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TheThe futures futures marketsmarkets - Harvey Mudd pages.hmc.edu/evans/  · PDF...

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    TheThe futuresfutures marketsmarkets

    IntroductionIntroduction and and MechanicsMechanics, , usingusingNatural Gas as Natural Gas as thethe exampleexample

    (c) 2006-2014 Gary R. Evans. May be used for non-profit educational purposes only without permission of the author.

    Forward contracts ... Forward contracts ... Forward contracts are custom contracts that stipulate that a given quantityof some commodity (or similar) will be delivered in the future at a priceagreed to today, sometimes with complicated clauses, variable pricing schedules (e.g. adjustments for general inflation), incident triggers and the ( g j g ), gglike.

    The power purchase agreements that are so common in the complicated electricity industry have been essential to the development of renewal energy no lender will cover the high cost of building large-scale wind or solar projects unless the owner of the power plant has a long-term forward contract (PPA) with a utility promising to buy most or all production at a

    t (t i ll hi h) i K H Th i dj t bl fcurrent (typically high) price per KwH. These prices are adjustable for externalities and are highly complicated.

    A futures contract is, to some extent, a liquid, tradable, standardized forward contract with all terms simplified and transparent.

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    Web sitesWeb sites

    Intercontinental Exchange (owns NYME): http://www.theice.com

    CMEGroupCMEGroup (CME and CBOT): http://www cmegroup comCMEGroupCMEGroup (CME and CBOT): http://www.cmegroup.com

    Ino (good free site for checking prices): http://www.ino.com

    Kitco (metals, including gold): http://www.kitco.com

    OpenECry (online futures broker): http://www.openecry.com

    Foreign exchange spot prices: http://www.xe.comg g p p p

    FOREX trading directly (trial account): forex.com or fxcm.com

    Peruse the CMEGroup site before the next lecture and see what information they provide. Look at the list of commodities they trade and look at their contract specifications and prices.

    Key termsKey terms Spot price: Today's cash price. Futures price: Today's price of a specified futures contract,

    like Mar 2014 CMEGroup Henry Hub nat gas contract.like Mar 2014 CMEGroup Henry Hub nat gas contract. Expected future spot price: Exactly what the name implies.

    There is a theory that says that this price will not be the same as the futures price.

    Volume (futures): The number of contracts traded today (or in any period of time)

    Open interest (futures): The number of contracts that are Open interest (futures): The number of contracts that are "open," that exist right now, that have a long and short position.

    e-Mini contract: A smaller contract in some commodity, usually about half the size, electronically traded.

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    What I expect you to know going in ...What I expect you to know going in ...If in doubt, go the the Economics 104 material page at

    http://www2.hmc.edu/~evans/e104ls.htmhttp://www2.hmc.edu/ evans/e104ls.htm

    and read Chapter 10, Futures Contracts, including the appendices, and consider looking at Lecture 12, Introduction to Futures.


    1 H ttl t k tl h it k !1. How settlement works exactly how it works!2. How cash/margin accounts are impacted by settlement.3. How delivery works for physical contracts and what prices

    are paid.4. The connection between delta, inversed and leveraged ETPs

    and futures.

    Example: Example: CMEG CMEG Henry Hub Natural Gas Futures (NG)Henry Hub Natural Gas Futures (NG)

    Source: CMEGroup.com

    Trading hours (Globex): 24/7 except 5:15-6:00 PM ET, Friday 5:15 PM Sunday 6:00 PM Mar 2014 contract, weekly dataweekly data

    This hit record volume on the day this slide was

    Pricing quotation: $ per mmBTU [million British Thermal Units]Contract size: 10,000 mmBTU (current value about $52,000)Initial margin: $5,005 e-Mini $1,251 [February, 2014]Maintenance margin: $4,550 e-Mini $1,137Contract price sensitivity: $100 per penny moveFinal trade day: (typically) 3 business days prior to first day of contract monthDelivery allowed?: Yes, complicated, only trading companies can do it.

    day this slide was created.

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    Performance Performance Bonds (margins)Bonds (margins)

    Unlike when you buy an option, when you enter into a futures contract you are not buying anything and you dont pay for anything. You have entered a contract that either (1) gives you the right to buy something in the future (traditional futures contract) or (2) or gives you a capital gain or capital loss as(traditional futures contract) or (2) or gives you a capital gain or capital loss as though you have the right to buy something in the future (modern futures contract with no delivery allowed).

