Sugar Futures Contract Commodity Trading Example Contract Specifications

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1 Finance 527: Lecture 33, Future V2 [John Nofsinger]: This is the second video for the futures topic. And here we re gonna go through a little example. So we ll use for example that sugar contract that we had shown in the previous video. Sugar goes for the quantity of 112,000 pounds of sugar is in one contract. The price is a hundredth of a cent per pound times 112,000 pounds means that each one hundredth of a cent move in the contract will cause a marked to market of 11 dollars and 20 cents. The initial margin is 700 dollars. Maintenance margin in 500. So let s say that an investor thinks that prices are gonna go down, and so they get on the short side of the contract, and they get 10 contracts. And they get in when the price is 5.29 cents per pound. So if they re going to-if this person is going to go for 10 contracts-each one being 112,000 pounds and this is the price in dollars per pound, then they are gaining or losing money in the price changes of the equivalent of almost 60,000 dollars worth of sugar. So sugar goes up 10% in price, they would be losing about 10% of 60,000 dollars. If the sugar price goes down about 10%, then they d be gaining about 10% of 60,000 dollars worth of sugar. So to give you the contract, they need to put up the initial margin so that s 700 dollars per contract. So 10 contracts as they ve put 7,000 in the margin account. And let s say by the end of the day, the price has gone the wrong way. It s gone up 3 cents or I should say.03 cents-2, 5,.32 cents per pound. So that is, right, 3 times 11 dollars and 20 cents up here. That is 3 times that is 33 dollars and 60 cents per contract. They have 10 contracts, so this person loses 336 dollars. It s taken out of their margin account to give to a person who is on the long side of the contract. And therefore, they have 6,664 dollars left in their margin account at the end of day one. Let s say on day two, they lose again. The price now goes up to 5.4 cents per pound. That s another.08 cents per pound that is going to be lost. So that is for 10 contracts 896 dollars. So now at the end of day two, they only have 5,768. Now note that 10 contracts time a 500 dollars is 5000 dollars is the maintenance margin. The investor gets below 5,000, they re gonna get a margin call. Sugar Futures Contract Commodity Trading Example Contract Specifications Size of the Contract 112,000 lbs Minimum Price Change Of one ounce 1/100 cents/lb Of one contract $11.20 Initial Margin Level $700 Maintenance Margin Level $500 Day 1 Investor shorts 10 sugar futures contract at 5.29 cents/lb. (Position value = 10 x 112,000 x $0.0529/lb = $59,248 Investor deposits initial margin $7,

2 Price rises to close at 5.32 cents/lb.; investor loss of 0.03 cents/lb. ($33.60 per contract) paid to clearinghouse -$ Account balance at end of Day 1 $6, Day 2 Opening Account Balance (from Day 1) $6, Price rises further to close at 5.40 cents/lb.; investor loss of 0.08 cents/lb. ($89.60 per contract) paid to clearinghouse $ Account balance on Day 2, after loss is paid to Clearinghouse $5, [John Nofsinger]: So let s go ahead and send them below 5,000 to see what happens. So day 3, the price goes up again, which is a.12 price per pound. They lose 134 dollars per contract. 10 contracts is a thousand dollars, 334. So now their margin account is down to 4,424 dollars. They get a margin call and say you need to bump this back up to the initial margin. Okay, so you don t have to go back up to the maintenance margin, you have to go all the way back up to the initial margin. You gotta get back up to 7,000. Now at this point, the investor could have got out of the contract, and just taken the losses. Okay, I m gonna take the loss. But they decide to stay in the contract, and provide an additional 2,576 dollars into the maintenance margin account so that the account now is back up to 7,000. Okay let s say that finally the price goes in the right direction and it falls.05 cents per pound. And so that s a gain of 56 dollars per contract or 560 dollars for 10 contracts. So now the maintenance margin account is up to 7,560. And let s say at the end of the day they go ahead and get out of this contract. They place an offsetting-offset the short position that they re in. So they get the long position to offset and so now they re out. And now they get to keep that 7,560 dollars. That s their money, right? But what happened here? They put in 7,000. Then they had to put in another 2,576. They got out 7,560. So they lost 2,000 dollars essentially-2,016 in this contract. If you divide it by the amount of money they totally put in to see what kind of return that was, and it s not good. Day 3 Opening Account Balance (from Day 2) $5, Price jumps to 5.52 cents/lb.; investor loss of 0.12cents/lb. ($ per contract) paid to clearinghouse $1, Intraday account balance on Day 3, after Loss is paid to clearinghouse $4, Margin call of $2,576 made to restore the Account to the initial margin level ($7,000) $2, Account balance at end of Day 3, after the margin call is met $7,000 Day 4 2

