Textbook Questions
The Futures Market
1. LG 1
“Psst, hey buddy. Wanna buy some copper? How about some coffee, or lean hogs, or propane? Maybe the Japanese yen or Swiss franc strikes your fancy?” Sound a bit unusual? Perhaps, but these items have one thing in common. They all represent real investments. This is the more exotic side of investing—the market for commodities and financial futures—and it often involves a considerable amount of speculation. The risks are enormous, but with some luck, the payoffs can be phenomenal. Even more important than luck, however, is the need for patience and know-how. Indeed, these are specialized investment products that require specialized investor skills.
Why the Economy Needs Futures Markets
The amount of futures trading in the United States has mushroomed over the past few decades. An increasing number of investors have turned to futures trading as a way to earn attractive, highly competitive rates of return. A major reason behind the growth in futures trading has been the number and variety of futures contracts now available for trading. Today futures contracts exist for the traditional primary commodities, such as grains and metals, as well as for processed commodities, crude oil and gasoline, electricity, foreign currencies, money market securities, U.S. and foreign debt securities, Eurodollar securities, and common stocks. You can even buy listed put and call options on just about any actively traded futures contract. All these commodities and financial assets are traded in what is known as the futures market.
Market Structure
When a bushel of wheat is sold, the transaction takes place in the cash market . The bushel changes hands in exchange for the cash price paid to the seller. For all practical purposes, the transaction is completed then and there. Most traditional securities are traded in this type of market. However, a bushel of wheat can also be sold in the futures market , the organized market for the trading of futures contracts. In this market, the seller would not deliver the wheat until some mutually agreed-upon date in the future. As a result, the transaction would not be completed for some time. The buyer, in turn, would own a highly liquid futures contract that could be held (and presented for delivery of the bushel of wheat) or traded in the futures market. No matter what the buyer does with the contract, as long as it is outstanding, the seller has a legally binding obligation to make delivery of the stated quantity of wheat on a specified date in the future. The buyer/holder has a similar obligation to take delivery of the underlying commodity.
Futures Contracts
A futures contract is a commitment to deliver a certain amount of a specified item at a specified date at an agreed-upon price. Each market establishes its own contract specifications. These include not only the quantity and quality of the item but also the delivery procedure and delivery month. The delivery month on a futures contract is much like the expiration date on put and call options. It specifies when the commodity or item must be delivered and thus defines the life of the contract. For example, the CME Group’s Chicago Board of Trade specifies that each of its full-sized soybean futures contracts will involve 5,000 bushels of USDA No. 2 yellow soybeans; soybean delivery months are January, March, May, July, August, September, and November.
How Futures Work
In addition, futures contracts have their own trading hours. Normal trading hours for commodities and financial futures vary widely, unlike listed stocks and bonds, which begin and end trading at the same time. For example, floor trading in futures contracts for oats is Monday through Friday from 9:30 a.m. to 2:00 p.m. (all hours are
Table 15.1 Futures Contract Dimensions
|
|
Size of a Single Contract * |
Market Value of a Single Contract ** |
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* Contract sizes are for CME Group futures products. |
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** Contract values are representative of those that existed on July 9, 2015, for the next expiring futures contract. |
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|
Corn |
5,000 bu |
$ 21,013 |
|
Wheat |
5,000 bu |
$ 28,863 |
|
Live cattle |
40,000 lb |
$ 59,500 |
|
Feeder cattle |
50,000 lb |
$106,213 |
|
Lean hogs |
40,000 lb |
$ 29,300 |
|
Coffee |
37,500 lb |
$ 46,950 |
|
Sugar |
112,000 lb |
$ 13,328 |
|
Gold |
100 troy oz |
$115,910 |
|
Copper |
25,000 lb |
$ 63,800 |
|
Crude oil |
1,000 bbls |
$ 52,870 |
|
Euro |
125,000 euro |
$137,950 |
|
Japanese yen |
12.5 million yen |
$ 103,113 |
|
10-year Treasury notes |
$100,000 |
$126,609 |
|
S&P 500 Stock Index |
$250 × S&P 500 futures price$250 × S&P 500 futures price |
$515,625 |
central time); silver is from 8:25 a.m. to 1:25 p.m.; live cattle is from 9:05 a.m. to 1:00 p.m.; U.S. Treasury bonds is from 7:20 a.m. to 2:00 p.m.; and the S&P 500 Stock Index is from 8:30 a.m. to 3:15 p.m. In addition to the set of hours for open-outcry or floor trading, there is another set of hours for electronic trading. CME Globex allows traders access to futures products on any exchange nearly 24 hours a day, 5 days a week, from anywhere in the world.
Table 15.1 lists a cross section of 14 commodities and financial futures. The market value of a single contract, as reported in Table 15.1 , is found by multiplying the size of the contract by the latest quoted price of the underlying commodity. For example, there are 37,500 pounds of coffee in a single contract, so if coffee’s trading at $1.252 a pound, then the market value of one contract is 37,500 × $1.252 = $46,95037,500 × $1.252 = $46,950. As you can see, the typical futures contract covers a large quantity of the underlying product or financial instrument. However, although the value of a single contract is normally quite large, the actual amount of investor capital required to deal in these vehicles is relatively small because all trading in this market is done on a margin basis.
Options versus Futures Contracts
In many respects, futures contracts are closely related to call options. For example, both involve the future delivery of an item at an agreed-upon price, and both are derivative securities. But there is a significant difference between a futures contract and an options contract. To begin with, a futures contract obligates a person to buy or sell a specified amount of a given commodity on or before a stated date—unless the contract is canceled or liquidated before it expires. In contrast, an option gives the holder the right to buy or sell a specific amount of a real or financial asset at a specific price over a specified period of time.
In addition, whereas call and put options specify the price at which investors can buy or sell the underlying asset, futures prices are not spelled out in the futures contract. Instead, the price on a futures contract is established through trading on the floor of a commodities exchange. This means that the delivery price is set at whatever price the contract sells for. So, if you bought a corn futures contract three months ago at $4.00 a bushel, then that’s the price you’ll pay to take delivery of the underlying product, even if the contract trades at, say, $4.50 a bushel at its date of expiration (i.e., delivery date). Equally important, the risk of loss with an option is limited to the price paid for it. A futures contract has no such limit on exposure to loss. Finally, while options have an explicit up-front cost (in the form of an option premium), futures contracts do not. The purchase of a futures contract does involve a margin deposit, but that’s nothing more than a refundable security deposit, not a sunk cost (like an option premium).
Major Exchanges
Modern futures contracts in this country got their start in the agricultural segment of the economy over 170 years ago when individuals who produced, owned, and/or processed foodstuffs sought a way to protect themselves against adverse price movements. Later, futures contracts came to be traded by individuals who were not necessarily connected with agriculture but who wanted to make money with commodities by speculating on their price swings.
The first organized commodities exchange in this country was the Chicago Board of Trade, which opened its doors in 1848. Over time, additional markets opened. There currently are more than a dozen U.S. exchanges that qualify as designated contract markets (DCM) and deal in listed futures contracts. Designated contract markets are boards of trade (or exchanges) that operate under the regulatory oversight of the U.S. Commodity Futures Trading Commission (CFTC). DCMs may list futures (or options) contracts based on any underlying commodity, index, or instrument. The majority of futures trading occurs on only a few exchanges. The Chicago Mercantile Exchange is the most active exchange, with about as much trading volume as all other futures exchanges combined. The CME is followed in size by the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX), which includes through a previous acquisition the Commodity Exchange, Inc. (COMEX). Together, these four exchanges account for about 95% of the trading conducted on U.S. futures exchanges. Although the exchanges continue to operate separately, in July of 2007 the CME Group was created through a merger of the CME and the CBOT. The CME Group expanded further in August of 2008 by acquiring the NYMEX, which included COMEX.
