Chapter 15

Commodities and
Financial Futures

Commodities and Financial Futures

Learning Goals
1. Describe the essential features of a futures
contract, and explain how the futures market
operates.
2. Explain the role that hedgers and speculators
play in the futures market, including how profits
are made and lost.
3. Describe the commodities segment of the
futures market and the basic characteristics of
these investments.

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Commodities and Financial Futures

Learning Goals (contd)
4.Discuss the trading strategies investors can use
with commodities, and explain how investment
returns are measured.
5.Explain the difference between a physical
commodity and a financial future, and discuss
the growing role of financial futures in the
market today.
6.Discuss the trading techniques that can be used
with financial futures and note how these
securities can be used in conjunction with other
investment vehicles.
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The Futures Market

Cash Market: a market where a product or
commodity changes hands in exchange for
a cash price paid when the transaction is
completed
Futures Market: the organized market for
the trading of futures contracts
Futures Contract: a commitment to
deliver a certain amount of some specified
item at some specified date in the future
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Table 15.1 Futures Contract Dimensions

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Characteristics of Futures Contracts

Transaction will not be completed until some
agreed-upon date in the future
Delivery date and quantity are all set when the
financial future is created
Seller has legally binding obligation to make
delivery on specified date
Buyer/holder has legally binding obligation to take
delivery on specified date
Futures may be held until delivery date or traded
on futures market
All trading is done on a margin basis
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Advantages of Using Futures

Contracts
Potential for very high returns
Margin buying allows use of leverage

Leverage: the ability to obtain a given equity

position at a reduced capital investment, thereby
magnifying total return

Allows producers to hedge prices

Dont have to sell crops at harvest time when

prices are often low

Commodities can provide an inflation hedge

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Disadvantages of Using Futures

Contracts
High risk of losing more than amount
originally invested; no limit on exposure
to loss
Involves considerable amount of speculation
Requires specialized investor skills and
patience

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Options versus Futures

Contracts
Options
Right to buy
Strike price specified in
option contract
Loss limited to price
paid for option

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Futures
Obligation to buy
Delivery price set by
supply and demand
No limit on
potential loss

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Futures Exchanges
Chicago Board of Trade (CBT) began in 1848
More than a dozen U.S. commodities exchanges
Chicago Mercantile Exchange (CME) is largest
Chicago Board of Trade (CBOT) and New York Mercantile
Exchange (NYMEX) also active
95% of U.S. commodities trade on these three exchanges
Although still operating independently, the CME, CBOT,
and NYMEX have all been merged to form the CME Group

Most exchanges use a combination of electronic

trading and open-outcry auction

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Players in the Futures Markets

Hedgers
Producers and processors
Protecting their interests in underlying
commodity or financial instrument
Provide the actual products being sold

Speculators
Investors
Trying to earn profit on expected swings in
prices of futures contracts
Provide liquidity
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Trading Mechanics
Contracts are easily traded on futures markets
Bought and sold through brokerage offices
Same types of orders are used as stocks
Market
Limit

Long positionbuying a contract

Investor wants contract price to go up

Short positionselling a contract

Investor wants contract price to go down

Long and short positions can be liquidated by

executing an offsetting transaction

About 1% of futures contracts are settled by delivery

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Margin Trading
All futures contracts are traded on margin
No borrowing is required
Initial margin deposit
Amount deposited with broker at time of commodity
transaction to cover any loss in market value of futures
contract due to price movements
Margin requirements range from 2% to 10%

Maintenance deposit
Minimum amount of deposit required at all times
Margin call occurs if value drops below allowed amount

Mark-to-the-market occurs daily

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Table 15.3 Major Classes of

Commodities

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Components of Commodity Contract

Type of product
Exchange where contract is traded
Size of contract (in bushels, pounds, tons)
Method of valuing contract (e.g., cents per
pound, dollars per ton)
Delivery month
Open Interest: the number of contracts
currently outstanding on a commodity or
financial future
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Factors in Commodity Price Behavior

Weather and crop forecasts
Economic factors
Political factors
International pressures
Settle Price: the closing price (last price
of the day) for commodities and financial
futures

