price of the commodity today:• There would be added price risk and
• The price to the consumer would be significantly higher
![Page 10: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/10.jpg)
10
Why We Have Futures Contracts (cont’d)
The basic function of the commodity futures market is to transfer risk from the hedger to the speculator• The speculator assumes the risk because of the
opportunity for profit
![Page 11: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/11.jpg)
11
How to Fulfill the Futures Contract Promise
The futures market would not work if people could back out of the trade without fulfilling their promise• Trades actually become sales to or by the
clearing corporation of the exchange
![Page 12: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/12.jpg)
12
How to Fulfill the Futures Contract Promise (cont’d)
Each exchange has a clearing corporation: • Ensures the integrity of the futures contract• Assumes the responsibility for those position
when a member is in financial distress• Requires good faith deposits to help ensure the
member’s financial capacity to meet the obligations
![Page 13: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/13.jpg)
13
Market Mechanics The marketplace Creation of a contract Market participants
![Page 14: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/14.jpg)
14
The Marketplace Commodity trades are made by open outcry
of the floor traders• Traders shout their offers to buy or sell
• Traders use hand signals to indicate their willingness to buy or sell and desired quantities
• Traders are located in the pit
![Page 15: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/15.jpg)
15
The Marketplace (cont’d) The pit:
• Is either octagonal or polygonal
• Contains a raised structure called the pulpit:– Representatives of the exchange’s market report
department enter all price changes
• Is surrounded by electronic wallboards reflecting price information
![Page 16: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/16.jpg)
16
The Marketplace (cont’d) Pit lingo:
• “See through the pit” is a day with little trading activity
• An “Acapulco trade” is an unusually large trade• Traders who lose all their trading capital have
“busted out” (gone to “Tapioca City”)• A “fire drill” is a sudden rush of trading activity
without apparent reason• A big price move is a “lights-out” move
![Page 17: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/17.jpg)
17
The Marketplace (cont’d) The Chicago Board of Trade (CBOT) is the
world’s largest futures exchange:• Has more than 3,600 members• Has 1,402 full members
– Have the right to trade in any of the commodities at the exchange
• Has associate members– Allowed to trade financial instrument futures and
certain other designated markets
![Page 18: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/18.jpg)
18
Creation of A Contract Buyers and sellers fill out cards to record
their trades• One side of the card is blue (buy trades)
• One side of the card is read (sell trades)
• Each commodity has a symbol– E.g., “US” means Treasury bonds
![Page 19: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/19.jpg)
19
Creation of A Contract (cont’d) Buyers and sellers fill out cards to record
their trades (cont’d)• Each delivery month has a letter code
– E.g., “U” means September
• Letters identify time blocks at which the trade occurred
– E.g., “A” is the first thirty minutes of trading
![Page 20: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/20.jpg)
20
Creation of A Contract (cont’d) Example of a trading card (see next slide):
• Dan Hennebry buys:– 5 September Treasury bond futures contracts
– From trader ZZZ working for firm OOO
– At a price of 77 31/32 of par
– In the first thirty minutes of trading
![Page 21: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/21.jpg)
21
Creation of A Contract (cont’d)
![Page 22: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/22.jpg)
22
Market Participants Hedgers Speculators Scalpers
![Page 23: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/23.jpg)
23
Hedgers A hedger is someone engaged in some type
of business activity with an unacceptable level of price risk• E.g., a farmer’s welfare depends on the price of
the crop at harvest– The farmer wants to transfer the price risk to a
speculator using the futures market
– The farmer cannot eliminate the risk of a poor crop through futures
![Page 24: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/24.jpg)
24
Hedgers (cont’d) Hedgers normally go short in agricultural
futures• A short hedge
– E.g., the farmer promises to deliver
Hedgers sometimes go long• A long hedge
– E.g., a manufacturer of college class rings wants to lock in the price of gold
![Page 25: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/25.jpg)
25
Speculators Speculators:
• Have no economic activity requiring the use of futures contracts
• Find attractive investment opportunities in the futures market
• Hope to make a profit rather than protecting one
![Page 26: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/26.jpg)
26
Speculators (cont’d) Speculators normally go long
• Speculating on price increases
It is possible for speculators to go short• Speculating on price declines
![Page 27: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/27.jpg)
27
Speculators (cont’d) Speculators are either day traders or
position traders:• Day traders close out all their positions before
trading closes for the day
• Position traders:– Routinely maintain futures positions overnight
– Sometimes keep a contract open for weeks
![Page 28: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/28.jpg)
28
Scalpers Scalpers:
• Are really speculators
