Future contracts

characteristics
submitted by :
vishal alluri
manik reddy
karthik agarwal
k jeevan
Topics covered…………

future contracts

features of futures contracts

What is a derivative?

Options

The value of the

derivative instrument
Futures is DERIVED from the
Forwards
underlying security

Swaps

Underlying instrument such as a commodity, a stock, a stock index, an

exchange rate, a bond, another derivative etc..
Introduction
In the financial marketplace some instruments are
regarded as fundamentals, while others are regarded as
derivatives.

Financial Marketplace

Derivatives Fundamentals

Simply another way to catagorize the diversity in the FM*.

*Financial
Introduction (II)

Financial Marketplace

Derivatives Fundamentals

• Futures • Stocks
• Forwards • Bonds
• Options • Etc.
• Swaps
 Introduction to futures ……..
A futures contract is just what it's called – a contract.
It is not equity in a stock or commodity.
It is a contract – a contract to make or take delivery of a product in the future, at a price
set in the present.

A standardized, transferable, exchange-traded contract that requires delivery

of a commodity , bond , currency, or stock index, at a specified price , on a
specified future date

The futures contract is a “paper” asset that is only converted to a commodity if the
“paper” is held to maturity and “delivery” takes place.

This “paper” is traded (auctioned) only at government regulated exchanges .

What can be traded in future contracts :-

•Agricultural commodities (e.g. grains, livestock,

meat, food and fiber)
•Metals and minerals (e.g. gold, platinum, crude oil,
and electricity)
•Foreign currencies
•Financial futures
Interest rate futures
Stock index futures
Spot, Forward, and Futures
Contracts
• A spot contract is an agreement (at time 0) when the seller
agrees to deliver an asset and the buyer agrees to pay for the
asset immediately (now)
• A forward contract is an agreement (at time 0) between a buyer
and a seller that an asset will be exchanged for cash at some later
date at a price agreed upon now
• A futures contract is similar to a forward contract and is normally
arranged through an organized exchange (i.e., ME, CBT)
The main difference between a futures and a forward contract
is that the price of a forward contract is fixed over the life of the
contract, whereas futures contracts are marked-to-market daily.

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Advantages of futures contracts
If price moves are favourable, the producer realizes the
greatest return with this marketing alternative.

No premium charge is associated with futures market

contracts.

Disadvantages of future contracts

Subject to margin calls

Unable to take advantage of favourable price moves

Net price is subject to Basis change

 Who uses futures markets ………
Participants in the futures markets are commercial or institutional users of the
commodities they trade.
These users, most of whom are called "hedgers," want the value of their assets to
increase and want to limit, if possible, any loss in value.
Hedgers may use the commodity markets to take a position that will reduce the risk
of financial loss in their assets due to a change in price.
Other participants are "speculators" who hope to profit from changes in the price of
the futures or option contract.
Purposes of futures markets………..

Meets the needs of three groups of futures market

users:
2. Those who wish to discover information about future
prices of commodities (suppliers)
3. Those who wish to speculate (speculators)
4. Those who wish to transfer risk to some other party
(hedgers)
 Reading Futures Prices
(Prices)
1. Opening
2. High
3. Low
4. Settlement
 Price at which the contracts are settled at
the close of trading for the day
 Typically the last trading price for the day

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Future Contracts (I)
Futures The owner of a future contract has the OBLIGATION to
sell or buy something in the future at a predetermined
price.
Scenario:

You are a farmer and you know that you will harvest corn in three months
from today on. How can you protect yourself from loosing if corn price
happens to drop until March by using corn forward contracts?

t
1/1 3/1
Harvest
Future Contracts
You lock into a price by holding a short position in a corn future contract
with a maturity date a little bit longer than the harvest date.

Suppose the price drops...

You close out the corn

You either take delivery and contract and the gain in the
lock in a price. futures market will offset
the loss in the sport market

“A futures contract makes unfavourable price movements less unfavourable and

a favourable price movements less favourable“!
 Trading Strategies
Speculation
Short - believe price will fall
Long - believe price will rise

Hedging
For someone who needs to buy or sell the underlying asset in the
future

Long hedge - protecting against a rise in price go long in the futures

contract and you effectively lock in the future purchase price today
Short hedge - protecting against a fall in price go short in thefutures
contract and you effectively lock in the
future sale price today
 Key terms …
 Initial margin
 Maintenance margin
 Margin call
 Going long
 Going short
 Spreads

Notes :-
Initial margin of $1,000
Maintenance margin level is $500
Losses dropped the value of your account to $400
Broker makes a margin call to you, requesting a deposit of additional $600
Bringing the account back up to the initial margin level of $1,000.

When a margin call is made, the funds usually have to be

delivered immediately. If they are not, the brokerage can have
the right to liquidate your position completely in order to make up
for any losses it may have incurred on your behalf.
Going long -
When an investor goes long - that is, enters a contract by
agreeing to buy and receive delivery of the underlying at a set
price - it means that he or she is trying to profit from an
anticipated future price increase.
Example :

Speculator buys one September contract of gold at 1400/gm

Total worth = 1400*1,000 gms or 14 lakhs
By buying in June is going long, with the expectation that the
price of gold will rise by the time the contract expires in
September.

By August, the price of gold increases by 200 rs to 1600/gm

Contract becomes worth 1600*1000=16 lakhs
Profit would be 2 lakhs

Given the very high leverage (remember the initial margin was

$2,000),
100% profit!
Going Short
A speculator who goes short - that is, enters into a futures
contract by agreeing to sell and deliver the underlying at a set
price - is looking to make a profit from declining price levels.

Initial margin deposit of 3000$

Mr. X sold one May crude oil contract ( 25 $/barrel *1000)
Total value of $25,000.

By March, the price $20/barrel

Mr. X bought back the contract which was valued at $20,000.
By going short, Mr. x made a profit of $5,000
Risks with
futures
qThe futures market was founded on the principle of risk
transfer.
qAny transaction can result in a loss that exceeds the
amount of the initial margin, and could potentially be an
almost unlimited amount
qThere may be no party willing to sell or buy the
offsetting contract you need to prevent further losses.
 Features of futures …
 Trading is conducted through an association /exchange

 It is entered into a standard variety known as basis variety .

 The delivery periods are specified .

 Seller has the choice to decide whether to deliver goods against

outstanding sale contracts
 Standardised contracts in terms of Quantity ,Quality ,Date of Delivery

 Exchange gaurantees the settlement hence no default risk .

 Contracts can be closed anytime before the expiry of contract hence no

liquidity risk
 Every transaction through memebers/broking .

 Price of the contract is available to public domain through media .

 WHAT IS BASIS ?????
Basis is the current cash price of a particular
commodity minus the price of a futures contract for
the same commodity.

BASIS = CURRENT CASH PRICE – FUTURES

PRICE
The Basis (continued)……
Price
s
Cash

Basis Future
s

Time
Presen Maturit
t y
 The Basis (continued)

Example: Gold Prices and the Basis: $441.00 12/16/03

MONTH PRICE BASIS

DEC 441.50 -.50

MAR ‘04 449.20 - $7.70
JUN 459.40 -$17.90
SEP 469.90 -$28.40
DEC 480.70 -$39.20
MAR ‘05 491.80 -$50.30
Word s of wisdoms future
contracts
• If you are going to sell something in the near future but want to lock
in a secured price, you take a short position.
• If you are going to receive/buy something in the future but want to
lock in a secured price, you take a long position.