Most exchanges deal in a number of commodities or financial assets, and many commodities and financial futures are traded on more than one exchange. Annual volume of trading on futures exchanges has surpassed three billion contracts with a total value above the trillion-dollar mark. Most exchanges now conduct trading electronically. The open-outcry auction method once used to conduct floor trading, which required traders to shout their orders while using elaborate hand signals (illustrated in Figure 15.1 ), has all but disappeared. As of July 2015 the CME Group continues open outcry futures trading for the S&P 500 futures contracts. The company also continues floor trading for the options on futures contracts.
In 1992 CME Globex became the first global electronic futures trading platform. Globex offers trading more than 23 hours a day, 5 days a week, and provides an international link among futures exchanges. Since 2000 electronic trading of futures contracts has grown from about 9 percent of trading volume to nearly 100 percent. Globex allowed the CME Eurodollar futures contract to become the most actively traded futures contract in the world. Indeed, the three most actively traded contracts on CME Globex (three-month Eurodollars, the E-Mini S&P 500 Stock Index, and the U.S. 10-year Treasury Note) represent more than 50% of futures trading volume on the U.S. exchanges.
Figure 15.1 The Auction Market at Work on the Floor of the Chicago Board of Trade
Traders once employed a system of open-outcry and hand signals to indicate whether they wished to buy or sell and the price at which they wished to do so. Fingers held vertically indicated the number of contracts a trader wanted to buy or sell. Fingers held horizontally indicated the fraction of a cent above or below the last traded full-cent price at which the trader would buy or sell.
Trading in the Futures Market
Basically, the futures market contains hedgers and speculators. The market could not exist and operate efficiently without either one. The hedgers are businesses that either produce a commodity or use it as an input to their production process. For example, a rancher might enter into a futures contract to lock in the price for his herd months before actually selling the herd. That way, the rancher’s revenues are predictable and are not affected by swings in the price of cattle. In effect, the hedgers provide the underlying strength of the futures market and represent the very reason for its existence. In the case of financial futures, hedgers are companies whose businesses are affected by swings in financial variables such as interest rates or exchange rates. Accordingly, hedgers also include financial institutions and other large corporations.
Speculators , in contrast, trade futures contracts simply to earn a profit on expected price swings. They have no inherent interest in the commodity or financial future other than the price action and potential capital gains it can produce. However, their presence in the market benefits others because speculators’ trades help make the futures market more liquid.
Trading Mechanics
Once futures contracts are created, they can readily be traded in the market. Like common stocks, futures contracts are bought and sold through local brokerage offices and on many Internet sites. Except for setting up a special commodities trading account, there is no difference between trading futures and dealing in stocks and bonds. The same types of orders are used, and margin trading is standard practice. Any investor can buy or sell any contract, with any delivery month, as long as it is currently being traded on one of the exchanges.
Buying a contract is referred to as taking a long position. Selling one is known as taking a short position. It is exactly like going long or short with stocks and has the same connotation. A speculator who is long wants the price to rise, and the short seller wants it to drop. Investors can liquidate both long and short positions simply by executing an offsetting transaction. The short seller, for example, would cover her position by buying an equal amount of the contract. In general, only about 1% of all futures contracts are settled by delivery. The rest are offset prior to the delivery month. The total number of contracts that are open and have not been settled by delivery or by an offsetting transaction is called open interest . All trades are subject to normal transaction costs, which include round-trip commissions for each contract traded. A round-trip commission includes the commission costs on both ends of the transaction—to buy and sell a contract. Although the size of the commission depends on the number and type of contracts being traded, trades that are executed electronically usually have round-trip commissions under $10 and are much less expensive than trades that have to be routed to a pit broker.
An Advisor’s Perspective
Rob Russell CEO, Russell and Company
“Futures contracts are quite different than stocks.”
MyFinanceLab
Margin Trading
Buying on margin means putting up only a fraction of the total price in cash. Margin, in effect, is the amount of equity that goes into the deal. All futures contracts are traded on a margin basis. The margin required usually ranges from about 2% to 10% of the contract value. This is very low compared to the margin required for stocks and most other securities. Furthermore, there is no borrowing required on the part of the investor to finance the balance of the contract. The margin deposit , as margin is called with futures, represents security to cover any loss in the market value of the contract that may result from adverse price movements. It exists simply to guarantee fulfillment of the contract. The margin deposit is not a partial payment for the commodity or financial instrument, nor is it related to the value of the underlying product or item.
Margins and Margin Calls
The size of the required margin deposit is specified as a dollar amount. It varies according to the type of contract and depends on the price volatility of the underlying commodity or financial asset. In some cases, it also varies according to the exchange on which the commodity is traded. Table 15.2 gives the margin requirements for the same 14 commodities and financial instruments listed in Table 15.1 . Compared to the size and value of the futures contracts, margin requirements are very low. The initial margin noted in Table 15.2 is the amount of capital the investor must deposit with the broker when initiating the transaction; it represents the amount of money required to make a
Table 15.2 Margin Requirements for A Sample of Commodities and Financial Futures
|
Contract |
Initial Margin |
Maintenance Margin |
Exchange |
|
Corn |
$ 1,375 |
$ 1,250 |
CBOT |
|
Wheat |
$ 1,925 |
$ 1,750 |
CBOT |
|
Live cattle |
$ 1,320 |
$ 1,200 |
CME |
|
Feeder cattle |
$ 2,475 |
$ 2,250 |
CME |
|
Lean hogs |
$ 1,320 |
$ 1,200 |
CME |
|
Coffee |
$ 4,675 |
$ 4,250 |
NYMEX |
|
Sugar |
$ 770 |
$ 700 |
NYMEX |
|
Gold |
$ 4,125 |
$ 3,750 |
COMEX |
|
Copper |
$ 3,410 |
$ 3,100 |
COMEX |
|
Crude oil |
$ 5,060 |
$ 4,600 |
NYMEX |
|
Euro |
$ 3,905 |
$ 3,550 |
CME |
|
Japanese yen |
$ 2,860 |
$ 2,600 |
CME |
|
10-year Treasury notes |
$ 1,485 |
$ 1,350 |
CBOT |
|
S&P 500 Stock Index |
$25,300 |
$23,000 |
CME |
|
Note: On July 9, 2015, the CME Group specified that speculative and nonmembers initial margin requirements for all products are set at 110% of the maintenance margin requirement for a given product. Hedge and member initial margin requirements for all products are set at 100% of the maintenance margin requirement for a given product. Margins are meant to be typical of the ongoing requirements that customers are expected to live up to. Depending on the volatility of the market, exchange-minimum margin requirements are changed frequently. Thus, the requirements in this table are also subject to change on short notice. The actual margin requirements for a specific type of transaction on a given exchange are typically reported on the exchange’s website. |
given investment. (The margins quoted in Table 15.2 are for speculative transactions. Typically, the initial margin amount is slightly lower for hedge transactions.)
After the investment is made, the market value of a contract will rise and fall as the quoted price of the underlying commodity or financial instrument goes up or down, and that fluctuation triggers changes in the amount of margin on deposit. To be sure that an adequate margin is always on hand, investors are required to meet a second type of margin requirement, the maintenance margin . The maintenance margin, which is slightly less than the initial margin, establishes the minimum amount of margin that an investor must keep in the account at all times. For instance, if the initial margin on a commodity is $1,100 per contract, its maintenance margin might be $1,000. As long as the market value of the contract does not fall by more than $100 (the difference between the contract’s initial and maintenance margins), the investor has no problem. But if the value of the contract drops by more than $100, the investor will receive a margin call. The investor must then immediately deposit enough cash to bring the position back to the initial margin level.
