Introduction to Futures¶

BUSI 722: Data-Driven Finance II¶

Kerry Back, Rice University¶

  • A forward contract is a contract to deliver something and to be paid at a later date.
  • A futures contract is like a forward contract, but it is traded on an exchange. Main exchanges are the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).
  • Like options, a clearinghouse steps between buyers and sellers and becomes the counterparty to both sides.
  • Unlike options, the buyer does not pay the seller when a futures contract is traded.
  • Both have to post collateral (margin) to ensure they can uphold their future obligations. Generally less than 10% of the contract value.

Types of futures¶

  • Agricultural (corn, wheat, ...)
  • Energy (crude, natural gas, ...)
  • Metals (gold, silver, ...)
  • Currencies (euro, yen, ...)
  • Financials (S&P 500, Treasury bonds, ...)

Examples of contracts¶

  • CME gold: 100 troy ounces
  • CME natural gas: 10,000 MMBtu delivered to Henry Hub, LA
  • CME gasoline: 42,000 gallons delivered to NY harbor
  • CME heating oil (ULSD) : 42,000 gallons delivered to NY harbor
  • CME WTI Crude: 1,000 barrels delivered to Cushing, OK

Exiting through trade¶

  • Like options, positions are usually cancelled by making offsetting trades.
  • Example: buy a contract at 70. Later sell when price is at 80.
    • Deliver/receive obligations cancel.
    • Buy at 70 and sell at 80 produces a cash gain of 10.

Daily Settlement (marking to market)¶

  • Gains and losses are realized daily.
  • Why? To protect the clearinghouse.
  • Any default will be for no more than the loss on a single day, because cash was transferred to cover prior losses.

Example¶

  • Suppose you bought 1 CME WTI contract for Dec, 2022 delivery on Jan 2, 2020.
  • You bought it at 51.80.
  • The contract closed (settled) that day at 51.97.
  • You made 1,000 barrels $\times$ 0.17/barrel = 170 on Jan 2. You receive that money at the end of the day.
  • You are now obligated to pay 51.97 upon delivery in December.
  • Deducting the 0.17 cash you already received, the net price is still 51.80.

The settlement prices for subsequent days were

Jan 3 51.72
Jan 6 51.81
Jan 7 52.13
Jan 8 51.31

Suppose you sold 1 contract on Jan 9 at 51.50.

Here are the daily cash flows per barrel

Day Price Gain/Loss
Jan 2 51.80
Jan 2 51.97 + 0.17
Jan 3 51.72 - 0.25
Jan 6 51.81 + 0.09
Jan 7 52.13 + 0.32
Jan 8 51.31 - 0.82
Jan 9 51.50 +0.19
TOTAL - 0.30

Cash settled contracts¶

  • Some contracts (mostly financials) do not have delivery provisions. Instead, the gain/loss on the last day is calculated from the market price of the underlying.
  • Example: S&P 500 contract is cash settled based on the prices of the 500 stocks (i.e., the S&P 500 index).

Convergence to spot¶

  • Spot price means price for "immediate" delivery.
  • Spot and futures are usually different.
    • Example: The price for a bushel of corn in six months is usually not quite the same as the price of a bushel of corn today.
  • However, as the maturity date of the futures approaches, the futures price and spot price must converge.
    • Because trading a futures near its maturity is the same as trading spot.

Hedging with futures¶

  • Example: grain processor will need to buy corn in December.
  • Buys corn in January on futures market at 5.00 per bushel.
  • If the spot price of corn is 4.00 per bushel in December,
    • Processor will probably sell the futures contract, taking a 1.00 loss
    • Buy corn spot at 4.00
    • Net cost is 5.00
  • If the spot price of corn is 6.00 per bushel in December, then ...

Does marking to market matter for hedgers?¶

  • It can matter. Consider a wheat farmer who sells futures at 6.00 per bushel.
  • Suppose the futures rises to 8.00 before harvest time. What are the cash flows?

What if quantities are uncertain?¶

  • In the previous example, suppose wheat futures rose because of a drought.
  • Suppose the farmer hedged by selling futures but then ends up with a smaller crop than anticipated.
  • What are the consequences?

Hedging with futures vs options¶

  • What option could a grain processor buy to cap the price of corn?
  • Calculate the net cost, including the option premium. under various scenarios for the price of corn.
  • How does marking to market and quantity uncertainty affect the choice between futures and options?

Options on futures¶

  • You can buy an option on corn over the counter (directly from a grain trader) but not on an exchange. However, you can buy an option on corn futures on the CME. Same for energy, metals, ...
  • Exercising a call option on a futures rolls you into a long futures contract. Exercising a put rolls you into a short futures contract.
  • Example. You are long a call option on crude with a strike of 70. The crude futures is at 80.
    • You do not pay the strike to exercise.
    • Exercising gives you a long futures contract as if you bought the contract at 70.
    • It is immediately marked to market. So you get 10 cash from the marking to market. And, you have a contract to pay 80 for crude.
    • You could sell a futures contract in the market at 80. This will cancel the delivery/receipt obligations.

Hedging with futures or futures options¶

  • A farmer wants to insure against the price of wheat falling.
  • The futures price is 6.00 per bushel.
  • A put on the futures with a strike of 6.00 has a premium of 1.00. The call expires at the same time as the futures.
  • Compare the outcomes for (a) futures, (b) put on futures, and (c) no hedge if the spot price of wheat at the option/futures maturity is 4.00, 5.00, 6.00, 7.00, or 8.00 per bushel.