Futures and Options Note 1

Basic Definitions:

Derivative Security: A security whose value depends on the worth of other basic underlying variables.
E.G. Futures, Options, Forward Contracts, Swaps. A derivative is a financial instrument whose value is
derived from that of another security. Consequently, the worth of a derivative contract is contingent
of that of another investment [stock, fixed income security, commodity, etc.].

Contingent Claims: A stock option that is a derivative security whose value is contingent on the price of
the stock.

Derivatives can be used in one of two ways: (1) to hedge an underlying position where an investor
hedges financial risk in the cash market by taking the opposite position in a derivative contract or (2) to
speculate by using the derivative security to implicitly buy or sell an underlying security on a leveraged
basis.

Contract Overview:
A futures contract is a transferable agreement to make [short] or take [long] delivery of a standardized
amount and designated quality, at a specified price, at a specified date in the future some tangible
[commodity, financial instrument] or intangible [index] entity.

Note: With a futures contract there is the obligation to make or take delivery NOT an option to make
or take delivery.

A futures market consists of contracts to make or take delivery, however generally these contracts are
negotiated with view of NOT making or taking delivery, but rather to:

Speculate on anticipated price movements

Hedge an existing or anticipated position in the cash market
Arbitrage inconsistent prices among financial securities or commodities.
Differences between Futures vs. Cash [Spot]Market

The majority of contracts are settled by offset, which means that prior to expiration, the owner of the
futures contract will take the opposite position by purchasing or selling a futures contract to offset the
current futures position.

Futures Market

Organized Exchange
[Auction, Open Outcry] Deal, Broker, Direct
Performance Guaranteed [by Clearinghouse]
Contract Standardization
Transferability
High degree of liquidity and information on price of the financial security
Fixed location, fixed trading hours
Brokerage fees charged Brokerage fees or Bid/Asked Spread
Margin Requirements
Contracts generally settled by offset
Regulated by CFTC Loosely regulated by the SEC under SEC Acts of
1933 and 1934

The Futures Market

A futures contract is a commitment to buy or sell a specific commodity, financial instrument or index, of
designated quality at a specified price at a specified date in the future.

The futures market consists of contracts to make or take delivery in commodities, financial instruments
or indexes. The intent of traders in this market is to take one of three possible positions:
(1) Speculate on anticipated price movements
(2) Hedge an existing or anticipated position that they may have in the cash (spot) market
(3) Arbitrage inconsistent prices among financial securities

and depending on which of this strategies they are using, they will be in a position for several hours
[short term, day trader] or many days [long term trader].

Although commodities and financial instruments are deliverable, the vast majority [98%] of all contracts
are settled by offset rather than delivery sometime over their life. In the case of a financial index futures
contract, there can be no delivery since it would be impossible to deliver all to the basket of securities
into the contract. Consequently, a financial index futures contract will trade based on the market value
of the index and settlement is at, wherever the index is at the time of offset.

A forward contract is a cash market transaction in which two parties agree to the purchase and sell of a
commodity or financial instrument at some future time under such conditions as the two agree.
Note: The forward contract is a negotiated contract, and generally, one that is similar to a European call,
you don’t know whether you have made or lost money in the transaction until the time of expiration.
With the marking to market of a futures contract, you will know whether you are making or losing
money and have the ability to exit the contract at any time prior to expiration.

Differences between Futures and Forwards Contracts

1. Terms and Conditions of the Contract
Forward: Negotiated, subject to interpretation, min. size: $ 1 million for competitive price
Futures: Standard provisions, not exceptions, delays in performance penalized, min. size: $100K

2. Margins

Forward: No initial margin required unless negotiated, no daily mark to market until delivery
Futures: Initial margins are always required, posted in cash or T-Bills, oversight by the CBOT Clearing
Corp., maintenance margin required to maintain initial margins requirement.
3. Liquidity

Forward: Very difficult because the contracts are custom and in order to unwind them you must
have both parties agree to have some other entity take over a position. [Low]

Futures: Can be offset at any time by buying or selling a contract with the same expiration date
and contract characteristics. [High]

4. Pricing

Forward: Negotiated through a dealer intermediary or directly with the parties. Price is
Is determined on what may be viewed as mutually beneficial and agreeable.
Spread on fixed rate commitments: 2/32 to 8/32

Futures: Prices are displayed nationally in real time and is based on what the market will bear
for each contract. Spread on fixed rate contracts: 1/32

5. Accounting

Forward: mark to market only at the time of expiration [European futures contracting]

Futures: mark to market daily based on how the contracts are being valued in the market
[American Futures Contracting].