An investor’s margin position is checked daily via a procedure known as mark-to-the-market . That is, the gain or loss in a contract’s value is determined at the end of each session. At that time the broker debits or credits the account accordingly. In a falling market, an investor may receive a number of margin calls and be required to make additional margin payments. Failure to do so will leave the broker with no choice but to close out the position—that is, to sell the contract.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 15.1 What is a futures contract? Briefly explain how it is used as an investment vehicle.
2. 15.2 Discuss the difference between a cash market and a futures market.
3. 15.3 What is the major source of return to commodities speculators? How important is current income from dividends and interest?
4. 15.4 Why are both hedgers and speculators important to the efficient operation of a futures market?
5. 15.5 Explain how margin trading is conducted in the futures market.
a. What is the difference between an initial margin and a maintenance margin?
b. Are investors ever required to put up additional margin? If so, when?
Commodities
1. LG 2
2. LG 3
3. LG 4
Physical commodities like grains, metals, wood, and meat make up a major portion of the futures market. They have been actively traded in this country for well over a century. The material that follows focuses on commodities trading. We begin with a review of the basic characteristics and investment merits of these contracts.
Basic Characteristics
Commodities are goods for which there is demand without differentiation of supplier. In other words, a commodity is a fungible good that is qualitatively the same regardless of the supplier. For example, a Troy ounce of gold from a mine in Uzbekistan is the same as a Troy ounce of gold from a mine in Indonesia. As long as the underlying commodity meets the contractual standard, it can be traded with futures. Table 15.3 divides the market for commodity contracts into six categories: agriculture, metals, livestock, food, energy, and other. Such segmentation does not affect trading mechanics and procedures. It merely provides a convenient way of categorizing commodities into groups based on similar underlying characteristics.
Table 15.3 Major Classes of Commodities
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Agriculture |
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Metals |
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Corn |
Soybean oil |
|
Silver |
Palladium |
|
Oats |
Wheat |
|
Copper |
Platinum |
|
Soybeans |
Canola |
|
Gold |
Iron ore |
|
Soybean meal |
Rice |
|
|
|
|
Livestock |
|
Food |
||
|
Live cattle |
Lean hogs |
|
Cocoa |
Sugar |
|
Feeder cattle |
|
|
Coffee |
Cotton |
|
|
|
|
Milk |
Orange juice |
|
Energy |
|
Other |
||
|
Coal |
Natural gas |
|
Weather |
Freight |
|
Crude oil |
Ethanol |
|
Interest rates |
Environment |
|
Heating oil |
Electricity |
|
Real estate |
Lumber |
Table 15.3 shows the diversity of the commodities market and the variety of contracts available. Although the list of available contract types changes yearly, the table indicates that investors have dozens of commodities to choose from. A number of the contracts in Table 15.3 (e.g., soybeans, wheat, and sugar) are available in several forms or grades. Not included in Table 15.3 are dozens of commodities (e.g., butter, cheese, whey, boneless beef, and others) that are not widely traded.
Investor Facts
Weather Futures Can Be Hot or Cold! If weather is a concern, buy a futures contract on the weather and eliminate your worries. Governments, companies, or individuals can use these financial instruments, also known as weather derivatives, to manage risk associated with unexpected or adverse weather conditions. Weather futures derive their value from an underlying weather index that can be based on any weather variation, such as temperature, rain, frost, snow, or even hurricanes.
For example, energy companies can use them to hedge against shifts in demand due to unexpected temperatures, like a warm winter or cool summer. Farmers can use weather futures to hedge against poor harvests caused by drought or frost, amusement parks can use them to insure against rainy weekends during their peak summer seasons, and ski resorts can use them to protect against lost revenue due to insufficient amounts of snow. The applications are quite numerous.
The Chicago Mercantile Exchange introduced the first exchange-traded weather futures contract in 1999. The CME currently offers weather futures indexed to temperature, frost, snow, and hurricanes.
(Source: CME Group, Weather Products, http://www.cmegroup .com .)
A Commodities Contract
Every commodity (whether actively or thinly traded) has certain specifications that spell out in detail the amounts and quality of the product being traded. Figure 15.2 shows the contract specifications of corn futures contracts that trade on the CBOT. You can see that a corn futures contract represents 5,000 bushels of #2 yellow corn, and its price is quoted in cents per bushel. In this case, the contract also allows for deliverable grades of either #1 or #3 yellow corn, but for a premium or discounted price, respectively. The futures contract also specifies the expiration months, trading hours, daily price limits, settlement procedures, and more. In the middle of the page of contract specifications is the exchange rule, which indicates the listing exchange and the trading rules and regulations that apply when trading the contract.
The quotation system used for commodities is based on the size of the contract and the pricing unit. Standard commodities quotations, like the one shown in Figure 15.3 , generally report the daily last, open, high, and low prices for each delivery month. With commodities, the last price of the day, or the closing price, is known as the settlement price . The daily settlement price is very important since it is used to determine the daily market value of a contract and, therefore, an investor’s profit or loss for the day, as well as margin requirements. The prior settle price is the final settlement price at the end of the previous day. The quotation in Figure 15.3 also reports the volume —the number of contracts traded—for the day. According to Figure 15.3 , the settle price for December 2016 corn futures contract is 439’6. The term after the apostrophe represents a fraction in eighths. Because corn futures are quoted in cents per bushel, the six following the apostrophe means 6/8ths of a cent. According to Figure 15.2 the minimum price fluctuation for corn futures contracts is 1/4th of one cent so 6/8ths is 3/4ths of one cent or 0.75 cents. Each contract represents 5,000 bushels of corn and each bushel is worth $4.3975, so the market value of the contract is 5,000 × $4.3975 = $21,987.505,000 × $4.3975 = $21,987.50.
Price Behavior
Commodity prices react to a unique set of economic, political, and international pressures—as well as to the weather. The explanation of the reasons that commodity prices change is beyond the scope of this text. But they do move up and down just like any other investment, which is precisely what speculators want. Because we are dealing in such large trading units (5,000 bushels of this or 40,000 pounds of that), even a modest price change can have an enormous impact on the market value of a contract and therefore on investor returns or losses. For example, if the price of corn goes up or down by just $0.20 per bushel, the value of a single contract will change by $1,000. A corn contract can be bought with a $1,375 initial margin deposit, so it is easy to see the effect this kind of price behavior can have on investor return.
Do commodity prices really move all that much? Judge for yourself. The price change columns in Figure 15.3 show some examples of price changes that occurred from the previous day’s closing price to the current day’s last price. For example, relative to the prior day’s settle or closing price, March 2016 corn dropped $75
Figure 15.2 Contract Specifications for Corn Futures
The contract specifications for any listed futures contract are typically available online at the listing exchange website. When traders buy or sell futures contracts, they are agreeing to uphold the terms defined by the contract specifications. In this case we see that a corn futures contract calls for the delivery of 5,000 bushels of #2 yellow corn by the end of the second business day following the last trading day of the delivery month, which would be the contract’s expiration month.
(Source: Reprinted with permission, CME Group, 2015.)
Figure 15.3 Quotations on Corn Futures Contracts
Readily available online quotations quickly reveal key information about various commodities in real time (or from some sources, slightly delayed). This quotation for corn futures contracts includes the daily last, open, high, and low prices. It also provides the change in price from the previous day’s closing price to the current day’s last price and the previous day’s settlement price (or prior settle), as well as the current day’s volume, and Hi/Lo limit.
(Source: Reprinted with permission, CME Group, 2015.)
(i.e., 5,000 bushels × $0.0155,000 bushels × $0.015). The price swing is even larger if you consider the current day’s low price relative to the prior day’s settle price. In this case March 2016 corn dropped $0.02 per bushel (i.e., $4.49 − $4.47$4.49 − $4.47) or $100 per contract (i.e., 5,000 bushels × $0.025,000 bushels × $0.02). Keep in mind that these intraday price swings are on a single contract. The impact of these small changes can quickly add up to significant profits or losses depending on the number of contracts, especially relative to the small initial investment required.