• Trade for their own account
• Make a living by buying and selling contracts in the pit
![Page 29: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/29.jpg)
29
Scalpers (cont’d) Scalpers (cont’d):
• May buy and sell the same contract many times during a single trading day
• Contribute to the liquidity of the futures market
• Are also called locals
![Page 30: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/30.jpg)
30
The Clearing Process Introduction Matching trades Accounting supervision Intramarket settlement Settlement prices Delivery
![Page 31: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/31.jpg)
31
Introduction The clearing process performs the following
functions:• Matching trades• Supervising the accounting for performance
bonds• Handling intramarket settlements• Establishing settlement prices• Providing for delivery
![Page 32: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/32.jpg)
32
Matching Trades All traders are responsible for ensuring that their
card decks are entered into the clearing process
The clearing corporation:• Receives the members’ trading cards
• Edits and checks the information on the cards by computer
• Returns cards with missing information to the clearing member for correction
![Page 33: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/33.jpg)
33
Matching Trades (cont’d) Unmatched trades are called outtrades:
• Result in an Unmatched Trade Notice being sent to each of the clearing corporation members
• Regardless of the reason for the Notice, it is the trader’s individual responsibility to resolve the error
• Outtrade clerks (employed by the exchange) assist in the process of reconciling trades
![Page 34: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/34.jpg)
34
Matching Trades (cont’d) Examples of outtrades:
• A “price out” means two traders wrote down different prices for a given trade
• A “house out” means the trading card lists an incorrect member firm
• A “quantity out” occurs when the number of contracts is in dispute
![Page 35: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/35.jpg)
35
Matching Trades (cont’d) Examples of outtrades (cont’d):
• A “strike out” occurs when the striking price is in dispute
• A “time out” occurs when the delivery month is in dispute
• A “side out” occurs when both parties marked either buy or sell
![Page 36: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/36.jpg)
36
Accounting Supervision Performance bonds deposited by member
firms remain with the clearing corporation until the member either:• Closes out her position by making an offsetting
trade or
• Closes out her position by delivery of the commodity
![Page 37: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/37.jpg)
37
Accounting Supervision (cont’d)
When successful delivery occurs:• Good faith deposits are returned to both parties
• Payment for the commodity is received from the buyer and remitted to the seller
• The warehouse receipt for the goods is delivered to the buyer
![Page 38: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/38.jpg)
38
Accounting Supervision (cont’d)
Futures contracts are marked to market every day• Can create accounting problems
![Page 39: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/39.jpg)
39
Accounting Supervision (cont’d)
Open interest is a measure of how many futures contracts in a given commodity exist at a particular time• Increases by one every time two opening
transactions are matched
• Published by the clearinghouse in the financial pages on a daily basis
![Page 40: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/40.jpg)
40
Intramarket Settlement Commodity prices may move so much in a
single day that good faith deposits for members are eroded before the day ends• May result in a market variation call:
– A call on members to deposit more funds into their accounts during the day
![Page 41: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/41.jpg)
41
Settlement Prices Settlement prices:
• Are analogous to the closing price on the stock exchanges
• Are normally an average of the high and low prices during the last minute or so of trading
• Are established by the clearing corporation
![Page 42: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/42.jpg)
42
Settlement Prices (cont’d) Many commodity futures prices are
constrained by a daily price limit:• The price of a contract is not allowed to move
by more than a predetermined about each trading day
• Commodities may be up the limit or down the limit when big price moves occur
– Trading will stop for the day once a limit move has occurred
![Page 43: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/43.jpg)
43
Delivery A seller who wishes to deliver fills out a
Notice of Intention to Deliver with the clearing corporation• Indicates the intention of delivering the
commodity on the next business day
Delivery can occur any time during the delivery month
![Page 44: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/44.jpg)
44
Delivery (cont’d) First notice day is the first business day prior to
the first day of the delivery month
Position day is the day prior to first notice day• Long position members must submit a Long Position
Report
On intention day, the clearing corporation may assign delivery to the member with the oldest long position in the particular commodity
![Page 45: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/45.jpg)
45
Delivery (cont’d) Speculators tend to move out of the market
a few days prior to first notice day
![Page 46: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/46.jpg)
46
Principles of Futures Contract Pricing
Expectations hypothesis Normal backwardation Full carrying charge market Reconciling the three theories