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Commodity Price Behavior

Prices change daily
Changes can be sizable
Because of leverage, small unit price changes can
cause large total dollar changes in contract price
To protect investors, daily price change limits are
set:
Daily price limit: restriction on the day-to-day change in
price
Maximum daily price range: the amount a commodity
price can change during the day; usually equal to twice
the daily price limit

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Return on Invested Capital

Commodities allow use of leverage for
potentially high returns
Return to investors is based upon amount of
money actually invested

Return on invested capital

Selling price of
Purchase price of

commodity contract
commodity contract
Amount of margin deposit

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Trading Strategies with Commodities

Speculating
Capitalizing on wide swings that are characteristic of
many commodities

Spreading
Used by producers and processors to protect a position in
a product or commodity
Producer or grower attempts to hedge as high a price
as possible
Processor or manufacturer attempts to hedge as low
a price as possible
No limit to the amount of loss that can occur with a
futures contract

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Financial Futures
Financial Futures: future contract in
which the commodity is a financial asset,
such as debt securities, foreign currencies
or market baskets of common stocks
Often used by large institutional investors to
hedge specific types of risk:
Offset interest rate risk on debt instruments
Minimize foreign currency rate risk on overseas
business transactions
Minimize market risk on common stock
investments

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Examples of Financial Futures:

Foreign Currency
Examples of Currency Futures
British pound
Swiss franc
Canadian dollar
Japanese yen
Euro
Other currencies

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Examples of Financial Futures:

Interest Rates
Examples of Interest Rate Futures
U.S. Treasury securities
Federal Funds
Interest rate swaps
Euromarket deposits
Foreign government bonds

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Examples of Financial Futures:

Stock-Indexes
Examples of Stock-Index Futures
Dow Jones Industrial Average
S&P 500 Index
Nasdaq 100 Index
Russell 2000 Index

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Financial Futures
Contract Specifications
Similar to commodities contracts
Control large sums of underlying
financial instruments
Have varying delivery dates
Stock-index futures are settled in cash
rather than underlying stocks of the specific
stock index.

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Speculating in Financial Futures

Allows large quantities of financial instruments to
be controlled through future contract
Leverage can provide high returns (or losses)
Long positions are used if investor speculates
values will go up
Short positions are used if investor speculates
values will go down

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Hedging with Financial Futures

Effective way of protecting stock or other securities
holdings in a declining market
Stock-index futures used to hedge stock portfolios
Interest rate futures used to hedge bond portfolios
Foreign currency futures used to hedge significant
exposure to foreign exchange rate risk

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Combining Futures and Options

Futures Options: options that give the
holders the right to buy or sell a single
standardized futures contract for a specified
period of time at a specified strike price
A significant advantage that a futures option has
over a futures contract is that the option limits
the buyers loss exposure to the price of the
option.

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Chapter 15 Review
Learning Goals
1. Describe the essential features of a futures
contract, and explain how the futures market
operates.
2. Explain the role that hedgers and speculators
play in the futures market, including how profits
are made and lost.
3. Describe the commodities segment of the
futures market and the basic characteristics of
these investment vehicles.

Copyright 2014 Pearson Education, Inc. All rights reserved.

15-28

Chapter 15 Review (contd)

Learning Goals (contd)
4. Discuss the trading strategies investors can use
with commodities, and explain how investment
returns are measured.
5. Explain the difference between a physical
commodity and a financial future, and discuss
the growing role of financial futures in the
market today.
6. Discuss the trading techniques that can be used
with financial futures and note how these
securities can be used in conjunction with other
investment vehicles.
Copyright 2014 Pearson Education, Inc. All rights reserved.

15-29

Chapter 15
Additional
Chapter Art

Figure 15.1

Source: Copyright 2003 Board of Trade of the City of Chicago, Inc. All Rights Reserved.
Used with permission.)
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Table 15.2 Margin Requirements for a Sample of

Commodities and Financial Futures

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Figure 15.2
Contract
Specifications
for Corn
Futures

Source: Reprinted with permission, CME

Group, 2012.
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Figure 15.3 Quotations on Corn Futures

Contracts

Source: Reprinted with permission, CME Group, 2012.

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Figure 15.4
Quotations on
Financial
Futures
Contracts

Source: Reprinted with permission,

CME Group, 2012.

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Figure 15.5 Quotations on Corn

Futures Options Contracts

Source: Reprinted with permission, CME Group, 2012.

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