In and Out of Futures

Mike Knapp

Background

• Dōjima Rice Exchange in Japan, 1730s• First futures exchange market

• Samurai paid in rice• Bad rice harvests affected rice conversion to coin• Samurai wanted stable conversion to coin

Background

• U.S. futures market in the 19th century• Farmers & Agriculture wholesalers • Hedge against seasonal price differences

• Lock in prices for crops prior to harvest/planting• Now futures have developed for financial futures• I.e. Stock indexes

Futures Contract

• One buyer & one seller• 3 Key Elements• Futures price• Settlement/delivery date• Underlying

• Need an exchange/clearinghouse to be a futures

Long Position

• Buyer of futures contract Profit

Loss

Futures Price

When does long position make profit? And loss?

Short Position

• Seller of futures contract Profit

Loss

Futures Price

When does short position make profit? And loss?

Clearinghouse

• Two functions• Guarantee Function• Takes opposite position of both long and short • Removes default risk for buyer/seller

• Place for unwinding position

Futures Buyer Futures Seller

Futures Buyer Clearinghouse Seller&

Clearinghouse Buyer Futures Seller

Without Clearinghouse

With Clearinghouse

Mark to Market

• Realize gains and losses daily• Initial Margin• Deposit for contract• How clearinghouse has guarantee function

• Settlement Price• Mark to market investor’s position

• Maintenance Margin• Minimum level that equity position may fall

• Margin Call• Request to bring equity position up to initial margin

Futures Contract

• Two liquidating options• Take offsetting position in same contract• Long becomes short• Sell same number of futures contracts

• Wait until settlement date• Long accepts delivery• Short delivers at the agreed-upon price• This is undesirable in most futures contracts

2 player Hedge Example

• Buyer = Long position• Seller = short position

Long Short

Day 1: Market Price = $10 per pound

Contract: Long sells 100 pounds of watermelons to short at $10 per pound in 30 days

2 player Hedge Example

Long Short

Clearinghouse:

Initial Margin: 10% of contract = $1,000 x 0.1 = $100

Maintenance Margin: $50

Initial Margin: $100

Maintenance Margin: $50

Initial Margin: $100

Maintenance Margin: $50

2 player Hedge Example

Long ShortClearinghouse:

Initial Margin: $100

Maintenance Margin: $50

Day 2: Settlement Price = $10.25 per pound

$0.25 x 100 pounds = + $25 $0.25 x 100 pounds = - $25

2 player Hedge Example

Long ShortClearinghouse:

Initial Margin: $100

Maintenance Margin: $50

Day 3: Settlement Price = $10.75 per pound

$0.75 x 100 pounds = + $75 $0.75 x 100 pounds = - $75

Short’s equity position is at $25, must bring equity back to $100

2 player Hedge Example

Long ShortDay 29: Settlement Price = $11.00 per pound

$1.00 x 100 pounds = + $100 $1.00 x 100 pounds = - $100

But….Long and Short decide to take offsetting positions in the contract

Long Short

Contract 2: Long sells 100 pounds of watermelons to short at $11 per pound in 1 day

2 player Hedge Example

Contract 1-Long = $10 x 100 pounds = - $1,000

Day 30: Settlement Price = $11.00 per pound

Contract 2-Short = $11 x 100 pounds = + $1,100

Contract 1-Short = $10 x 100 pounds = + $1,000

Contract 2-Long = $11 x 100 pounds = - $1,100

+$100

-$100

2 player Hedge Example

Futures Contracts total = + $100

But supposed to be zero-sum game when hedging……

Market purchase price of 100 pounds @ $11 per pound

= - $100

Total = Futures + Market = $ 0

Futures Contracts total = - $100Market selling price of 100 pounds @ $11 per pound

= + $100

Total = Futures + Market = $ 0

Questions

References• How a forward/futures contracts work: http://www.youtube.com/watch?v=2hp9w-gXRjM

• What is a clearinghouse: http://www.youtube.com/watch?v=nwR5b6E0Xo4

• http://en.wikipedia.org/wiki/Clearing_house_(finance)• http://www.cmegroup.com/education/files/a-traders-guide-to-futures.pdf

• http://books.google.com/books?id=6N7vc7skff4C&pg=PT177&lpg=PT177&dq=D%C5%8Djima+Rice+Exchange&source=bl&ots=v_bsmO6P7K&sig=ihVbjfoTZG5MCIrwils4zmQlSzk&hl=en&sa=X&ei=e4OaUfbTM46UjAK0w4HYDA&ved=0CEIQ6AEwBTgK

• http://www.investopedia.com/university/futures/futures2.asp• http://www.investopedia.com/university/futures/futures7.asp