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Finance and capital markets
Unit 9: Lesson 2
Forward and futures contracts- Forward contract introduction
- Futures introduction
- Motivation for the futures exchange
- Futures margin mechanics
- Verifying hedge with futures margin mechanics
- Futures and forward curves
- Contango from trader perspective
- Severe contango generally bearish
- Backwardation bullish or bearish
- Futures curves II
- Contango
- Backwardation
- Contango and backwardation review
- Upper bound on forward settlement price
- Lower bound on forward settlement price
- Arbitraging futures contract
- Arbitraging futures contracts II
- Futures fair value in the pre-market
- Interpreting futures fair value in the premarket
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Verifying hedge with futures margin mechanics
Verifying Hedge with Futures Margin Mechanics. Created by Sal Khan.
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How do speculators play into this? I thought speculators were responsible for incurring some of the risk involved by promising to either pay the difference between the forward contract price and the actual commodity price when prices rise or keep the difference when prices fall. I don't understand the role of speculators if futures markets are marked-to-market and buyers and sellers are responsible for paying the difference themselves after margin calls are made...(12 votes)
People who own futures frequently sell them before the due date. In the example here, suppose the pie factory has a slowdown and decides in August that they are only going to need 950,000 pounds, instead of a million, in November. They would sell 50 of the futures to some other apple user, perhaps a grocery store who isn't sure they have enough apples coming in November, for whatever the going price for apple future contracts is. Or perhaps a speculator sees the offer to sell the future on the market, and thinks the price on the future is a bit too low, so he buys it and holds it for a while. If he was right, the then speculator will make money on the deal when he sells it. If he was wrong, then .... tough. Speculators have a bad name, after all they do not grow apples or make pies, but they do tend to keep the market active, which is a good thing.(11 votes)
- What prevents one of the parties from not topping up their margin accounts if the market price moves in their favour?(4 votes)
- If you do not top up margins, you can be forced by the exchange or brokerage to "close out" of your position and lose the margin that you have put up. This is called a sell-out. If you originally bought a futures contract, it would be sold. If you sold a futures contract, it would be bought. You would be left with your margin losses neither the exchange or the person on the other side of the contract (counter party) would lose out.(17 votes)
Why can't you just get rid of marking to market and margins? It seems like more of a hassle anyway. In the end, both the farmer and pie company ended up with what was on the future agreement.(3 votes)- Thats true, but if there was no marking to market and margins, there's no guarantee that the Pie Chain would have paid up the entire amount of 200$ if say apple prices had dropped to 0.10$ on or before Nov 15th. Let's say the apple prices did actually fall to 0.10$ and the Pie Chain found an alternate apple farmer/seller. The Pie Chain would just pay 100$ to the new farmer, and renege on his obligation to pay the original farmer. Having margins and marking to market prevents such cases where the contract is not honored by the two parties. So no CounterParty Risk as Sal initially explained. Hope this explanation is right/makes sense.(6 votes)
- i understood how margin works...but then i dont know how people make profits in futures...because ultimately you are just reducing your volatility risk...so if u have already decided the price at which you will buy or sell and the change thereafter is deducted/added to/from the margin....how are you making a profit?...Can you please explain this a little more in detail.?(4 votes)
Well, the agreed upon price would inherently ensure a profit for both parties. The point of a futures contract is not to let one party gain more of the profits, but to ensure that both parties get the same deal, irrespective of the market's mood swings.
If, however, you were a speculator, you could actually make an extra profit. For example, if your future's contract let you buy a thousand units of something at a later date and those units actually went up in value, you could sell those units on an exchange after the future's contract is carried out. In that case you would have bought 1k of something at a cheap price, even though it ended up gaining value.You could then sell those units to profit the difference.(8 votes)
- Do the margin accounts gather interest?(6 votes)
Yes. magin accounts CAN earn interest. Many brokerage firms will allow you to purchase 90 day (aka 13 week, 3 month) T-bills. A portion of the T-bills can be used as margin, typically 75-90% for your futures positions. However, you can earn the interest on all of the amount you have in T-bills. The historical average
The Philly Fed has some historical info and the Treasury keeps a pricing of the most recent auctions
http://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters/data-files/TBILL/
http://www.treasurydirect.gov/RI/OFBills
Per NYU/Stern the historical average yield on Bills is 3.66% (1928-2011)
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html(1 vote)
- a seller sold the future initially at say$200 and earned margin as rate fell to $100.what if the production of apple falls and there is not enough apple in the markets to satisfy the futures sold?obviously the seller will call out but do he need to pay back his margin earning.(1 vote)
- All futures, including those calling for delivery, are eligible to be settled in cash. This is to protect the exchanges from default. If the world literally runs out of apples, the contracts will still be honored and whoever is holding the contracts at delivery will get a cash settlement equal to current market prices.
