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Page 1: TheThe futures futures marketsmarkets - Harvey Mudd …pages.hmc.edu/evans/E136l42pp.pdf · TheThe futures futures marketsmarkets ... account in a stock trading account. Each futures

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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.

Additionally,

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 don’t 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 Cash

0 4.80 48,000 0 20,000

1 4.98 49,800 1800 21,800

2 4.92 49,200 -600 21,200

3 5.01 50,100 900 22,100

4 5.14 51,400 1300 23,400

5 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 25,500

6 5.22 52,200 -1300 24,200

4,200

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

account!

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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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14.00

16.00

NG Spot has been Volatile …NG Spot has been Volatile …

2.50

3.00

3.50

4.00

4.50

5.00

Spot Dec 2010 - Dec 2012

Inventory glut

1997 to now, monthly data…

6.00

8.00

10.00

12.00

0.00

0.50

1.00

1.50

2.00

Dec‐2010 Mar‐2011 Jun‐2011 Sep‐2011 Dec‐2011 Mar‐2012 Jun‐2012 Sep‐2012 Dec‐2012

Katrina

We saw gas below $2.00 in April 2012

0.00

2.00

4.00

Jan‐1997

Jul‐1997

Jan‐1998

Jul‐1998

Jan‐1999

Jul‐1999

Jan‐2000

Jul‐2000

Jan‐2001

Jul‐2001

Jan‐2002

Jul‐2002

Jan‐2003

Jul‐2003

Jan‐2004

Jul‐2004

Jan‐2005

Jul‐2005

Jan‐2006

Jul‐2006

Jan‐2007

Jul‐2007

Jan‐2008

Jul‐2008

Jan‐2009

Jul‐2009

Jan‐2010

Jul‐2010

Jan‐2011

Jul‐2011

Jan‐2012

Jul‐2012

Jan‐2013

Jul‐2013

2012.

Source: Energy Information Administration

Generally this is thought to have a slight deflationary effect

Natural Gas longNatural Gas long--term supply surge:term supply surge:

yupon spot natural gas prices, but prices have to remain high enough to cover higher extraction costs.

Source: Annual Energy Outlook 2013 (early release draft) with Projections to 2040, Energy Information Administration, U.S. Department of Energy.

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... but the long-term demand picture is complicated by this!

Source: Energy Information Administration Annual Energy Outlook Early Release Overview (published early 2014)

Storable Storable Commodity Supply and DemandCommodity Supply and DemandIn the modern era, the global supply curve for key commodities can be sticky and inelastic.1

Q

PX

P

Qs

Inelastic when ...

... but as other economies flex their growth muscles, demand can be fickle and robust!

Pe e

QP

Qe

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Severe Supply Inelasticity of OilSevere Supply Inelasticity of Oil

Demand Price

Global Oil Market55.00

60.00

Footnote: A classical example in oil ...

2000 76,619 30.262001 77,406 25.952002 78,082 26.152003 79,742 30.992004 82,452 41.472005 83,837 56.70

Daily m illions barre ls

Source: EIA

20.00

25.00

30.00

35.00

40.00

45.00

50.00

76,000 78,000 80,000 82,000 84,000 86,000

D2003

D2004

WEFA study commissioned by the American Petroleum Institute in 1990 concluded that the supply elasticity of oil was only 0.13! (controversial)

Data source: Energy Information Agency.

Storable Storable Commodity Supply and DemandCommodity Supply and DemandIn the modern era, the global supply curve for key commodities can be sticky and inelastic.

... but as other economies flex their growth muscles, demand can be fickle and robust!

Pe e

P2

so as demand increases

Qe Q2

... so as demand increases quickly and unexpectedly, prices, including futures, soar, and inventories deplete (e to 2)

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3,500

4,000

Natural Gas Underground Working Gas InventoriesNatural Gas Underground Working Gas InventoriesWeekly data, December 1993 to August 2009Weekly data, December 1993 to August 2009

Billions of cubic feet

An example where inventory matters ...