6. Credit Risk

Forward: Only as good as either party in terms of fulfillment of the contract, which will not be
completely known until expiration.

Futures: Trades are guaranteed by a clearing broker and the CBOT Clearing Corp.

Summary: Futures and forward markets are designed to let people eliminate price risk inherent in
certain financial transactions that call for future delivery of money, financial instruments, or a
commodity. These markets will also allow for positions to be taken relative to financial indexes to be
able to hedge price risk associated with large baskets of commodities or financial instruments. In this
case, the futures position can be settled by offset, whereas, the forward can only be resolved through
negotiation or a final determination of gain/loss at time of expiration

7. Delivery

Forward: tailored to fit the needs of participants.

Futures: delivery date and contract size standardized.

8. Commissions

Forward: Bid/Ask Spread

Futures: Published rates [either flat or based on size of contract]

9. Security Deposit

Forward: Negotiable

Futures: 3 to 8% of the contract position

10. Accessibility and Regulation

Forward: Mostly large customers who contract amongst a large set of financial institutions; Self
regulating

Futures: Anyone who can come up with the initial commission and pay margin; CFTC, SEC and the
Exchanges

Futures and forward markets are designed to let people eliminate price risk inherent in transactions that
call for future delivery of money, a security or commodity. They do so by allowing people to establish
the terms of exchange prior to the scheduled delivery date.

E.G. Futures on Fixed Income Securities [Fixed Rate/Bonds]

Buy Contracts (Long) are purchased if bond prices are expected to rise (interest rates fall) and sell
(Short) contacts are purchased if prices are expected to fall (interest rates rise).

Differences Between the Futures and Cash (Spot) Markets

Futures Market Cash (Spot) Market

Organized Exchange (Auction, Open Outcry) Dealer, Broker, Direct Placement

Performance Guarantee by Clearing Corp. No guarantee

Standardized Contract Agreements not Standardized

Contracts Transferable Agreements May Not Be Transferable

Highly Liquid Less Liquid – depends on marketability of security

Brokerage Fee Charged Brokerage Fee or Bid/Ask Spread

Margin Requirement (initial/maintenance) Margin less likely

Usually settled by Offset Usually results in physical delivery

Regulated by the CFTC through Ag Dept. Loosely Regulated through the SEC

Types of Futures Contracts

Short Term Contracts: Based on $ 1 million par value with the underlying security having a duration of
90 days of less(e.g. T-Bill Contract priced based on discount)

Long Term Contracts: Based on $100K - $200K par value with the underlying security having a duration
of 10 years or longer

Long Term Contract Examples

Type Par Value Sample Quote Min. Fluctuation Tick Value

2-Yr. Treas. Note $200,000 102.225 ¼ of 1/32 1 pt. =$2,000

1 Tick = $2,000/ 4 x 32

= $15.625

10-Yr. Treas. Note $100,000 99.10 1/32 1 pt. = $1,000

1 Tick = $1,000/32

= $31.25

30-Yr. Treas. Bond $100,000 114.10 1/32 1 pt. = $1,000

1 Tick = $31.25

Short Term Contract Examples

Eurodollar Time Deposit $1,000,000 90.07 .01% of Index Value Tick Value = $25

90-day Domestic CDs $1,000,000 91.06 .01% of Index Value Tick Value = $25

13-Week US T-Bills $1,000,000 92.01 .01% of Index Value Tick Value = $25

1 Point = 100 ticks = $25 x 100 or $2,500

NOTE: The short term contracts can not be settled by delivery, but rather offset because there is no
underlying instrument on which the futures contract is based. The underlying is an index consisting of a
set of securities. This delivery method has certain advantages or disadvantages based on the purpose on
which the contract is being used [to hedge interest rate risk or speculate on a fundamental move in
rates].

Fulfillment Requirements when Settling a Futures Contract

Most contracts are settled by offset, however when delivery occurs deliver occurs according to the
following process:

The short indicates their decision to initiate deliver:

Day 1: Notification of Intention Day – short informs broker of intention to deliver. Announcement can
take place on any during the delivery month. (Note: with T-Bonds any day, except the last 8 days of the
deliver month is acceptable); the broker then informs the clearing house of impending delivery.

