Markets and Mechanics of Trading

Question 1

Spot markets

Answer 1

Instant Trading in actual commodity

Low cost to trade (almost zero)

Price depends on agent numbers

Great price transparency

Outcomes:

For sellers, price and income are risky
For buyers, quantity and quality are risky

Question 2

Forward Markets

Answer 2

A market in which an agreement is made to either buy or sell a commodity at some point in the future for an agreed price.
Features of forward market:
- Delay of physical trade
- buyer and seller must meet to form private contract
- Sets date, quantity, quality
- Price is agreed and is thus certain

Problems:

• No centralised market
• search every time
• imbalance of buyers/sellers
• No information is traded
• No central regulation/enforcement
• Other interests excluded

Question 3

Futures markets

Answer 3

Spot markets are risky, forwards less so, So ideally agents want a way to trade a commodity while reducing their risk

Futures Markets: Sale and purchase of a good/commodity is co-ordinated through the medium of highly standardised contracts which allow for the delivery of a defined product at a defined future date”

CLEARING HOUSE

Question 4

Standardisation of contract is crucial

Answer 4

• Act like a medium of exchange
• no dispute over detail
• Can be bought and sold with no further commitment
• Organisation means centralisation of traders and information
• Can be traded over several months.

Question 5

How do futures markets operate

Answer 5

CLEARING HOUSE

Selling is going short
Buying is going long

Question 6

Clearing house is markets policeman

Answer 6

• Run as a board drawn from members
• oversees activities and records them
• Controls finances
• arbitrates in disputes
• Maintains balance of supply and demand

Question 7

Contract Maturity

Answer 7

Reach the date on the contract for physical delivery to occur but this is rare.

Question 8

Cash settlement

Answer 8

futures price at maturity set equal to cash price. Those with a price higher receive money; those lower pay money

Question 9

Closing out

Answer 9

buy/sell back original contract. Can do so as contract is standard. However, there are costs of using the market

Question 10

Broker’s fee

Answer 10

Usually percentage of contracts value

Question 11

Margins

Answer 11

Payments based on market rules and consist of two parts

Question 12

Initial Margin

Answer 12

A good faith payment or a deposit

Paid into trader’s account to cover any losses e.g. contract price moves against you so no incentive to meet it therefore default

Initial margin guards against this possibility

Varies between 2-10% of underlying cash value and is a function of recent volatility

Repaid after the contract finishes

Question 13

Maintenance Margin

Answer 13

Lowest point which a traders account can fall before they must pay in more funds. As futures prices fluctuate over time, contracts make profits or losses

Use marking to market

• contract price in relation to price changes
• If prices move against a trader, good faith account declines
• If it keeps falling then money needs to be paid in

Question 14

The Relationship Between Spot and Futures Markets

Answer 14

It is essential that there is a clear link between the spot market for a commodity and the futures markets. If not futures markets become pure gambling markets.

Co movement of prices

• Futures prices for delivery in different months tend to move together
• Spot (cash) prices move up/down in similar manner to futures prices.

Question 15

Cost of Carry Price Relationship

Answer 15

Costs of Carry are the costs of carrying commodities forward through time and are a function of:

• Warehousing Costs
• Insurance Costs
• Financing Costs (interest rates)

Question 16

Convenience Yield

Answer 16

Negative Costs
Marginal convenience yield high with low stock levels:

• Merchants and processors could potentially face a stock out and pipeline stocks have high value.
• Merchants wish to hold stocks to meet demand from longstanding customers and to meet unexpected demand
• Processors hold stocks to avoid disruptions in production

Question 17

Types of Markets

Answer 17

Contango market:
futures>spot
futures = spot + cost of carry
distance > nearby futures

Backwardation or inverted market:
Strong backwardation (large convenience yield)
futures < spot
(distance futures < nearby futures)

Weak backwardation (Small convenience yield)
futures < spot + cost of carry

Question 18

Who trades futures and Why ?

Answer 18

Speculators

• purely to make profits/reduce risk premia of the whole market
• Buy cheap and sell dear

Hedgers

• Offset risk in spot market by trading in futures market
• Insurance market
• Can include physical delivery too (or purchase)

Question 19

Futures Trading

Answer 19

futures trading allows the price risk at least to be offset (can’t offset quantity risk)

Does this by Selling futures and goes Short thus if spot price falls, futures prices also fall.

When crop is harvested, he sells in the spot market. He makes a loss in this spot trade but hope this is (partially?) offset by gain in futures as contract is bought back (Closed out)