1 000

1,500

2,000

2,500

3,000

0

500

1,000

12/3

1 /93

4/30

/94

8/31

/94

12/3

1 /94

4/30

/95

8/31

/95

12/3

1 /95

4/30

/96

8/31

/96

12/3

1/96

4/30

/97

8/31

/97

12/3

1/97

4/30

/98

8/31

/98

12/3

1 /98

4/30

/99

8/31

/99

12/3

1 /99

4/30

/00

8/31

/00

12/3

1 /00

4/30

/01

8/31

/01

12/3

1/01

4/30

/02

8/31

/02

12/3

1/02

4/30

/03

8/31

/03

12/3

1 /03

4/30

/04

8/31

/04

12/3

1 /04

4/30

/05

8/31

/05

12/3

1 /05

4/30

/06

8/31

/06

12/3

1 /06

4/30

/07

8/31

/07

12/3

1/07

4/30

/08

8/31

/08

12/3

1/08

4/30

/09

Working gas equals total gas inventory less base gas, which is required to maintain pressure in underground gas storage.

Source: Energy Information Administration

Working Underground Gas Inventories for Working Underground Gas Inventories for a Typical Year: 2008a Typical Year: 2008

Here the seasonal feature3,500

4,000

Here the seasonal feature is obvious ...

1 500

2,000

2,500

3,000Winter draw-down for heating.

Summer build-up from production less electricity demand

0

500

1,000

1,500

1/4/08 2/1/08 2/29/08 3/28/08 4/25/08 5/23/08 6/20/08 7/18/08 8/15/08 9/12/08 10/10/08 11/7/08 12/5/08

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... massive inventory drawdown due to record-setting cold weather

The “polar vortex” in early January pushed

2014:

y ptemperatures in the East to record lows ...

... which in turn caused a huge drawdown in seasonal natural gas inventories.

Nat gas is in backwardation ...

How to play it?? A14S to A15L spread? Jan 20, 14

Feb 5, 14

4.2974.546

AA: 0.300MA: 0.733

AA: 0.517MA: 1.001

3.997

4.029

A narrow spread bet would be losing ...

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Background on Nat Gas Background on Nat Gas 2012 2012 contangocontango This inventory situation

implies low prices.

Because of the success of shale gas drilling (not shown) and because we are having one of the warmest winters on record (see heat map) underground inventory is full – there is no storage available for gas, which is why it can’t be arbitraged. There is a massive supply glut.

Example: Spreading the Nat Gas Example: Spreading the Nat Gas contangocontangoof 2012of 2012

0.15.00

What we

0.02

0.04

0.06

0.08

3.00

3.50

4.00

4.50 noticed at the start of class ...

-0.04

-0.02

0

2.00

2.50

Mar July Nov Mar July Nov Mar July Nov Mar

Price Monthly CGR

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A quick futures spread ...A quick futures spread ...Settlement Calculation

Natural Gas Spread of January 25, 2012CMEGroup Henry Hub (HH) Mar 2012 long, Mar 2013 short

Day DateMarch 2012

(L)March 2013

(S)Settlement delta long

Settlement delta short

Notional value

W 1/25/2012 2.650 3.620 0 0 62,700T 1/26/2012 2.756 3.659 1,060 -390 63,370F 1/27/2012 2.774 3.675 180 -160 63,390M 1/30/2012 2.756 3.659 -180 160 63,370T 1/31/2012 2.713 3.607 -430 520 63,460W 2/1/2012 2.503 3.482 -2,100 1,250 62,610

F 2/3/2012 2.499 3.622 -40 -1,400 61,170M 2/6/2012 2 550 3 700 510 780 60 900M 2/6/2012 2.550 3.700 510 -780 60,900T 2/7/2012 2.472 3.580 -780 1,200 61,320W 2/8/2012 2.448 3.562 -240 180 61,260F 2/10/2012 2.477 3.657 290 -950 60,600

We went long on the nearest term contract (March 2012) and shorted a contract one year later, knowing that gas has a one-year cycle,


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