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Chapter 22_Hand-out 16

Chapter 22_Hand-out 16 - CHAPTER 21 FUTURES MARKETS 21.1...

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CHAPTER 21 FUTURES MARKETS 21.1 THE FUTURES CONTRACT Futures and forwards contracts are like options in that they specify purchase or sale of some underlying security at some future date. The key difference is that the holder of an option is not compelled to buy or sell, and will not do so if the trade is unprofitable. A futures or forward contract, however, carries the obligation to go through with the agreed-upon transaction. A forward contract is not an investment in the strict sense that the funds are paid for an asset. It is only a commitment today to transact in the future. Forward arrangements are part of our study of investments, however, because they offer powerful means to hedge other investments and generally modify portfolio characteristics. 1. The Futures Contract To see how futures and forwards work and how they might be useful, consider the portfolio diversification problem facing a farmer growing a single crop, let us say wheat. The entire planting season’s revenue depends critically on the highly volatile crop price. The farmer cannot easily diversify his position because virtually his entire wealth is tied up in the crop. The miller who must purchase wheat for processing face a portfolio problem that is the mirror image of the farmer’s. He is a subject to profit uncertainty because of the unpredictable future cost of the wheat. Both parties can reduce this source of risk if they enter into a forward contract requiring the farmer to deliver the wheat when harvested at a price agreed upon now, regardless of the market price at harvest time. No money need change hands at this time. A forward contract is simply a deferred-delivery sale of some asset with the sales price agreed upon now. All that is required is that each party be willing to lock in the ultimate price to be paid or received for delivery of the commodity. A forward contract protects each party from future price fluctuations. Futures markets formalize and standardize forward contracting. Buyers and sellers trade in a centralized futures exchange. The exchange standardizes the types of contracts that may be traded: it establishes contract size, the acceptable grade of commodity, contract delivery dates, and so forth. Although standardization eliminates much of the flexibility available in forward contracting, it has the offsetting advantage of liquidity because many traders will concentrate on the same small set of contracts. Futures contracts also differ from forward contracts in that they call for a daily settling up of 1
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any gains or losses on the contract. In the case of forward contracts, no money changes hands until the delivery date. (The centralized market, standardization of contract, and depth of trading in each contract allows future positions to be liquidated easily through a broker rather than personally negotiated with the other party to the contract. Because the exchange guarantees the performance of each party to the contract, costly credit checks on other traders are not necessary. Instead, each trader simply post a
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