Very few contracts (about 2%) are actually settled through delivery of the underlying commodity. Most are settled in cash.(7 votes)
Someone explain me how would the Buyer benefit from all this, if he could buy the apples he needs at the end with only 100 dollars? I think i'm missing something. For me it seems that the only one who would benefit is the seller.(2 votes)
The buyer can be sure that he or she will only have to pay $200 and no more. If the price of apples goes up to $300, the buyer would still only have to pay $200.(3 votes)
- How would time value of money be taken into account here? If the margin of 10$ is taken from the buyer and given to the seller when the price fell to 190$, the value of the 10$ received by the seller today is more than the 10$ (of the total 200$) he would have received on the 15th of November?(3 votes)
- The forward curve for the futures contract will take into account interest/dividend yield, cost of storage, financing, and any other factors which make it advantageous or disadvantageous to hold the commodity until delivery date. In this example, a further out contract (say, December 15) will likely cost more to enter into today than a November 15 contract. Why? Because the seller (farmer) will charge a premium to store the apples. And, the cost will be higher because of what you said, since the TVM will allow the buyer to invest money in that extra month for a profit. The December 15 contract would take these into account and typically will be higher.(1 vote)
- What if the farmer had very bad cultivation (due to natural causes) and he couldn't deliver the 1000 pounds of apple?(3 votes)
or settle the deal in cash, All futures, including those calling for delivery, are eligible to be settled in cash.(2 votes)
- What is the point of making these contracts exchangeable if the whole point to have them originally was to match up buyers and sellers of a commodity who wanted to avoid volatile trading markets and lock in a set price? Set and forget? The tradeability seems to be at odds with this attitude. The buyers and sellers in these contracts weren't supposed to be 'watching markets' looking for a quick profit, they were looking to build their businesses in a sustainable, less volatile way. The market has perverted the original intent of these contracts.(2 votes)
The purpose is to match up anyone who wants to buy with anyone who wants to sell, not to match a specific buyer with a specific seller. The market would be much less liquid if people could not trade. It's no different than the stock market in that regard.
Buyers and sellers who want a non-tradeable contract are certainly free to enter into that, but that would have nothing to do with an exchange, who's entire purpose is to enable trading.
Trading provides valuable price information, by the way.(2 votes)
Video transcript
Let's verify that
the margin mechanics in the marking to market
of the futures contract actually gets both the seller
and the buyer what they originally wanted, which
is that they don't have to be susceptible to the
volatility in apple prices. They both wanted
to, effectively, sell the apples for $0.20
a pound or buy the apples for $0.20 a pound. And they didn't want to,
in the farmer's case, go out of business if they could
only sell the apples for $0.10 a pound, or in the
pie company's case, go out of business if they had
to buy the apples for $0.30 a pound. So let's verify
that this works out. So they originally
had a contract price of $200 for 1,000 pounds. So this is essentially
$0.20 a pound. And as we said in
the previous video, as the futures contract
delivery price changes day by day, as we get closer and
closer to the actual delivery date, what happens
is that we transfer money between the buyer's margin
account and the seller's margin account. As the delivery price
of the future contract goes down, in order to mark
the delivery price down-- so in order to mark it down
from $200 to $190 to $185-- this guy keeps getting a better
deal on the actual delivery price. So to make things fair, he has
to transfer the same amount of money to the margin
account of the seller. So let's imagine two scenarios. Let's say that
eventually, as we approach November 15-- remember,
this is the delivery date-- the futures contract
delivery price is going to approach
the market price. You can imagine right
when we're like a second before the delivery date, the
futures contract and the market price aren't going
to be that different. And let's say that this goes
all the way down to $100. So in that whole process,
this futures contract keeps getting
marked down to $100. So on that day, it is
true that the seller will sell 1,000 pounds of apples
to the buyer for only $100. You might say, hey, wait. What did the seller
get out of this? He's only getting $0.10
per pound for his apples. This was what he feared. He is susceptible to the
volatility of the market prices. But remember, because of this
marking to market, and because of the margin transfers here,
as this delivery price went down from $200 to $100,
there would have been a transfer from
this guy's margin account to this guy's margin
account of $100. So instead of just
getting the $100 for that 1,000 pounds of
apples, because this seller had this futures contract,
he would have also gotten another $100 transferred
into his margin account. So the true economic value he
gets is $200, no matter what, for his 1,000 pounds of
apples, or $0.20 a pound. You can imagine
the other scenario. What if the delivery price
as we get closer and closer to delivery date goes up? If it goes to $300
per 1,000 pounds? Well, you might say, hey,
the seller is going to get a bonanza, and this guy's
going to go out of business because he's going to be
essentially paying $0.30 per pound. But you gotta remember,
if the price went up and it becomes more and more
favorable to the seller, because of the margin
mechanics, the seller would have to transfer $100 over--
as the price moves up-- to the buyer, to
his margin account. And so even though this guy
has to pay $300 per pound, because that's where the market
price eventually ended up, he would get $100
from the seller. So effectively, he would
still only have to pay $200. And even though this guy
is selling it for $300, he actually had to
pay another $100. So net, he's really only
getting $200 for it. So no matter how you look at
it, both parties are transacting at $200, or $0.20 a pound.