3 Opening Account Balance (from Day 3) $7, Price falls 0.05 cents/lb. to 5.47cents/lb.; investor gain of $56 per contract) $560 Account balance $7, Trader offsets the short futures position at 5.47cents/lb, and liquidates the account $7, Account balance at the end of Day 4 0 Profit/Loss Summary Profit/Loss = 10 (Contract selling price contract buying price) = 10 (112,000 lbs (5.29 cents/lb cents/lb.)) = -$2, (loss) Profit/Loss = Sum of deposits (-) and receipts (+) Day 1 Initial Margin Deposit -$7, Day 3 Margin Call Deposit -$2, Day 4 Account Liquidated Receipt +$7, Net Trading Loss -$2, [John Nofsinger]: Alright so that s how that example of how that works. The players in the market are both hedgers and speculators. I know speculators often have a bad reputation in finance. The way I would put it is the markets are there for the hedgers. There are people, they are farmers, they are people that use agricultural products like their Campbell soup. And they want to hedge their price risks, and so these future contracts are an excellent way to do that. So they re kind of an insurance policy. So let s say you re a farmer, and you grow wheat. And you kind of want to lock in the wheat price. Essentially what you could do is since you re going to be selling wheat, if prices go down, that would be bad for you. So you want to have a futures contract that does better when wheat goes down. Right, so they would want to be on the short side of the futures contract so that if wheat prices go down, when they actually sell their wheat, they re gonna get a lower price. That s bad. But some of that is offset by the mart-to-market profits they get from the short contract. If prices go up, they re gonna get to sell their wheat at a higher price. That s good, but some of that is going to be offset by the losses they re going to take in the short contract. So they re essentially kind of locking in the price. So we have hedgers. What we often say is hedgers make the market. That s why it s there. But hedgers don t enter into contracts very often. So you need more equity, and that s where the speculators come in. the speculators can be in and out. They re just simply seeking profit from price changes trying to guess which way it s going and make money. So we do need these speculators for the equity they provide in the market. Hedgers vs. Speculators Hedgers: seek to reduce risks 3

4 Purpose: lock in a favorable contract price Insurance policy for their business Taking a future position opposite to that of a cash market position Speculators: seek to profit from price changes Not using commodities in any manufacturing capacity Strictly for the purpose of acquiring profits [John Nofsinger]: So for those hedgers, there is some additional information we need to know. First of all, the future s price and the price of the actual commodity are not the same. The future s price tends to be different. Now it could be that the future s price is at this price level here, and the actual market price or spot price is up here when the contract is initially initialized. And that difference is something we call basis. K? And over time in the very end, they ll have to merge together. K because the future s price actually becomes a more marketable price on the day that you are actually delivering the underlying assets. But in between there, it can you know these prices they change over time. They can-that basis-can increase or it can decrease. So in hedging strategies, it s not just you have to worry about the price risk itself, but you also have to worry about this basis risk and the basis changing. Also, you often can t perfectly hedge whatever it is you want to hedge in the future s market. Let s just take something like you want to hedge your stock portfolio. This is a pedget plan and you have a large stock portfolio, and you want hedge. Hedge is a risk right now. But your portfolio is not exactly the same as the SOP500. And that s the tool you have as a future s contract is you can use the SOP500 index. It does not match your portfolio so there s a little bit of you have to make some adjustments. Let s say your portfolio is riskier than the SOP500 because it s gotten smaller firms, etcetera. And so it s more volatile. Well then you need to know a hedge ratio you can determine, which will help tell you how much of the index-the future s index- you need in order to hedge the risks you have because it s not a one-to-one match because yours is more volatile. There s also a from this you can hedge time so to speak. The intramarket spread is one where you are say in a long position in one contract and a short position in another contract, and its two different months even though it s the same market. Right? They re both of them are gold. But one is a contract that expires in July and the next one expires in December. So that s using you re staying within contract but you re just doing different months. That s different from an intermarket spread, where you re actually using two different kinds of assets. You can have a long position in one and a short position in another. One common one is called the TED spread, and that s the treasury bill verses the Euro dollar interest rate. And so you re just trying to profit or lose money on the differences between the T bill rate and the Euro dollar rate as they change over time, and you ll only make money or lose money as the difference between the two gets bigger or smaller on a TED spread. Hedging Concepts 4

