Chapter 15- Commodities and Financial Futures Flashcards
Cash Market
- a market where a product or commodity changes hand s in exchange for a cash price paid when the transaction is completed
- takes place on location, not an exchange
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 at a negotiated price
Purpose of Futures Market-
- Price Discovery
- Risk Bearing/Sharing
Futures Participants
- Speculators: 80 to 90% of them lose money
- Hedgers: Users of the product or producers of the product
Futures Exchanges
- US exchanges use electronic trading and open cry auction”
- futures are mostly electronic
- options are mostly open outcry - the exchange serves to guarantee the credibility of the parties involved
Advantages of using a Futures Contract:
- potential for very high returns
- margin buying allows use of leverage ( the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return
- allows producers to hedge prices
- don’t have to sell crops at harvest time when prices are often low
Disadvantages of Futures Contract:
- high risk of losing more than the amount originally invested; no limit on exposure to loss
Options vs. Futures Contract
(Options)
- right to buy
- strike price specified in option contract
- loss limited to price paid for option
Options vs. Futures Contract
(Futures)`
Obligation to buy
Delivery price set by supply and demand
No limit on potential loss
Trading Mechanics:
- bought and sold through brokerage offices
- same types of orders are used as stocks
- market
- limit - long position- buying a contract
- investor wants contract price to go up - short position- selling a contract
- investor wants contract price to go down - long and short positions can be liquidated by executing and offsetting transaction
- about 1-4% of futures contracts are settled
Margin Trading:
- all futures contracts are traded on margin
- initial margin deposit is the
amount deposited with broker at time of commodity transaction to cover any loss in market value of futures contract due to price movements- usually $10- 20,000 to open an account
- margin requirements range from 2- 10% - maintenance deposit
- minimum amount of deposit requires at all times
- margin call occurs if value drops below allowed amount - mark- to- the- market occurs daily
Factors in commodity price behavior
- weather and crop forecasts
- economic factors
- Political factors
- international pressures
Components of a Commodities Contract
- the product
- the exchange
- size of the contract
- pricing units
- the delivery months
Factors in Commodity Price Behavior
Weather and crop forecasts
Economic factors
Political factors
International pressures
Commodity Price Behavior
- 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
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
Speculating in Financial Futures
- leverage can provide high returns (or losses) enhances chance of return.
- “long” positions are used if investor speculates values will go up
- “short” positions are used if investor speculates values will go down
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
Penny Stocks:
Trade at or under $5 a share
- less than $4 million in net tangible assets
- some are “legit”
- shell companies that do not provide a lot of information about what they do