Day 2: Position Day – the Clearing House selects the oldest standing long to receive delivery and tells the
long of the soon to be completed delivery.

Day 3: Settlement Day – the long settles with the short, by paying the short the:

Original Contract Price x # Contracts x Size of each Contract

and then the short delivers to the long the asset/title to complete the contract.

Reasons why an institution or individual entity may use futures relate to: uncertainty with respect to
inflation, level of interest rates, foreign exchange, price movements in commodities all of which create a
need to transfer risk.

Underlying Risk Factors:

Rapid Growth in Monetary Base

Primary Focus of the Fed. Reserve on Controlling Monetary Aggregates (Not Interest Rates)

Floating Exchange Rates Balance of Trade Deficits, US Dollar Balances Overseas, Price of Oil [as a
defacto currency]
Use of Overseas Balances Denominated in US Dollars

Eurodollar Time Deposits – time deposits denominated in dollars held in banks outside the US,

Including foreign branches of US Banks.

Motivation for US Depositors

=== To obtain higher interest rates on funds deposited with a foreign bank, and at the same time face
no current exchange rate risk because the deposit remains in US Dollars.

Creation of a Euro$ Time Deposit

GE currently holds $50 billion in a Chase time deposit. However, GE determines it can earn a higher rate
of interest elsewhere. Not wanting to lose the deposit, Chase suggests that GE deposit the $50 bilion as
a Euro$ deposit at its London Branch where deposits earn a higher rate of interest. All transactions are
carried out through CHIPS (the Clearing House Interbank Payment System) and consists exclusively of
paper transfers. At no time does the Euro$money actually leave the US. Funds that start in the US stay
there – the accounting entries are as follows:

GE B/S Chase, NY B/S

Chase Savings -50 Reserves - 50 | Savings -50

Euro$Deposit London +50 Reserves +50 | London Office Acct. +50

“due to” Chase NY  Chase, London

Chase, London

NY Office Acct. +50 | Euro $ Deposit +50

“due to” Chase, London  Chase, NY

Note: Interest received and technically held overseas may be subject to tax advantages in regards to the
treatment of income –i.e., GE may benefit from holding Euro$ deposits because they can defer taxes on
the income until it is repatriated back into the US. [A major externality in favor of US Corporations].
Futures Market Participants

Exchanges are organizations incorporated in the states where they reside. The organization is governed
by the membership – Full or Associate members are bought and sold and have ranged dramatically in
price based on market conditions over time.

Some exchanges, such as the Chicago Board of Trade [CBOT] have conditional memberships which
provide some benefits enjoyed by full members.

CBOT = 1402 memberships, 681 Associate Memberships, 9 conditional Memberships.

22 Members of the Board of Governors and approximately 500 staff members.

CME (Chicago Mercantile Exchange)

1,300 Memberships

24 Members of the Board of Governors

Approximately 292 staff members.

4 Major Futures Market Participants

Trading Volume Open Interest

Floor Traders 40% 3%

Arbitraguers 15% 5%

Speculators 24% 30%

Commercial Hedgers 21% 62%

Open Interest = total number of contracts not offset or satisfied by delivery for a given contract.

Floor Traders:
(1) Scalpers – traders who seek to take advantage of short term changes in the price of a
contract.

= Their roles resemble that of a stock specialist, although scalpers are not obligated to make a
market.
 (2) Day Traders – a type of scalper who focuses on intra-day changes in the value of contracts.
-Carries a longer position in larger amounts, some follow a trend, others are contrarian.

(3) Position Traders – take positions based on expectations of price movements over several
days; transactions are based on basic shifts in supply/demand for actuals (underlying assets
In the spot market).

Arbitrageurs
Ensure cash and futures prices converge at delivery. An arbitrageur seeks to exploit differences
between the futures price and the cost to carry in relation to spot prices on commodities. If there are
significant anomalies then there may be cash and carry, or reverse cash and carry arbitrage. For
example, if the futures price + cost to carry is significantly less than the spot price, then an arbitrageur
will simultaneously sell the commodity in the cash market and buy the futures contract for future
deliver into the short cash market position --- thereby locking in a profit on the difference between the
cash price less the futures price [which is called basis].

Note: Arbitrage makes the markets more efficient == by taking the above mentioned arbitrage
position, the cash price will be driven down, and the futures price will go up in response to increase
demand, thereby narrowing the basis to the point where the only difference equals the cost to carry
[which implies no excess profits].