    The trader has a cash account that is used to meet performance bonds, also called margin requirements, on all futures contracts. It is identical to a cash account in a stock trading account.

    Each futures contract held by the trader, long or short, has an initial margin and a maintenance margin (also called a day margin). g g ( y g )

    The initial margin defines the minimum amount of cash that must be remaining in the account when a new futures contract is undertaken.

    The cash balance in the account may not drop below the sum total of all maintenance margins, otherwise there is a margin call.

    SettlementSettlementEach day at 2:30 PM ET the cash account referred to in the previous slide

    is adjusted in the process called settlement. For the front month futures contract the settlement price is calculated by

    taking the Volume Weighted Average Price (VWAP) for all trades in the two minutes before 2:30 PM.

    For the second month, contract trade must first meet a minimum volume threshold (50 contracts for NG), then the settlement price is calculated at the VWAP of the spread between the front month base value and second month value.

    For later months, a related, complicated, but understandable weighted VWAP formula is applied.

    As of early 2014 this daily settlement procedure was used for WTI CrudeAs of early 2014, this daily settlement procedure was used for WTI Crude, Natural Gas, Heating Oil, and RBOB gasoline.

    Expiring contract settlement is similar to daily settlement except the VWAP is calculated for the period between 2:00 and 2:30 (half and hour instead of two minutes),with potential complications.

    For more, see the pdf settlement procedures downloaded from the cmegroup.com

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    AnAn exampleexample of cash of cash accountaccount adjustmentadjustmentMarch Natural Gas futures contract, long 10,000 mmBTUs

    D P i P iti G i C h

    Natural Gas (NG) daily settlment

    Day Price Position Gain Cash0 4.80 48,000 0 20,0001 4.98 49,800 1800 21,8002 4.92 49,200 -600 21,2003 5.01 50,100 900 22,1004 5.14 51,400 1300 23,4005 5 35 53 500 2100 25 500

    For a short contract, the signs in the Gain would simply reverse.Contract price sensitivity: $100 per penny.

    5 5.35 53,500 2100 25,5006 5.22 52,200 -1300 24,200


    Net gain:

    ExampleExample In February, you buy a March NG natural gas futures

    contract for $4.80 per mmBTU (nominal value $48,000). You are long. You want to take delivery.

    Spot price on the day you enter this contract is $4.84 (notrelevant to settlement nor to this contract).

    When March delivery arrives, spot price has risen to $5.22. Question: What are the settlement terms?

    You take delivery of the nat gas in March at the new spot ($5.22), not $4.90, so you pay $52,200.

    You have gained $4,200 in your cash (margin) account. The total cost of this contract to you is

    ($52,200 4,200) = $48,000 exactly as you intended. The only asset you have is the cash balance of your margin


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    Exiting the contract (offset)Less than 1% of all futures contracts end with delivery of the commodity! Nearly all traders reverse their trades (called "offset") before the contract expiration date.

    Remember that the futures price must converge to the spot price as the expiration date approaches. Open interest declines until it is zero.

    Generally long positions exit at about the same pace as short positions, so open interest is gradually cleared off by the exchange.

    Remember, you did not "buy" or pay for anything when you opened the contract. You agreed to daily settlement terms, which have been satisfied daily. When you

    ff t d t ll thi t id Y j t i f b k th toffset you do not sell anything or get paid. You just inform your broker that you are closing out your trade and the exchange says goodbye.

    Most ICE contracts allow either futures swaps (EFP) or cash settlement instead of delivery even if you do not offset. Many contracts are cash settlement only.

    Many non-commodity contracts do not have deliverables so offset is automatic.

    Pricing fundamentals of tangible, storable Pricing fundamentals of tangible, storable commodities (like commodities (like oil and oil and natnat gas)gas)

    The prices of tangible storable commodities like crude oilThe prices of tangible, storable commodities like crude oil, natural gas, wheat, copper, and so forth are fundamentally determined by global trends in supply (production), demand (consumption), and stored inventory, which acts as a buffer between supply and demand. Often futures prices, which have a short-run orientation (although they are influenced by long-run expectations) are strongly affected by unexpected p ) g y y pinventory fluctuations.

    Supply DemandSupply Demand

    InventoryInventory... and Long run vs. Short run!!!

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