Lecture 7 Futures Markets and Pricing Prof. Paczkowski Lecture 7 Futures Markets and Pricing Prof. Paczkowski Rutgers University Spring Semester, 2009 Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 1 / 65 Lecture 7 Futures Markets and Pricing Prof. Paczkowski Part I Assignment Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 2 / 65 Assignment Lecture 7 Futures Markets and Pricing Prof. Paczkowski Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 3 / 65 Lecture 7 Futures Markets and Pricing Prof. Paczkowski Introduction Part II Background Financial Markets Forward Markets Introduction Futures Markets Roles of Futures Markets Existence Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 4 / 65 Pricing Incorporating Risk Profiting and Offsetting Futures Concept Lecture 7 Futures Markets and Buyer Seller Pricing Wants to buy Prof. Paczkowski Situation - but not today Introduction Price will rise Background Expectation before ready Financial Markets to buy Forward Markets 1 Futures Markets Buy today Roles of before ready Futures Markets Strategy 2 Buy futures Existence contract to Roles of Futures hedge losses Markets Locks in low Result Futures price Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 5 / 65 Pricing Incorporating Risk Profiting and Offsetting Futures Concept Lecture 7 Futures Markets and Buyer Seller Pricing Wants to buy Wants to sell Prof. Paczkowski Situation - but not - but not Introduction today today Price will rise Price will fall Background Expectation before ready before ready Financial Markets to buy to sell Forward Markets 1 1 Futures Markets Buy today Sell today Roles of before ready before ready Futures Markets Strategy 2 Buy futures 2 Sell futures Existence contract to contract to Roles of Futures hedge losses hedge losses Markets Locks in low Locks in high Result Futures price price Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 6 / 65 Pricing Incorporating Risk Profiting and Offsetting Background Lecture 7 Futures Markets and Pricing Modern futures trading began in the early 1800s and was tied Prof. Paczkowski closely to the development of Chicago as a grain terminal Introduction As grain trade expanded, problems of supply and demand, Background transportation, and storage led to a chaotic marketing Financial situation. Markets Forward Markets Futures Markets To stabilize the situation, a central marketplace The Roles of Chicago Board of Trade (CBOT) was formed in 1848. Futures Markets Purpose: to promote commerce in the city by providing a Existence place where buyers and sellers could meet to exchange Roles of Futures commodities. Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 7 / 65 Pricing Incorporating Risk Profiting and Offsetting Background (Continued) Lecture 7 Futures Markets and The CBOT introduced the first standardized forward contract, Pricing Prof. called a "to-arrive" contract. Paczkowski Later it established rules for trading contracts and Introduction developed a system in which traders ensured their Background performance by depositing good faith money to a third Financial Markets party (i.e. margin requirements). Forward Markets Futures Markets These actions made it possible for speculators as well as Roles of farmers and dealers who were hedging their positions to Futures Markets trade their forward contracts. Existence By definition, futures are marketable forward contracts. Roles of Futures Thus the CBOT evolved from to the first organized Markets futures exchange. Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 8 / 65 Pricing Incorporating Risk Profiting and Offsetting Background (Continued) Lecture 7 Futures Markets and Pricing Prof. Paczkowski Since then, new exchanges have emerged in Chicago, New Introduction York, and other large cities throughout the world. Background Financial The types of futures contracts have grown from grains and Markets Forward Markets agricultural products to commodities and metals and Futures Markets finally to financial futures: futures on foreign currency, Roles of Futures interest rates and stock markets. Markets Existence Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 9 / 65 Pricing Incorporating Risk Profiting and Offsetting Financial Markets Lecture 7 Futures Markets and Pricing Prof. Paczkowski There is a new complication introduced into an analysis of Introduction decision making: do not have to pay for or receive item today Background Can pay for and receive item tomorrow Financial Markets Forward Markets But make decision today Futures Markets Decisions are now complicated Roles of Futures Markets Have further division of markets Existence Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 10 / 65 Pricing Incorporating Risk Profiting and Offsetting FinancialFinancial MarketsMarkets CurrentCurrent FutureFuture CashCash oror SpotSpot TransactionTransaction ForwardForward FuturesFutures Note the “s” on futures Financial Markets (Continued) Lecture 7 Futures Markets and Pricing Prof. Paczkowski Forward markets. Introduction Specific contracts involved Background Agents agree on the details of a transaction for delivery at Financial a specified date in the future Markets Contracts highly illiquid Forward Markets Futures Markets Very common in foreign exchange markets Roles of Futures Especially between large banks Markets Contracts loosely written without collateral Existence Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 12 / 65 Pricing Incorporating Risk Profiting and Offsetting Financial Markets (Continued) Lecture 7 Futures Markets and Pricing Prof. Paczkowski Futures market. Introduction Similar to forward market except contracts are Background standardized Financial Transaction costs are minimized Markets Contracts highly liquid Forward Markets Futures Markets Contracts bought and sold many times during their Roles of Futures lifetimes in contrast to forward contracts Markets Resulting from high liquidity Existence Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 13 / 65 Pricing Incorporating Risk Profiting and Offsetting Financial Markets (Continued) Lecture 7 Futures Markets and Pricing Prof. Paczkowski Forward Contract Futures Contract Introduction Margin No Background Risk Relatively High Financial Markets Resale Limited Forward Markets Futures Markets Contract Terms Custom Made Roles of Futures Delivery Delivered Markets Market Size Small/Private Existence Trading OTC Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 14 / 65 Pricing Incorporating Risk Profiting and Offsetting Financial Markets (Continued) Lecture 7 Futures Markets and Pricing Prof. Paczkowski Forward Contract Futures Contract Introduction Margin No Yes Background Risk Relatively High Relatively Low Financial Markets Resale Limited Active Forward Markets Futures Markets Contract Terms Custom Made Standardized Roles of Futures Delivery Delivered Usually Offset Markets Market Size Small/Private Large/Public Existence Trading OTC Exchange Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 15 / 65 Pricing Incorporating Risk Profiting and Offsetting Financial Markets (Continued) Lecture 7 Futures Markets and Pricing Prof. Paczkowski Introduction Role is to. Background Spread and, hence, reduce risk Financial Markets Collect and disseminate information Forward Markets Futures Markets Need to develop how role is fulfilled Roles of Futures Markets Existence Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 16 / 65 Pricing Incorporating Risk Profiting and Offsetting Financial Markets (Continued) Lecture 7 Futures Markets and Pricing Prof. Paczkowski Not every item (product, security), has a futures market Introduction There are markets for wheat, corn, oats but not for rye Background and barley Financial These once did, but on longer Markets Forward Markets Tabacco never had a futures market Futures Markets Tabacco was once used as a currency in the U.S. until Roles of Futures people realized they could literally grow money Markets Why not? Existence Roles of Futures Markets Futures Contracts Terminology Prof. Paczkowski (Rutgers University) Lecture 7 Futures Markets and Pricing Spring Semester, 2009 17 / 65 Pricing Incorporating Risk Profiting and Offsetting Financial Markets (Continued) Lecture 7 Futures Markets and Factors contributing to existence of a futures market. Pricing 1 There must be enough of the underlying, standardized Prof.