Speculators
Assume price risk on futures contracts as they attempt to anticipate commodity [or financial
asset] price changes.

Past statistical characteristics of Speculators

Approx. 200,000 Active Speculators

50% over 50; 15% less than 35

36% in the market have been trading more than 6 years

Commercial Hedgers

Consists of Institutions (Banks, Insurers, Grain Companies, Brokers, Large Farm Operations,
Manufactures] with underlying securities or commodities that need to be hedged. They are
taking positions over the period when they hold the securities or commodities, or may be
 seeking to acquire them in a short period of time. These hedgers will maintain a position for as
long as they need to maintain price and so their activities account for a large amount of open
interest in the futures market.

Corn Futures Contract Specification [CME Group]

Source: www.cmegroup.com

Contract Size: 5,000 Bushels [approx.. 127 metric tons]

Deliverable Grade: #2 Yellow at contract price; #1 at a 1.5 cent/bushel premium, #3 Yellow

at a 1.5 cent discount

Pricing Unit: Cents per bushel

Tick Size (min. fluctuation): ¼ of one cent per bushel (i.e., $12.50 per contract).

5,000 bushels x ¼ = 1,250 cents  1,250 cents/ 100 = $12.50

Contract Months/Symbols: March (H), July (N), September (U) & December (Z)

Trading Hours: CME Globex (Electronic Platform):

Sunday-Friday 7 PM to 7:45 CT and

Monday – Friday, 8:30AM-1:15 PM CT

Open Outcry Auction on Trading Floor:

Monday – Friday, 8:30 AM to 1:15 PM CT

Daily Price Limit: View Daily Price Limits for initial and expanded price limits. There shall
be no price limits on the current month contact on or after the second
business day preceding the first day of the delivery month.

Settlement: Daily Grains Settlement – see specifications at website

Final Settlement Procedure – see specifications at website

Last Trade Date: The business day prior to the 15 calendar day of the contract month.

Last Delivery Date: The second business day following the last trading day of the delivery
month.

Product Ticker Symbols: CME Globex (Electronic Platform): ZC

Open Outcry (Trading Floor): C

 Example of a Corn Futures Hedge

A Grundy Center, Iowa farmer has 500 acres of high yielding land that produces 150 bushels of
corn per acre each growing season. In May 2013, the 500 acres were planted in corn and then
insured against hail and wind crop damage. Input costs including fertilizer, seed, insurance, and
chemicals amounted to $1.75 per acre. At the time of planting spot corn prices for standard 1
was $4.50. After about 4 weeks into the growing season, although there had been some major
storms in Grundy County, the field was a good share and likely to produce at of above 150
bushels corn per acre. Across the state of Iowa, and Illinois there had been no major drought,
hail, excess rain or wind damage to crops. Consequently, by June 12th the price of corn is down
to $4.25 per acre. Given this emerging situation, the farmer is concerned that there may be
excess supply of corn at the time of harvest leading to lower corn prices. Lower prices could
mean a substantial loss in profit or no profit at all. Therefore, this farmer is looking at using a
CME corn futures contract to lock in $4.25 per bushel corn which will guarantee him a profit this
year.

The 90-day futures prices for corn [i.e., Sept. ] are as follows

Bid Asked

1 Contract [5,000 Bushels] 4.25 4.30

Delivery Date: September 15th.

How might this farmer use the futures market to hedge his underlying corn crop price exposure?

The hedge must involve locking in the $4.25 price on the Sept. futures contract and then either
delivering the corn at the end of the growing season into the contract or settling the contract by
offset and then selling the corn at the local grain elevator. Therefore the farmer will take a
short [sell] position by selling contracts at the 4.25 bid price, and put down the initial and
maintenance margin to retain the position until September.

How much corn does the farmer expect to produce this year?

The answer to this question depends on a fairly accurate assessment of how many bushels of corn the
farm is able to produce this year. In order to deal with this uncertainty it would be useful to perform
sensitivity analysis under several different yield scenarios [e.g. 100, 150, 200 bushels of corn per acre] in
order to gauge how this might impact futures results. For purposes of this problem, we will go with 150
bushels an acre—the mathematics will be the same using other viable estimates.

How many contracts should be shorted?

The number of contracts, in this case, will be equal to:

75,000 bushels of corn produced/5,000 bushels per contract = 15 contracts.