Clearly, such price behavior is one of the magnets that draw investors to commodities. The exchanges recognize the volatile nature of commodities contracts and try to put lids on price fluctuations by imposing daily price limits and maximum daily price ranges. (Similar limits also are put on some financial futures.) The daily price limit restricts the interday change in the price (i.e., the price change from one day to the next day) of the underlying commodity. For example, a corn futures contract has an initial price limit of $0.30 per bushel and an expanded price limit of $0.45 per bushel. The maximum daily price range (shown in Figure 15.3 as the difference between the Hi/Lo limits) limits the amount of intraday price movement (i.e., the price can change during the day) and is usually equal to twice the daily price limit. For example, the daily price limit on corn is $0.30 per bushel and its maximum daily range is $0.60 per bushel. In fact, the prior day’s settlement price (i.e., the settle price) plus and minus the daily price limit determines the Hi/Lo limits. Because futures prices can become extremely volatile as the contract nears expiration, there are no price limits on the current month contract on or after the second business day preceding the first day of the delivery month. Such limits, however, still leave plenty of room to turn a quick profit. Consider that the daily price limits on one corn futures contract translates into a per-day change in value of $1,500 to unlimited depending on the contract and prior pricing.
Return on Invested Capital
Futures contracts have only one source of return: the capital gains that result when prices move in a favorable direction. There is no current income of any kind. The volatile price behavior of futures contracts is one reason why high returns are possible, and the other reason is leverage. Because all futures trading is done on margin, it takes only a small amount of money to control a large investment position—and to participate in the price swings that accompany futures contracts. Of course, the use of leverage also means that an investment can be wiped out in just a matter of days.
We can measure the return on a commodities contract by calculating the return on invested capital . This variation of the standard holding period return formula bases the investment’s return on the amount of money actually invested in the contract rather than on the value of the contract itself. The return on invested capital for a commodities position can be determined according to the following simple formula.
Return on invested capital=Selling price of commodity contract−Purchase price of commodity contractAmount of margin depositReturn on invested capital=Selling price of commodity contract−Purchase price of commodity contractAmount of margin depositEquation15.1
We can use Equation 15.1 for both long and short transactions. To see how it works, assume you recently bought two March 2017 corn futures contracts at 447’0 ($4.47 per bushel) by depositing the required initial margin of $2,750 ($1,375 for each contract). Your investment, therefore, amounts to only $2,750, but you control 10,000 bushels of corn worth $44,700 (i.e., 10,000 × $4.4710,000 × $4.47) at the time of purchase. Now, assume that March 2017 corn has just closed at 458, making the market value of your position equal to 10,000 × $4.58 = $45,80010,000 × $4.58 = $45,800. At this point, you decide to sell and take your profit. Your return on invested capital is:
Return on invested capital=$45,800 − $44,700$2,750=$1,100$2,750=0.40=40%Return on invested capital=$45,800 − $44,700$2,750=$1,100$2,750=0.40=40%
Famous Failures IN Finance Shady Trading at Enron
Before it was known for its financial problems, Enron, a utility firm operating pipelines and shipping natural gas, had become famous as a business pioneer, blazing new trails in the market for trading risk. In the 1980s the price of natural gas was deregulated, which meant that its price could go down and up, exposing producers and consumers to risks. Enron decided to exploit new opportunities in the commodities business by trading natural gas futures. The natural gas futures that traded on the New York Mercantile Exchange did not take into account regional discrepancies in gas prices. Enron filled this void by agreeing to deliver natural gas to any location in the United States at any time.
In addition to trading natural gas and other energy contracts, in the late 1990s Enron began trading weather derivatives for which no underlying commodities existed. These were just bets on the weather. Its weather-derivatives transactions were worth an estimated $3.5 billion in the United States alone. Thanks to its near-monopoly position in derivatives products, Enron’s trading business was initially highly profitable. At one point, the company offered more than 1,800 different contracts for 16 product categories, ranging from oil and natural gas to weather derivatives, broadband services, and emissions rights, and it earned 90% of its revenues from trading derivatives. And unlike traditional commodity and futures exchanges and brokers, Enron’s online commodity and derivative business was not subject to federal regulations.
However, Enron eventually lost its unique position as the energy business started to mature. When other firms entered the online derivatives-trading business, they competed by charging lower commissions and exploiting the same regional price discrepancies that had been Enron’s bread and butter. Enron’s trading operations became less profitable. To find new markets and products, the company expanded into areas such as water, foreign power sources, telecommunications, and broadband services. The farther it moved from its core businesses of supplying gas, the more money Enron lost.
The company sought to hide those losses by entering into more risky and bizarre financial contracts. When financial institutions began to realize that Enron was essentially a shell game, they withdrew their credit. At that point, despite rosy assurances from its founder and CEO Ken Lay, Enron went into a death spiral that ended in bankruptcy on December 2, 2001.
In July 2004 Lay was indicted on 11 counts of securities fraud and related charges. He was found guilty on May 25, 2006, of all but one of the counts. Each count carried a maximum 5- to 10-year sentence and legal experts said Lay could face 20 to 30 years in prison. However, about three and a half months before his scheduled sentencing, Ken Lay died on July 5, 2006, while vacationing in Snowmass, Colorado. On October 17, 2006, as a result of his death, the federal district court judge who presided over the case vacated Lay’s conviction.
Critical Thinking Questions
1. Could the Enron debacle have been prevented? If so, what actions should have been taken by auditors, regulators, and lawmakers?
Clearly, this high rate of return was due not only to an increase in the price of the commodity but also to the fact that you were using very low margin, or very high financial leverage. The initial margin in this transaction is only about 6% of the underlying value of the contract.
Watch Your Behavior
It is well known that individual investors are reluctant to sell stocks that have experienced a loss. Perhaps surprisingly, experiments have discovered that professional futures traders exhibit an even stronger tendency to hang onto their losing positions too long.
(Source: Michael S. Haigh and John A. List, “Do Professional Traders Exhibit Myopic Loss Aversion? An Experimental Analysis,” Journal of Finance, 2005, Vol. 60, No.)
MyFinanceLab
Trading Commodities
Investing in commodities takes one of three forms. The first, speculating, involves using commodities as a way to generate capital gains. In essence, speculators try to capitalize on the wide price swings that are characteristic of so many commodities. As explained in the accompanying Famous Failures in Finance box, this is basically what Enron was doing—until things started turning nasty.
While volatile price movements may appeal to speculators, they frighten many other investors. As a result, some of these more cautious investors turn to spreading, the second form of commodities investing. Futures investors use this trading technique as a way to capture some of the benefits of volatile commodities prices but without all the exposure to loss.
Finally, commodities futures can be used for hedging. A hedge in the commodities market is more of a technical strategy that is used almost exclusively by producers and processors to protect a position in a product or commodity. For example, a producer or grower would use a commodity hedge to obtain as high a price as possible for its goods. The processor or manufacturer who uses the commodity would use a hedge for the opposite reason: to obtain the goods at as low a price as possible. A successful hedge, in effect, means more predictable income to producers or costs to processors.
Let’s now look briefly at the two trading strategies that are most used by individual investors—speculating and spreading—to gain a better understanding of how to use commodities as investments.
