Chapter 17

FUTURES

Futures have a long history. For centuries, producers and traders of goods have agreed on prices long in advance of the delivery, or even the production, of the goods being offered for sale. Indeed, without such forward commitments, the large trading networks of a modern economy would be difficult if not impossible. Markets for trading of standardized contracts in futures evolved as a means to lower the costs and risks of trade, both to the producer and consumer of goods, by transferring that risk to a financial intermediary willing and able to accept that risk in exchange for some compensation.

A Seller’s Need to Hedge . . .

To see how the need for futures arose, consider the case of a farmer who grows soybeans. Many factors influence the income he can derive from selling his beans at market. How large his crop is depends on many local conditions, including weather, soil, the quality of the seeds, loss due to harmful insects and other pests, and effectiveness of insecticides. All other things being equal, the more beans he produces, the more money he will receive when it comes time to sell. It is, however, quite unlikely that local conditions alone determine the value of the farmer’s crop. Shortages, oversupplies, and shifts in demand can all have a major impact on the price he receives, making it very difficult for him to keep his farm financially healthy. If, on the other hand, he could lock in a future price for his soybeans sufficiently far in advance, he would have a less volatile asset—cash—with which to meet his liabilities.

Example of Seller Hedging with Futures

Let’s say a farmer expects to have one million bushels of soybeans to sell. He can proceed in one of several ways. The most obvious is to wait until the beans are harvested and then deliver them to a local elevator, selling them at whatever market price prevails at that time. But this leaves him open to the risk that the price of soybeans will fall when he is ready to sell. One alternative is to enter into a forward contract, locking in a cash price for the soybeans before they are sold. The other alternative is to sell an appropriate number of soybean futures contracts before the harvest, thereby locking in a sales price.

 

Either of these alternatives will protect his gross profit margin (GPM)—even though the soybeans themselves won’t be sold for another two months. The futures market approach offers more flexibility, but also more risk, than the forward contract. The flexibility comes from the existence of an active market in soybean futures. The risk derives from the difference between the type and the location of the beans specified by the standard futures contract and the beans that the farmer is selling. It is called basis risk.

Most likely the soybean futures will be sold at the Chicago Board of Trade (CBOT, now part of the CME Group), where soybean futures have been traded since the 1930s. At the CBOT, each soybean contract is for 5,000 bushels of number 2 yellow soybeans. There are six separate contracts per year, expiring in alternate months: January, March, May, July, September, and November.

basis risk

Risk deriving from variations in type and quality between a marketable commodity and the specific commodity described in a standard futures contract.

Some Buyers Need to Hedge, Too

Further up the food chain, a food processor consumes prodigious amounts of soybeans in the manufacture of soybean oil and meal. Market forces constantly change the relationship between the price of the processor’s raw material (soybeans) and its finished product (oil and meal). If the price of soybeans soars, the food processor may find its GPM shrinking dangerously. This can be avoided by a combination of buying futures in the raw material and selling futures in the finished product. Soybean oil and meal contracts have been traded on the CBOT for nearly 50 years. Together, the three contracts (soybeans, soybean oil, and soybean meal) are referred to as the soybean complex.

Speculation or Insurance? Maybe a Little of Both

So it is evident that there are occasions when it makes sense for buyers and sellers to hedge their price risks by contracting for future sale, through forwards or futures contracts. When sufficient numbers of buyers and sellers have an interest in hedging, futures markets emerge as places for buyers and sellers to meet. As in other markets, the broker’s role is to facilitate market liquidity.

What is the relationship between prices in the spot market and the futures market? Putting aside possible differences in contract terms, how prices in the spot market for a commodity relate to prices in the futures market will depend on many factors, including supply and demand forces in these markets, liquidity, financial forecasts, and importantly, arbitrage possibilities arising from differences in costs of maintaining positions in these markets. These costs include insurance and storage costs until delivery is taken on a physical commodity; margin costs for leveraged positions; and opportunity costs for capital tied up in a commodity (unless it can be used as collateral for other investments).

arbitrage

Buying and selling of equivalent investments to take advantage of mispricings in different markets.

Actuals versus Cash-Settled Contracts

Futures may be classified by the way in which the contracts are settled at expiration. Futures contracts in a physical commodity are settled by the actual delivery of the underlying good, whether it is gold bars or pork bellies. “Delivery” does not necessarily mean that the goods physically change hands; ownership of the goods is what changes.

Cash-settled contracts do not involve any change in ownership of the underlying asset. Instead, the value of the asset is calculated by predetermined rules, and the contract is concluded with a cash payment. This is the way that index futures are settled. These futures’ value is linked to an index such as the S&P 500 or the S&P Goldman Sachs Commodity Index (S&P GSCI). While it would be theoretically possible to “deliver” such an index, in practical terms, cash settlement makes far more sense.

What Is Triple Witching Friday?

Sometimes, around a particularly volatile day in the markets, you may hear about triple witching Friday. This is a day on which three related contracts expire: index options, index futures, and options on the index futures. Triple witching Friday occurs four times a year, on the third Friday of March, June, September, and December.

Margin and Collateral

Futures contracts, like many stocks, can be purchased on margin. In the case of futures, however, the amount of initial margin can be very low, often as low as 10 percent. The result is that a small initial investment is often said to “control” a large position. The word control may be inappropriate, however. Each day the position is marked to market, meaning that its current value is determined and any loss in the large position is subtracted from the value of your net position. Over time, even modest price movements can precipitate a margin call, the broker’s demand for additional funds to bring the ratio of funds left in the account back over the minimum threshold. In fact, a sudden price move could precipitate a margin call at any time. Failure on the part of the customer to come up with the required margin allows, and in some cases requires, the broker to close out the position, erasing any assets you had in the account and potentially leaving you with a liability for costs incurred by the broker.

An Example of Marking to Market

Let’s say you purchase a single soybean futures contract on the CBOT. The cost of the contract is the price of soybeans, say $6.50 per bushel, times the number of the bushels in a contract, 5,000:

Total cost: $6.50 X 5,000 = $32,500

Do you have to come up with $32,500? Not at all. What you need is only a small percentage of the full cost—namely, the cost times the initial margin requirement. Let’s say the broker sets an initial margin requirement of 10 percent. That means you must deposit $3,250 into the margin account you have set up with that broker. The rest of the money is a loan from the broker, on which you pay interest.

 

Each day, the broker determines the value of your futures position. Let’s say that soybeans increase in price by 10 percent. The contract is now worth $35,750. Your position, however, has done even better. You put up only $3,250, but now you have a position worth $6,500. You have doubled your money.

 

Now let’s assume that the market declines to the point that your position is worth less than, say, 5 percent of the total value of the contract. This triggers a maintenance margin call from your broker. You must come up with additional money immediately or face being closed out—having the position sold by the broker in order to protect the money he or she loaned you. In the worst case, by the time the broker sells out your position, the contract is worth less than the loan, in which case you’ve lost your entire investment and owe the broker the difference between the amount realized on the sale and amount he or she loaned you—plus interest and commissions.

For these reasons, many individual investors avoid the futures markets entirely. For those who wish to participate in these markets, caution is advisable. One way for individuals to participate is through managed (futures) accounts. These are investment partnerships that trade futures, primarily for institutions and high-net-worth individuals. Such accounts, like the underlying futures, are usually highly leveraged investments, offering high potential returns—with high levels of risk.