![Page 47: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/47.jpg)
47
Expectations Hypothesis The expectations hypothesis states that the
futures price for a commodity is what the marketplace expects the cash price to be when the delivery month arrives
One of the major functions of the futures market is price discovery:• The market’s consensus about likely future
prices for a commodity
![Page 48: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/48.jpg)
48
Normal Backwardation Normal backwardation:
• Is attributed to John Maynard Keynes
• Argues that the futures price is a downward-biased estimate of the future cash price
– The hedger essentially buys insurance
– The speculator must be rewarded for taking the risk the hedger was unwilling to bear
![Page 49: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/49.jpg)
49
Full Carrying Charge Market A full carrying charge market is one where
the prices for successive delivery months reflect the cost of holding the commodity• The futures price (FP) is equal to the current
cash price (CP) plus the carrying charges (c) until the delivery month:
FP = CP + c
![Page 50: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/50.jpg)
50
Full Carrying Charge Market (cont’d)
Basis is the difference between the futures price and the current cash price:• In a contango market, the futures price is
greater than the cash price
• In an inverted market, the cash price is greater than the futures price
![Page 51: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/51.jpg)
51
Full Carrying Charge Market (cont’d)
Basis is the difference between the futures price and the current cash price (cont’d):• If the gap between the futures price and the
cash price narrows, the basis strengthens
• If the gap between the futures price and the cash price widens, the basis weakens
![Page 52: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/52.jpg)
52
Full Carrying Charge Market (cont’d)
The basis is often very close to the carrying costs between the two points in time• Arbitrage would be possible if this were not the
case– Exists if someone can buy a commodity, store it at a
known rate, and get someone to promise to buy it later at a price that exceeds the cost of storage
![Page 53: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/53.jpg)
53
Reconciling the Three Theories The three theories are compatible:
• The expectations hypothesis says that a futures price is the expected cash price at the delivery date
• A full carrying charge market adds costs of carry to the cash price to determine the futures price
• Normal backwardation says that hedgers are willing to take a bid less than the actual expected future cash price
![Page 54: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/54.jpg)
54
Foreign Currency Futures Hedging and speculating with foreign
currency futures Pricing of foreign exchange futures
contracts
![Page 55: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/55.jpg)
55
Hedging and Speculating With Foreign Currency Futures
Goods and services traded between countries must be valued in a currency
Relative exchange rates fluctuate daily due to changes in:• The world political situation• International interest rates• Inflationary fears
![Page 56: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/56.jpg)
56
Hedging and Speculating With Foreign Currency Futures
U.S. importers purchasing goods denominated in a foreign currency engage in two transactions:• Buying the foreign currency
• Paying for the imported goods
![Page 57: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/57.jpg)
57
Hedging and Speculating With Foreign Currency Futures
Foreign currency futures can eliminate the price risk• Go long in foreign currency futures to lock in
the future price for the foreign currency:– If the currency appreciates, the gain in the futures
market offsets the higher cost of the currency
– If the currency depreciates, the lower cost in the cash market is offset by a loss in the futures market
![Page 58: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/58.jpg)
58
Pricing of Foreign Exchange Futures Contracts
The cost of holding a currency is an opportunity cost measured by differences in the interest rates prevailing in the two countries• Interest rate parity states that securities with
similar characteristics should differ in price by an amount equal to (but opposite in sign from) the difference between national interest rates in the two countries
![Page 59: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/59.jpg)
59
Pricing of Foreign Exchange Futures Contracts (cont’d)
A basic model for pricing foreign currency futures contracts:
days to delivery spot rate 1 ( )
365
where futures price
Eurodollar rate
local currency rate
f ed lc
f
ed
lc
P I I
P
I
I
![Page 60: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/60.jpg)
60
Pricing of Foreign Exchange Futures Contracts (cont’d)
Example
Interest rates are 6 percent in Europe, and the prevailing eurodollar deposit rate is 7.5 percent. The current dollar price for a euro is $0.90.
For how much should a 90-day futures contract on euros sell?
![Page 61: 1 Chapter 21 Principles of the Futures Market. 2 As near as I can learn, and from the best information I have been able to obtain on the Chicago Board](https://reader035.vdocuments.mx/reader035/viewer/2022062518/56649ea25503460f94ba6775/html5/thumbnails/61.jpg)
61
Pricing of Foreign Exchange Futures Contracts (cont’d)
Example (cont’d)
Solution: Using the pricing model for foreign currency futures:
days to delivery spot rate 1 ( )
365
90$0.90 1 (0.075 0.06)
365
$0.90 1.004
$0.903
f ed lcP I I