Speculating
Speculators hope to capitalize on swings in commodity prices by going long or short. To see why a speculator would go long when prices are expected to rise, assume you buy a June 2021 gold futures contract at 1287.4 by depositing the required initial margin of $4,125. One gold contract involves 100 troy ounces of gold, so it has a market value equal to 100 troy ounces × $1,287.4 = $128,740100 troy ounces × $1,287.4 = $128,740. If gold goes up, you make money. Assume that one month after you purchased the June 2021 contract, its price is 1313.1. You then liquidate the contract and make a profit equal to $1,313.10 − $1,287.40 = $25.70$1,313.10 − $1,287.40 = $25.70 per ounce. That means a total profit of $2,570 on the long gold contract position with an investment of $4,125—this translates into a return on invested capital of 62.3%. Not bad for a month of speculation.
Of course, instead of rising, the price of gold could have dropped by $25.70 per ounce. On a 100-ounce contract, that amounts to $2,570 loss on the position. As a result, you would have lost a good bit of your original investment: $4,125 − $2,570$4,125 − $2,570 leaves $1,555.
But a drop in price would be just what a short seller is after. Here’s why. You sell “short” the June 2021 gold contract at 1287.4 and buy it back one month later at 1261.7. Clearly, the difference between the selling price and the purchase price is the same $25.70. But in this case it is profit because the selling price exceeds the purchase price.
Spreading
Instead of attempting to speculate on the price behavior of a futures contract, you might follow the more conservative tactic of spreading. Much like spreading with put and call options, the idea is to combine two or more different contracts into a position that offers the potential for a modest amount of profit but restricts your exposure to loss. One very important reason for spreading in the commodities market is that, unlike options, there is no limit to the amount of loss that can occur with a futures contract.
You set up a spread by buying one contract and simultaneously selling another. Although one side of the transaction will lead to a loss, you hope that the profit earned from the other side will more than offset the loss and that the net result will be at least a modest amount of profit. If you’re wrong, the spread will limit, but not eliminate, any losses.
Here is a simple example of how a spread might work. Suppose you buy contract A at 533.50 and at the same time short sell contract B for 575.50. Sometime later, you close out your position in contract A by selling it at 542, and you simultaneously cover your short position in B by purchasing a contract at 579. Although you made a profit of 8.50 points (542 − 533.50)(542 − 533.50) on the long position (contract A), you lost 3.50 points (575.50 − 579)(575.50 − 579) on the contract you shorted (B). The net effect, however, is a profit of 5 points. If you were dealing in cents per pound, those 5 points would mean a profit of $250 on a 5,000-pound contract.
All sorts of commodity spreads can be set up for almost any type of investment situation. Most of them, however, are highly sophisticated and require specialized skills.
Famous Failures IN Finance Diving Oil Prices Send Cal Dive into Bankruptcy
One of the reasons that commodity futures markets exist is the price volatility of the underlying commodity. Futures contracts give firms a way to manage that volatility, but it isn’t always possible to insulate a company from commodity price risk. Swings in oil prices, for example, have created many millionaires through the years, but they have also brought about financial ruin. The chart below illustrates the volatility in crude oil prices from 2007 to 2015. In 2007 and 2008 crude oil futures prices were reaching all-time highs of over $100 per barrel, which triggered an explosion in oil futures trading. The average daily trading volume in 2008 was about 15 times the daily world production of oil. But as the global economy turned south and began to slip into recession, demand for oil and other commodities fell off sharply. After peaking during the summer of 2008, the price of oil responded true to form, falling by almost 70% in six months and sending the stock prices of oil-related businesses into freefall. Since then, as the economy has slowly rebounded, so has the oil futures price, again surpassing $100 per barrel. Interestingly, in mid-2014 the price of oil again plummeted, this time blamed mostly on oil futures speculation and a flood of worldwide supply of oil. Even so, the drop in prices sent many oil-related businesses into bankruptcy, among them Cal Dive International, which filed for bankruptcy in March 2015.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 15.6 List and briefly define the five essential parts of a commodities contract. Which parts have a direct bearing on the price behavior of the contract?
2. 15.7 Briefly define each of the following:
a. Settlement price
b. Daily price limit
c. Volume
d. Maximum daily price range
e. Delivery month
3. 15.8 What is the source of return on futures contracts? What measure is used to calculate the return on a commodities contract?
4. 15.9 Note several approaches to investing in commodities and explain the investment objectives of each.
Financial Futures
1. LG 5
2. LG 6
Another dimension of the futures market is financial futures , a segment of the market in which futures contracts are traded on financial instruments. Financial futures are an extension of the commodities concept. They were created for much the same reason as commodities futures, they are traded in the same market, their prices behave a lot like commodities, and they have similar investment merits. However, financial futures are unique because of the underlying assets. Let’s now look more closely at financial futures and see how investors can use them.
The Financial Futures Market
Although relatively young, financial futures are the dominant type of futures contract. The level of trading in financial futures far surpasses that of traditional commodities. Much of the interest in financial futures is due to hedgers and institutional investors who use these contracts as portfolio management tools. But individual investors can also use financial futures to speculate on the behavior of interest rates and to speculate in the stock market. Financial futures even offer a convenient way to speculate in the highly specialized foreign currency markets.
The financial futures market was established in response to the economic turmoil the United States experienced in the 1970s. The instability of the dollar on the world market was causing serious problems for multinational firms. Interest rates were highly volatile, which caused severe difficulties for corporate treasurers, financial institutions, and money managers. All of these parties needed a way to protect themselves from the wide fluctuations in the value of the dollar and interest rates. Thus, a market for financial futures was born. Hedging provided the economic rationale for the market, but speculators were quick to join in.
Most of the financial futures trading in this country occurs on the Chicago Board of Trade, the Chicago Mercantile Exchange and, to a much lesser extent, the New York Mercantile Exchange. Financial futures also are traded on several foreign exchanges, the most noteworthy of which is the London International Financial Futures Exchange. The basic types of financial futures include foreign currencies, debt securities (more commonly known as interest rate futures), and stock indexes.
Investor Facts
Single Stock Futures Several years ago, single stock futures (SSFs) began trading on an exchange called OneChicago. SSFs allow investors to buy or sell futures contracts written on 100-share lots of a given common stock. SSFs today are available on more than 1,500 well-known companies and ETFs. Because of their lower margin requirements (20% for SSFs versus 50% for regular stock trades), SSFs are highly leveraged investments, with substantial risk but also with very attractive return potential. Depending on their risk profiles, investors can use this futures version of a stock to support both speculative and hedging investment strategies.
(Source: OneChicago, LLC, Press Release 7/1/2015, http://www .Onechicago.Com/?p=10392 , accessed July 11, 2015.)
Foreign Currencies, Interest Rates, and Stock Indexes
The financial futures market started rather inconspicuously in May 1972, with the listing of a handful of foreign currency contracts. Known as currency futures , they have become a major hedging vehicle as international trade has mushroomed. Most of the trading in this market is conducted in major market currencies such as the British pound, Swiss franc, Canadian dollar, Japanese yen, and the euro—all of which are issued by countries or regions with strong international trade and economic ties to the United States.
The first futures contract on debt securities, or interest rate futures , began trading in October 1975. Today trading is carried out in a variety of interest-rate-based securities, including U.S. Treasury securities, Federal Funds, interest rate swaps, Euromarket deposits (e.g., Eurodollar and Euroyen), and foreign government bonds. Interest rate futures were immediately successful, and their popularity continues to grow.
In February 1982 still another type of trading vehicle was introduced: the stock-index futures contract. Stock index futures are contracts pegged to broad-based measures of stock market performance. Today trading is done in most of the (major) U.S. stock indexes, including the Dow Jones Industrial Average, the S&P 500, the Nasdaq 100, and the Russell 2000, among others.
In addition to U.S. indexes, investors can trade stock index futures contracts based on the London, Tokyo, Paris, Sydney, Berlin, Zurich, and Toronto stock exchanges. Stock index futures, which are similar to the stock index options we discussed earlier, allow investors to participate in the general movements of the entire stock market.
