Commodity Markets Flashcards
Forward Contract Limitations (6)
LIQUIDITY- Little to no liquidity of the contracts
INTEGRITY- Lack of integrity upon the part of both the buyer and the seller.
STANDARDIZATION- No checking (standardization) of grades
PRICING - No regulations as to pricing, in many cases, due to no price competition
DEFAULTS-No delivery (defaults)- no money from buyer or crop from seller
RULES- No specified rules of conduct regarding these cash forward contracts.
What is a futures contract
an agreement between two parties that commits one to sel and the other to buy a specified amount and grade of a particular commodity at a specific price on, or before, a specific date in the future.
3 ways a futures contract differs from a forward contract.
- Public Price
- Standard Specifications.
- Guaranteed performance.
What is a cash trade?
immediate exchange of ownership of a commodity or good for an agreed upon amount of money.
What is a forward contract
a direct commitment between one buyer and one seller. It is not standardized
What are the elements of a forward contract? 5
- Quantity of the commodity
- Quality of the commodity
- Time of delivery
- Place for delivery
- Price to be paid at delivery
Who oversees the US commodity futures exchanges?
Commodity Futures Trading Commission (CFTC)
What is a hedger?
A person participating in the physical commodity who also holds positions in futures and/or options in order to be protected from the risk of unfavorable price movements.
How does a futures trade differ from a cash trade? 3
- Not negotiated between individual buyer and seller originating the trade
- Specifies a grade and amount of a commodity. The contract specifies a range of acceptable grades, so another grade may be delivered at a discount or a premium to the agreed-upon price as long as it falls within an acceptable range (usually for grains).
- The commodity must be delivered from locations and at times confirming to the exchange rules.
What is a contract market?
a specific exchange where the particular commodity futures contract is traded.
What is liquidity?
the ease with which a position can be converted into cash.
Who determines the contract specs of a futures commodity?
The exchange in which it is traded on
What are the 4 standardized parts of an exchange traded futures contract?
Quantitiy
Quality
Time
Location
What is a base grade?
minimum accepted standard that a deliverable commodity must meet for use as the actual asset of a futures contract.
What is basis
the price difference between the local cash price of a commodity and the price of a specific futures contract of the same commodity at any given time.
what is the formula for Basis
Basis= Cash - Futures
What commodities don’t typically have carrying charges?
Any “live commodity” such as live hogs, live cattle, feeder cattle.
What typically happens to the difference of price between cash and futures as delivery approaches?
It typically decreases or converges.
5 factors that create a negative basis
- Storage costs
- Insurance
- Interest and financing costs
- Transportation costs
- Time to delivery
What is the largest portion of carrying costs?
financing cost
Normal STRENGTHENING BASIS market conditions
Futures higher initially and price converges as expiration nears. Basis converges to zero over time
What is a negative basis?
Cash under futures
What is a positive basis
Cash over futures
Strengthening basis
cash market prices increase relative to the futures prices. The difference between cash and futures prices narrows
Who does a strengthening basis benefit
Short Hedgers
What is a short hedger
someone who owns or deals in a commodity and hedges (protects) its future sale price by selling futures. In other words, a short hedger is long the spot and short the futures.
When does a weakening basis occur
when either cash market prices increase more slowly than futures prices or cash prices decrease more quickly than the futures prices.
Who does a weakening basis benefit?
A long hedger
What is a long hedger
Someone who will need to buy a commodity in the future and hedges (protects) its future cost by buying futures. In other words, a long hedge is short the spot and long the futures.
What is Country basis?
Used in Grain markets. It refers to the local cash market price compared with the nearby futures price (nearby month)
What is local basis
Used in Grain markets. It refers to the local cash market price compared with the nearby futures price (nearby month)
Premium basis
refers to an inverted market in which the cash prices are higher than distant futures contracts.
7 factors that affect the relationship between local cash prices and futures prices: (IT STEPS)
- Time, interest (financing costs)
- Insurance
- Supply and demand (domestic and foreign)
- Transportation
- Production cost
- Storage cost
- Expectations about the future
What is the largest portion of carrying charges?
Financing costs
Normal Futures Market
price of nearby contract is lower than the price of a distant futures contract
What is a futures market in which the distant months are selling at a premium to the nearby months referrer as?
Normal futures market
what is a discount basis?
cash prices are lower than the futures prices.
what are 2 other names for a normal futures market?
Carrying charge (storage) market futures price in contango
Carrying charge
the cost to hold (or store) inventory of the commodity
Inverted Market
the more distant the contract, the lower the contract price.
How would you calculate carrying charges in a normal market?
Carrying charges= price difference between futures prices of differing delivery months.
When does a carrying charge market or contango take place?
when futures contract prices equal or exceed the cash price PLUS full carrying charges.
Arbitrage
the opportunity to profit from such temporary abnormal price differences and, when used correctly, is relatively riskless.
Guarantee fund
Clearing house set aside a percentage from their gross revenue.
Margin
Earnest money deposited in cash (and occasionally the collateral value of U.S. T-Bills present in the investors account, a bank guarantee letter, or a letter of credit) an exchange requires an investor to have on account to establish and maintain positions in futures contracts.
Clearing House
An organization that acts as a third party guarantor and counterparty to the ultimate buyers and sellers of futures contracts, it provides integrity to the market place.
How does a clearing house effect liquidity
A clearing house increases market liquidity by enabling traders to establish (open) or offset (close) futures positions by buying from or selling to the clearing house rather than directly with another party.
Who does a buying/selling customer place orders through?
Their brokerage firms, called Futures Commission Merchants (FCMs)
What does Margin cover?
the potential liability from adverse price change to the investors futures position.
Who sets margin requirements and what are they based on?
- Board of directors of the exchanges
- based and changed on volatilty
Who else besides exchanges, set up margin requirements.
Brokerage firms may set higher margin requirements than those set by the exchange, and most do, but they may not set margins lower than exchange requirements.
What is Maintenance margin
the minimum amount of money that must be present in a commodity contract at all times. If the margin prescribed by the exchange or brokerage firm in the position falls to or below a pre-specified level (the maintenance level), a call for additional funds will be made in order to restore the account back up to the initial margin level. These funds are due the next business day.
Maintenance margin definition #2
additional money that the customer has to deposit into the account if the market moves against him.
Initial Margin
The minimum amount needed to open, or to establish, a futures position.
Excess margin
money in the customers account in excess of the initial margin requirement to open positions.
Where can excess margin come from?
additional deposits by the customer or profits on open positions.