5 Basis: difference between a commodity s cash price (spot price) and the futures price Hedging strategies with futures can eliminate price risk, but not basis risk. (cross hedging) Hedge ratio: underlying asset price volatility divided by the price volatility of the hedging instrument Intramarket spread: long position in one contract month against a short position in another contract month at the same market Intermarket spread: long position in one market and a short position in another market trading same or closely related commodity (TED) [John Nofsinger]: This is a picture of basis over time. The contract might get initiated right here, and you can see the futures price in this case is the opposite as the way I showed it in the last one. The futures price is higher than the cash price. There are contracts where this is case, and there are contracts where the other one that I mentioned last time is the case and it has to do with futures pricing and we will talk about that in just one minute. But you can see here let s say over time that this basis could be small or it could be very large at different times over time. But eventually, they ll converge when the futures contract expires. [Image of a graph of the difference between cash and Futures Prices] Figure 19.5 The Difference between Cash and Futures Prices is the Cash-Futures Basis [John Nofsinger]: So the cash price-this is just a little example with heating oil-but with the cash price going up and down and up, the futures price does as well. Okay? But notice that in this case, it s maintaining a constant five cent basis. Now that could change, right? This could actually be go up to 56 and this could be 63, right? Making the basis actually smaller as we go through in time. So that could be a possible way it turns out as well. Table 19.3 A Hypothetical Hedging Example for the Heating Oil Market Prices per gallon on June 1: Cash price (Spot Price) (Oct) Futures 65 cents 60 cents A. Cash and futures price rise (in tandem), such that: Prices (per gal.) Local Cash (Oct) Futures On Oct cents 70 cents B. Cash and futures prices fall (in tandem), such that: Prices (per gal.) Local Cash (Oct) Futures 5

6 On Oct 1 60 cents 55 cents C. Cash and futures prices remain the same, such that: Prices (per gal.) Local Cash (Oct) Futures On Oct 1 65 cents 60 cents [John Nofsinger]: We hear a lot about program trading in the markets. What that a lot of the program trading is index arbitrage, where they re looking at the SNP500 futures contract and they re looking at the actual price of the SNP500 index, and if it seems to be mispriced then the programs-these computers are always watching that-the computers will suddenly let s say if the futures contract is too price is too high they will suddenly start shortening a bunch of futures contracts as get on the sale side. And at the same time, they ll buy baskets of stock to represent the SNP500 to capture the mispricing-exploit the differences. And so computers are always looking for those kinds of things that they can quickly and easily buy itself big baskets of stock in order to get mispricing, some profit from that. Then of course, you can get more complicated. You can throw in stock options into that picture as well-exchange trade of funds on the SNP500 and lots of other kinds of places to look for mispricing. Program trading Index arbitrage: stock index futures to offset security risk through a host of complicated investment strategy Exploits divergences between actual and theoretical futures prices Program trading of index arbitrage: investment strategy of using a mix of index futures, leveraged stock portfolios, and stock options to profit from mispricing. [John Nofsinger]: Quick comment on pricing itself. There are two kind of ways that it happens. Some-mostly commodities futures prices-the actual futures price is higher than this bought price and that s because if you have the spot price-let s say of gold, right?-i have two choices. I could buy a futures contract where I will buy gold in the end of two months from now. Or I could go ahead and buy gold now, in which case I would have it in two months from now. If I buy gold now, I have a cost of carry for those two months. For example, we always think of I have to pay all of this money now so there s an opportunity cost or risk free rate cost right there plus I have to store the gold for two months. So there are costs that should be associated with it. We call those cost of carry. We can think of it as a dollar cost or in this way looking at the equation this way-this is more of a percentage cost. The other kind is financial futures. For financial futures, it oftentimes-not always-but oftentimes for financial futures, the futures price actually ends up being less than the spot price. And in this case it s because yes, you look at the spot price for the financial instrument. And yes, if you owned the instrument like the bond-let s say I have a financial futures to buy a bond in two months-or I could just buy the bond now. But of course, there s an opportunity cost I have to put out to buy all that bond now. But the advantage of 6