Stock index futures, and other futures contracts, are a type of derivative security. Like options, they derive their value from the price of the assets that underlie them. In the case of stock index futures, they reflect the general performance of the stock market as a whole or various segments of the market. Thus, when the market for large-cap stocks, as measured by the S&P 500, goes up, the value of an S&P 500 futures contract should go up as well. Accordingly, investors can use stock index futures as a way to buy or sell the market—or reasonable proxies thereof—and thereby participate in broad market moves.
Contract Specifications
In principle, financial futures contracts are like commodities contracts. They control large sums of the underlying financial instrument and are issued with a variety of delivery months. The lives of financial futures contracts run from about 12 months or less for most stock index and currency futures to two to three years or more for interest rate instruments. In terms of quotations, Figure 15.4 shows quotes for a foreign currency, an interest rate, and a stock index futures contract. Looking first at the Canadian dollars futures quotation, we see information very similar to that of commodity futures quotations. In particular, currency futures quotations provide the last, prior settle, open, high, and low prices, as well as contract trading volume. The owner of a currency futures contract holds a claim on a certain amount of foreign money, in this case 100,000 Canadian dollars. Underlying currency amounts can vary widely across currency futures contracts, such as 62,500 British pounds or 12.5 million Japanese yen.
Holders of interest rate futures have a claim on a certain amount of the underlying debt security. The contract for interest rate futures shown in Figure 15.4 represents a claim to $100,000 worth of U.S. Treasury bonds. Recall from earlier in the text that bond quotations are expressed as a percentage of the par value, and the same is true for interest rate futures quotations. Figure 15.4 indicates that the September 2015 contract price is 149’21 and in the case of interest rate futures contracts the value following the apostrophe refers to the number 1/32 of a percentage point. So 149’21 is 149.65625% (i.e., 149 + 21/32149 + 21/32) and that means that the contract value is $100,000 × 149.65625% =$149,656.25$100,000 × 149.65625% =$149,656.25.
Stock index futures are a bit different from most futures contracts because the seller of one of these contracts is not obligated to deliver the underlying stocks at the expiration date. Instead, ultimate delivery is in the form of cash. This is fortunate, as it would indeed be a task to make delivery of the 500 issues in the S&P 500 Index. Basically, the amount of underlying cash is set at a certain multiple of the value of the underlying stock index. Some common examples for U.S. indexes:
|
Index |
Multiple |
|
E-mini Dow ($5) |
$5 × index$5 × index |
|
E-mini S&P 500 |
$50 × index$50 × index |
|
E-mini S&P MidCap 400 |
$100 × index$100 × index |
|
E-mini NASDAQ 100 |
$20 × index$20 × index |
|
S&P 500 |
$250 × index$250 × index |
Figure 15.4 Quotations on Financial Futures Contracts
These quotations for financial futures contracts include the daily last, prior settle, open, high, and low prices, as well as the change in price from the previous day’s closing price to the current day’s last price and the current day’s volume. The top panel shows euro futures contracts that trade on CME, the middle panel shows U.S. Treasury bond futures that trade on CBOT, and the bottom panel shows the E-mini Dow ($5) index futures.
(Source: Reprinted with permission, CME Group, 2015.)
Example
Consider a December 2015 E-mini NASDAQ 100 stock index futures contract, which stands at 4,407.25. The amount of cash underlying a single futures contract is $20 × 4,407.25 = $88,145$20 × 4,407.25 = $88,145. The amount of cash underlying an E-mini NASDAQ 100 futures contract is quite substantial; however, the initial margin amount for a single contract is a much more manageable $3,960.
Prices and Profits
Not surprisingly, the price of each type of financial futures contract is quoted somewhat differently.
· Currency futures. All currency futures are quoted in U.S. dollars or cents per unit of the underlying foreign currency (e.g., U.S. dollars per Canadian dollar or cents per Japanese yen). For example, the value of a September 2013 Japanese yen contract with a settlement price of 0.012774 is calculated as 12,500,000 yen ×$0.012774 = $159,67512,500,000 yen × $0.012774 = $159,675.
· Interest-rate futures. Except for the quotes on Treasury bills and other short-term securities, interest rate futures contracts are priced as a percentage of the par value of the underlying debt instrument (e.g., Treasury notes or bonds). Because these instruments are quoted in increments of 1/32 of 1%, a quote of 148’11 for the settlement price of the December 2015 U.S. Treasury bonds (in Figure 15.4 ) translates into 148–11/32, which converts to a quote of 148.34375% of par. Multiply this rate times the $100,000 par value of the underlying security, and we see that this contract is worth $148,343.75. The pricing conventions for the variety of other interest rate futures contracts are found in their contract specifications or often included with their quotations.
· Stock index futures. Stock index futures are quoted in terms of the actual underlying index. As noted above, they carry a face value of anywhere from $5 to $250 times the index. Thus, according to the settlement price in Figure 15.4 , the December 2015 E-mini Dow ($5) contract would be worth $87,915 because the value of this particular contract is equal to $5 times the settlement price of the index or $5 × 17,583$5 × 17,583.
Example
Suppose a September 2019 S&P 500 Stock Index contract has a settlement price of 2072.80. The contract’s market value can be calculated as follows:
$250 × 2072.80 = $518,200$250 × 2072.80 = $518,200
The initial margin requirement for this position is $25,300, which is less than 5% of the total contract value.
The value of an interest rate futures contract responds to interest rates exactly as the debt instrument that underlies the contract. That is, when interest rates go up, the value of an interest rate futures contract goes down, and vice versa. The quote system used for interest rate as well as currency and stock index futures is set up to reflect the market value of the contract itself. Thus, when the price or quote of a financial futures contract increases (for example, when interest rates fall or a stock index goes up), the investor who is long makes money. In contrast, when the price decreases, the short seller makes money.
Price behavior is the only source of return to speculators. Financial futures contracts have no claim on the dividend and interest income of the underlying issues. Even so, huge profits (or losses) are possible with financial futures because of the equally large size of the contracts. For instance, if the price of Swiss francs goes up by just $0.02 against the U.S. dollar, the investor is ahead $2,500 (i.e., 125,000 Swiss francs × $0.02125,000 Swiss francs × $0.02). Likewise, a 6-point drop in the Nasdaq 100 index means a loss of $20 × 6$20 × 6 or $120 to an E-mini Nasdaq 100 futures investor. When related to the relatively small initial margin deposit required to make transactions in the financial futures markets, such price activity can mean very high rates of return—or very high risk of a total wipeout.
Trading Techniques
Investors can use financial futures, like commodity futures, for hedging, spreading, and speculating. Multinational companies and firms that are active in international trade might hedge with currency or Euromarket futures. Various financial institutions and corporate money managers often use interest rate futures for hedging purposes. In either case, the objective is the same: to lock in the best monetary exchange or interest rate possible. In addition, individual investors and portfolio managers often hedge with stock index futures to protect their security holdings against temporary market declines. Financial futures can also be used for spreading. This tactic is popular with investors who simultaneously buy and sell combinations of two or more contracts to form a desired investment position. Finally, financial futures are widely used for speculation.
Although investors can employ any of the trading strategies noted above, we will focus primarily on the use of financial futures by speculators and hedgers. We will first examine speculating in currency and interest rate futures. Then we’ll look at how investors can use futures to hedge investments in stocks, bonds, and foreign securities.
Speculating in Financial Futures
Speculators are especially interested in financial futures because of the size of the contracts. For instance, in mid-2015, euro currency contracts were worth $139,262.50 or 125,000 euros × $1.1141125,000 euros × $1.1141, 10-year Treasury note contracts were going for 125’26 or $100,000 × 125.8125 = $125,812.50$100,000 × 125.8125 = $125,812.50 and Dow Jones Real Estate futures contracts were being quoted at $100 × 288.9$100 × 288.9 or $28,890 each. With contracts of this size, even small movements in the underlying asset can produce big price swings—and therefore big profits.
Currency and interest rate futures can be used for just about any speculative purpose. For example, if you expect the dollar to be devalued relative to the euro, you could buy euro currency futures because the contracts should go up in value, right along with the appreciation of the euro. If you anticipate a rise in interest rates, you might “go short” (sell) interest rate futures, since they should go down in value. Because margin is used and financial futures have the same source of return as commodities (price appreciation), we can measure the profitability of these contracts using return on invested capital ( Equation 15.1 ).
Going Long a Foreign Currency Contract
Suppose you believe that the Swiss franc (CHF) is about to appreciate in value relative to the dollar. You decide to go long (buy) three December 2017 CHF contracts at 0.9728—that is at a quote of just under $1.00 a franc. Each contract would be worth 125,000 CHF × 0.9728 = $121,600125,000 CHF × 0.9728 = $121,600, so the total underlying value of the three contracts would be $364,800. Given an initial margin requirement of, say, $5,400 per contract, you would have to deposit only $16,200 to acquire this position.
Now, if Swiss francs do appreciate and move up from 0.9728 to, say, 0.9965, the value of the three contracts will rise to $373,687.50. In a matter of months, you will have made a profit of $8,887.50. Using Equation 15.1 for return on invested capital, we find that such a profit translates into a 54.9% rate of return. Of course, an even smaller fractional change in the other direction would have wiped out this investment. Clearly, these high returns are not without equally high risk.
Going Short an Interest Rate Contract
Let’s assume that you’re anticipating a sharp rise in long-term rates. A rise in rates translates into a drop in the value of interest rate futures. You decide to short sell two June 2016 T-bond contracts at 147’00, which means that the contracts are trading at 147% of par. Thus, the two contracts have a value of $100,000 × 1.47 × 2 = $294,000$100,000 × 1.47 × 2 = $294,000. You need only $7,560 (the initial margin deposit is $3,780 per contract) to make the investment.
Assume that interest rates do, in fact, move up. As a result, the price on Treasury bond contracts drops to 138’16 (or1381213812). You could now buy back the two June 2016 T-bond contracts (to cover the short position) and in the process make a profit of $17,000. You originally sold the two contracts at $294,000 and bought them back sometime later for $100,000 × 1.385 × 2 = $277,000$100,000 × 1.385 × 2 = $277,000. As with any investment, such a difference between what you pay for a security and what you sell it for is profit. In this case, the return on invested capital amounts to 225%. Again, this return is due in no small part to the enormous risk of loss you assumed.
Trading Stock-Index Futures
Most investors use stock index futures for speculation or hedging. (Stock index futures are similar to the index options introduced earlier in the text. Therefore, much of the discussion that follows also applies to index options.) Whether speculating or hedging, the key to success is predicting the future course of the stock market. Because you are “buying the market” with stock index futures, it is important to get a handle on the future direction of the market via technical analysis or some other technique. Once you have a feel for the market’s direction, you can formulate a strategy for stock index futures trading or hedging. For example, if you feel that the market is headed up, you would want to go long (buy stock index futures). In contrast, if your analysis suggests a drop in equity values, you could make money by going short (sell stock index futures).
Assume, for instance, that you believe the market is undervalued and a move up is imminent. You can try to identify one or a handful of stocks that should go up with the market (and assume the stock selection risks that go along with this approach), or you can buy an S&P 500 stock index futures contract currently trading at, say, 2101.60. To execute this speculative transaction, you would need to deposit an initial margin of $25,300. Now, if the market does rise so that the S&P 500 Index moves to, say, 2176.6 by the expiration of the futures contract, you earn a profit of (2,176.6 − 2,101.6) × $250 = $18,750(2,176.6 − 2,101.6) × $250 = $18,750. Given the $25,300 investment, your return on invested capital would amount to a hefty 74%. Of course, keep in mind that if the market drops by 75 points (or 3.6%), the investment will be a total loss.
Hedging with Stock Index Futures
Stock index futures are also used for hedging. They provide investors with a highly effective way of protecting stock holdings in a declining market. Although this tactic is not perfect, it does enable investors to obtain desired protection against a decline in market value without disturbing their equity holdings.
Here’s how a so-called short hedge would work: Assume that you hold a total of 2,000 shares of stock in a dozen companies and that the market value of this portfolio is around $235,000. If you think the market is about to undergo a sharp decline, you can sell all of your shares or buy puts on each of the stocks. You can also protect your stock portfolio by short selling stock index futures.
Suppose, for purposes of our illustration, that you short sell three E-mini Dow ($5) stock index futures contracts at 17672. These contracts would provide a close match to the current value of your portfolio since they would be valued at 3 × $5 × 17,672 = $265,0803 × $5 × 17,672 = $265,080. Yet these stock index futures contracts would require an initial margin deposit of only $4,290 per contract, or a total deposit of 3 × $4,290 = $12,8703 × $4,290 = $12,870 Now, if the DJIA drops, causing the value of your futures contract to drop to 17165, you will make a profit of $7,605 from this short sale. That is, because the futures contract value fell 507 points (17,672 − 17,165)(17,672 − 17,165), the total profit is 3 × $5 × 507 = $7,6053 × $5 × 507 = $7,605. Ignoring margin costs and taxes, you can add this profit to the portfolio (by purchasing additional shares of stock at their new lower prices). The net result will be a new portfolio position that will approximate the one that existed prior to the decline in the market.
Investor Facts
Triple Witching Day Watch out for the third Friday in March, June, September, and December. It’s “triple witching day,” when stock options, stock index options, and stock index futures all expire more or less simultaneously. On these days, the equities markets are more volatile than usual because speculators and traders may have to buy or sell large quantities of stock or index positions to fulfill their obligations. As a result, stock prices may fluctuate considerably, creating bargains or windfall profits.
To reduce the impact of triple witching day, the exchanges now spread the expirations of the options so that they occur throughout the day, instead of within an hour of each other. For example, the S&P 500 Index options and futures expire at the start of that business day, while individual stock options and the S&P 100 Index options expire at the close of that day.
How well the “before” and “after” portfolio positions match will depend on how far the portfolio dropped in value. If the average price dropped about $5 per share in our example, the positions will closely match. But this does not always happen. The price of some stocks will change more than that of others, so the amount of protection provided by this type of short hedge depends on how sensitive the stock portfolio is to movements in the market. Thus, the types of stocks held in the portfolio are an important consideration in structuring a stock index short hedge.
A key to success with this kind of hedging is to make sure that the characteristics of the hedging vehicle (the futures contract) closely match those of the portfolio (or security position) being protected. If the portfolio is made up mostly (or exclusively) of large-cap stocks, use something like the S&P 500 Stock Index futures contract as the hedging vehicle. If the portfolio is mostly blue-chip stocks, use the DJIA contracts. If the portfolio holds mostly tech stocks, consider the Nasdaq 100 Index contract. Again, the point is to pick a hedging vehicle that closely reflects the types of securities you want to protect. If you keep that caveat in mind, hedging with stock index futures can be a low-cost yet effective way of obtaining protection against loss in a declining stock market.
Hedging Other Securities
Just as you can use stock index futures to hedge stock portfolios, you can use interest rate futures to hedge bond portfolios. Or, you can use currency futures with foreign securities as a way to protect against foreign exchange risk. Let’s consider an interest rate hedge. If you held a substantial portfolio of bonds, the last thing you would want to see is a big jump in interest rates, which could cause a sharp decline in the value of your portfolio. Assume you hold around $300,000 worth of Treasury and agency bonds, with an average maturity of 18 years. If you believe that market rates are headed up, you can hedge your bond portfolio by short selling three U.S. Treasury bond futures contracts. (Each T-bond futures contract is worth about $100,000, so it would take three of them to cover a $300,000 portfolio.) If rates do head up, you will have protected the portfolio against loss. As noted above, the exact amount of protection will depend on how well the T-bond futures contracts parallel the price behavior of your particular bond portfolio.