7 buying the bond now is I get interest income. Whereas in a commodity, you have to pay to store it. In a lot of the financial scenarios, you get paid to hold it. Right? If it s the SNP index, you get dividends if it is the interest you would get if it s a bond. So in those cases, it kind of depends. Is the borrowing cost-the risk free rate-is that greater or less than the interest or dividends you re getting on the financial futures? So this sign is minus and it kind of depends on the sizes of these relative to each other that will determine whether the financial futures price is greater or less than the spot price. Futures pricing Same asset trading in different markets will have the same price (law of one price) Strict relationship between the prices for underlying assets and related financial derivatives Commodity futures price = spot price + cost of carry = spot price (1+ risk-free interest rate + percentage storage cost) Financial futures price=spot price for financial instrument + borrowing costs of carry dividend yield or interest income = spot price (1+ risk interest free rate percentage income on financial instrument) [John Nofsinger]: So let s do a treasury note example. Here s a treasury note, that s the quote-it s in percent of par value. The annual risk free rate is 4%. But the treasury notes yield a 6%. The futures contract is for three months. What do I expect the futures price to be? So the borrowing cost for three months-that s one quarter of the year-at a 4% risk free rate is 1% over that three months. But the interest that I m going to get represents one and a half percent. So you can see the price of the bond plus the adjustments for the borrowing cost and then the income I get shows that the futures price is gonna be as a percent of the par value , which is less than the actual bond is trading for. So that s how that works. Example The spot price for a T-note: Annual risk free rate: 4% T-note s yield: 6% per year Delivery month: in three month What would you expect the futures price to be? Solution Borrowing cost for three months: ¼ x 4% = 1% 7

8 Interest income ¼ x 6% = 1.5% Futures price = x ( ) = x = [John Nofsinger]: So if you have the commodity type prices, the futures price as you get longer in time, you get more storage cost, right? So for futures prices, the longer the futures contract is out into the future, the higher the prices are going to be because you have more storage costs. We call this relationship contango. If a futures price is a financial future, the longer the futures hold, the actually the lower the actual futures price will be because it s more of an advantage to actually hold the asset and receive the interest payments. This is called backwardation. I have no idea why we use such bizarre terms-contango and backwardation-to show this relationship between futures prices and times for the two different kinds. But we do. Figure 19.6 Intramarket Spreads Reflect Influences of Supply, Demand and Carrying Costs A. With carrying costs, the futures price for each succeeding delivery month is usually higher. [Image of graph of time vs. futures price for Sept-July titled Contango] B. In some futures markets, futures prices are inverted with highest prices for the nearby spot month [Image of graph of time vs. futures price for Sept-July titled Backwardition] [John Nofsinger]: And the last slide just shows that we do have regulations in the derivatives markets-the Commodity Futures Trading Commission, National Futures Association as well. So those are the main regulators that-or the first step regulators. And certainly they have web pages and stuff where you can see how all of that works. So this concludes the second and last video for the futures topic. Futures markets regulation Commodity Futures Trading Commission (CFTC) Independent federal regulatory agency with jurisdiction over futures trading Monitors registrant supervision system, internal controls and sales practice compliance program National Futures Association (NFA) 8

9 Any company or individual futures traders must apply for registration through NFA. Self-regulatory organization 9