There is, of course, a downside. If market interest rates go down rather than up, you will miss out on potential profits as long as the short hedge position remains in place. This is so because the profits being made in the portfolio will be offset by losses from the futures contracts. Actually, this will occur with any type of portfolio (stocks, bonds, or anything else) that is tied to an offsetting short hedge. When you create the short hedge, you essentially lock in a position at that point. Although you do not lose anything when the market falls, you also do not make anything when the market goes up. In either case, the profits you make from one position are offset by losses from the other.
Hedging Foreign Currency Exposure
Now let’s see how you can use futures contracts to hedge foreign exchange risk. Let’s assume that you have just purchased $200,000 of British government one-year notes. (You did this because higher yields were available on the British notes than on comparable U.S. Treasury securities.) Because these notes are denominated in pounds, this investment is subject to loss if currency exchange rates move against you (i.e., if the value of the dollar rises relative to the pound).
If all you wanted was the higher yield offered by the British note, you could eliminate most of the currency exchange risk by setting up a currency hedge. Here’s how: Let’s say that at the current exchange rate, 1 U.S. dollar will “buy” 0.606 of a British pound. This means that pounds are worth about $1.65 (i.e., $1.00/0.606£ = $1.65$1.00/0.606£ = $1.65). So, if currency contracts on British pounds were trading at around $1.65 a pound, you would have to sell two contracts to protect the $200,000 investment. Each contract covers 62,500 pounds; if they’re being quoted at 1.65, then each contract is worth $103,125.
Assume that one year later the value of the dollar has increased relative to the pound, so that 1 U.S. dollar will now “buy” 0.65 pound. Under such conditions, a British pound futures contract would be quoted at around 1.54 (i.e., $1.00/.065£ = $1.54$1.00/.065£ = $1.54). At this price, each futures contract would have a value of 62,500 × $1.54 = $96,25062,500 × $1.54 = $96,250. Each contract, in effect, would be worth $6,875 less than it was a year ago. But because the contract was sold short when you set up the hedge, you will make a profit of $6,875 per contract—for a total profit of $13,750 on the two contracts. Unfortunately, that’s not net profit because this profit will offset the loss you will incur on the British note investment. In very simple terms, when you sent $200,000 overseas to buy the British notes, the money was worth about £121,000. However, when you brought the money back a year later, those 121,000 pounds purchased only about 186,500 U.S. dollars. Thus, you are out some $13,500 on your original investment. Were it not for the currency hedge, you would be out the full $13,500, and the return on this investment would be a lot lower. The hedge covered the loss (plus a little extra), and the net effect was that you were able to enjoy the added yield of the British note without having to worry about potential loss from currency exchange rates.
Financial Futures and the Individual Investor
Like commodities, financial futures can play an important role in your portfolio so long as three factors apply: (1) You thoroughly understand these investments. (2) You clearly recognize the tremendous risk exposure of these investments. (3) You are fully prepared (financially and emotionally) to absorb some losses.
Financial futures are highly volatile securities that have enormous potential for profit and for loss. For instance, the September 2015 S&P 500 futures contract traded at a low of 1963.50 on January 1, 2015, and a high of 2122.00 on June 1, 2015. This range of 158.5 points for a single contract translated into a potential profit—or loss—of $250 × 158.5 = $39,625$250 × 158.5 = $39,625 and all from an initial margin investment of only $25,300. Investment diversification is obviously essential as a means of reducing the potentially devastating impact of price volatility. Financial futures are exotic investments, but if properly used, they can provide generous returns.
Options on Futures
The evolution that began with listed stock options and financial futures spread, over time, to interest rate options and stock index futures. Eventually, it led to the creation of the ultimate leverage vehicle: options on futures contracts. Futures options , as they are called, represent listed puts and calls on actively traded futures contracts. In essence, they give the holders the right to buy (with calls) or sell (with puts) a single standardized futures contract for a specific period of time at a specified strike price.
Such options can be found on both commodities and financial futures. Notice that each of the corn futures contracts quoted in Figure 15.3 include an options icon under each contract delivery month, indicating that a futures option exists for that futures contract. In fact, the CME Group quotations allow you to click on the options icon to access the futures options quotations. Figure 15.5 shows the options quotations for the July 2015 corn futures contract quoted in Figure 15.3 . For the most part, these puts and calls cover the same amount of assets as the underlying futures contracts—for example, 112,000 pounds of sugar, 100 troy ounces of gold, 62,500 British pounds, or $100,000 in Treasury bonds. Thus, they also involve the same amount of price volatility as is normally found with commodities and financial futures.
Futures options have the same standardized strike prices, expiration dates, and quotation system as other listed options. Depending on the strike price on the option and the market value of the underlying futures contract, these options can also be in-the-money or out-of-the-money. Futures options are valued like other puts and calls—by the difference between the option’s strike price and the market price of the underlying futures contract. They can also be used like any other listed option—for speculating or hedging, in options-writing programs, or for spreading. The biggest difference between a futures option and a futures contract is that the option limits the loss exposure to the price of the option. The most you can lose is the price paid for the put or call option. With the futures contract, there is no real limit to the amount of loss you can incur.
To see how futures options work, assume that you want to trade some gold contracts. You believe that the price of gold will increase over the next four or five months from its present level of $1,160.80 an ounce. You can enter into an August 2016 futures contract to buy gold at $1,163.90 an ounce by depositing the required initial margin of $4,125. Alternatively, you can buy a futures call option with a $1,160 strike price that is currently being quoted at $9.80. Because the underlying futures contract covers 100 ounces of gold, the total cost of this option would be 100 × $9.80 = $980100 × $9.80 = $980. The call is an in-the-money option because the market price of gold exceeds the exercise price on the option. The following table summarizes what happens to both investments if the value of the gold futures contract increases to $1,182.54 an ounce by the expiration date and also what happens if the value of the gold futures contract drops to $1,139.75 an ounce.
|
|
Futures Contract Futures Option |
|||
|
Price Change |
Profit (or Loss) |
Return on Invested Capital |
Profit (or Loss) |
Return on Invested Capital |
|
If futures contract value increases to $1,182.54 an ounce |
$1,864 |
45.2% |
$1,274 |
130% |
|
If futures contract value decreases to $1,139.75 an ounce |
($2,415) |
−58.5% |
($980) |
−100% |
Figure 15.5 Quotations on Corn Futures Options Contracts
This quotation for call and put options on corn futures contracts includes the daily last, open, high, and low prices, as well as the prior settle and strike price. It also provides the change in price from the previous day’s closing price to the current day’s last price, the current day’s volume, and the Hi/Lo limit.
(Source: Reprinted with permission, CME Group, 2015.)
Clearly the futures option provides a superior upside rate of return but also a reduced exposure to loss since the maximum loss is limited to the price of the options. Futures options offer interesting investment opportunities. But as always, they should be used only by knowledgeable commodities and financial futures investors.
Concepts in Review
Answers available at http://www.pearsonhighered.com/smart
1. 15.10 What is the difference between physical commodities and financial futures? What are their similarities?
2. 15.11 Describe a currency future and contrast it with an interest rate future. What is a stock index future, and how can it be used by investors?
3. 15.12 Discuss how stock index futures can be used for speculation and for hedging. What advantages are there to speculating with stock index futures rather than specific issues of common stock?
4. 15.13 What are futures options? Explain how they can be used by speculators. Why would an investor want to use an option on an interest rate futures contract rather than the futures contract itself?