Forward and futures contracts

Forward contract introduction

• Apple farmer produces one million pounds of apples annually.
• Faces a problem with fluctuating apple prices, impacting profit margins.
• Pie chain specializes in making apple pies, also affected by price volatility.
• Both parties dislike the unpredictability of feast or famine scenarios.
• Solution: They can enter into a forward contract to mitigate price risk.
• Forward contract involves an agreement to transact at a specified price in the future.
• Example: The pie chain agrees to buy one million pounds of apples after the harvest for $0.20 a pound.
• Benefits: Provides predictability for both parties, ensuring a fixed price regardless of market fluctuations.
• Farmer can cover costs and plan finances, while the pie chain can maintain profitability.
• Forward contract helps avoid volatility and ensures stability for both parties.

Futures introduction

• Forward contract raises concerns about counterparty risk for both the farmer and the pie chain.
• Counterparty risk is the risk that the other party may fail to fulfill their contractual obligations.
• Farmer’s counterparty is the pie chain, and vice versa.
• Another concern is the ability to trade or sell the forward contract to someone else.
• Local brain proposes standardizing forward contracts to address these issues.
• Standardized contracts involve smaller, more granular increments, making trading more flexible.
• Rich individual, also running a stock exchange, guarantees all contracts, reducing counterparty risk.
• Standardized forward contracts, now called futures, are traded on the exchange.
• Futures allow smaller farmers (e.g., Farmer A, Farmer B) to transact with customers (e.g., Customer C, Customer D) in standardized increments.
• Exchange facilitates trading, providing a platform for buying and selling futures contracts.
• Futures maintain the essence of forward contracts but are standardized and traded on an exchange, providing liquidity and risk mitigation.

Motivation for the futures exchange

• Exchange takes on counterparty risk for standardized Futures Contracts.
• Exchange profits by setting a settlement price for buyers and sellers.
• Example: Buyers enter into a Futures Contract at 22 cents per pound, while sellers deliver at a settlement price of 20 cents per pound.
• The exchange makes a 2 cent profit per pound during the settlement.
• For 1,000 pounds of apples per contract, the exchange earns $20 profit per transaction.
• Exchange engages in continuous trading with various farmers, customers, and speculators.
• Profit maintained through a consistent 2 cents spread on each Futures Contract.
• To protect against losses, the exchange requires parties to set aside money called Margin.
• Margin acts as insurance, covering potential losses in case the Futures Contract price moves unfavorably.
• Margin ensures that both parties can meet their obligations on the settlement date.

Futures margin mechanics

• Margin in futures contracts involves an initial and maintenance margin.
• Example: Contract for 1,000 pounds of apples with a future delivery price of $200.
• Both buyer and seller must provide an initial margin of $20 each.
• Market to market adjustment occurs if the contract is traded at a different price the next day.
• If a new contract is traded at $190, the exchange resets the contract price, and the initial margin is adjusted accordingly.
• Buyer’s margin decreases from $20 to $10 (reflecting the $10 better deal in the market).
• Seller’s margin increases from $20 to $30 (compensating for the $10 better deal given to the buyer).
• Maintenance margin is triggered if the margin falls below a certain threshold.
• If the price further decreases to $185, the process repeats, and the buyer’s margin decreases to $5, while the seller’s margin increases to $35.
• Margin call is triggered for the buyer, requiring an additional $15 to meet the maintenance margin.
• Margin must be replenished to the initial margin level every time it falls below the maintenance margin.

Verifying hedge with futures margin mechanics

• Margin mechanics in marking to market aim to protect both the seller and the buyer from volatility in apple prices.
• Initial contract: 1,000 pounds of apples for delivery on November 15 at $200, equating to $0.20 per pound.
• As the delivery price changes leading to the delivery date, money is transferred between buyer’s and seller’s margin accounts to maintain fairness.
• Scenario 1: Delivery price approaches the market price, going down to $100.
• The seller sells 1,000 pounds of apples for $100, but a $100 transfer from the buyer’s margin account to the seller’s margin account occurs.
• The true economic value for the seller is $200 ($100 from the sale + $100 transfer), maintaining $0.20 per pound.
• Scenario 2: Delivery price increases as delivery date approaches, going up to $300.
• The seller appears to get a favorable deal, but a $100 transfer from the seller’s margin account to the buyer’s margin account occurs.
• The buyer effectively pays $200 ($300 market price - $100 transfer), maintaining $0.20 per pound.
• In both scenarios, both parties transact at $200, or $0.20 per pound, regardless of market price fluctuations.

Futures and forward curves

• Two futures curves represent different settlement prices for various delivery dates.
• Spot price is the current market price, in this case, 10 cents per pound for apples.
• Futures curve indicates settlement prices for future delivery dates, not predicting spot price changes.
• Example: One month from now, the futures contract for apples may have a settlement price of 12 cents.
• The entire curve could shift if market sentiment changes (e.g., increased demand for apples).
• An upward-sloping orange curve is considered normal for most commodities, indicating higher prices for later delivery dates.
• The normal curve aligns with the expectation that holding onto a commodity should come with a higher future price.
• Downward-sloping (inverted) curves, though theoretically uncommon, will be discussed in the next video.
• The inverted curve implies lower prices for distant delivery dates compared to nearby dates.
• The next video will explore reasons behind an inverted futures curve.

Contango from trader perspective

• Contango in the market means the commodity is cheaper on the Spot Market today than in the future through Futures or Forward Contracts.
• Example: Gold is $1,500 per ounce today, but a Futures Contract for one year later could be $1,600 per ounce, indicating Contango.
• In Contango, traders may prefer entering Futures Contracts for long-term investments, avoiding immediate purchase costs and storage expenses.
• Opportunity Cost and storage costs are factors influencing the choice between buying in the Spot Market or entering into Futures Contracts.
• Contango is common for commodities like gold, where long-term investment and storage considerations are relevant.
• Severe Contango, like a significant price difference between current and future prices, may occur with consumable commodities like oil.
• Severe Contango might be due to market dynamics, such as a surplus in the current oil market or perceived future shortages.
• Severe Contango is unusual, and minor Contango is more common, allowing for potential arbitrage opportunities.

Severe contango generally bearish

• Contango is normal, considering Opportunity Cost and storage cost for commodities.
• Severe Contango, where the spot price is significantly lower than the future’s price, is less usual and implies a bearish signal.
• Severe Contango suggests a perceived surplus in the spot market or an anticipated future shortage.
• It is important to note that a single signal like Contango shouldn’t be solely relied upon for market predictions.
• In a severe Contango scenario, it is considered bearish for the future price of the commodity.
• Traders might exploit severe Contango by buying the commodity at a lower spot price, storing it, and selling in the future at a higher agreed-upon price.
• This process increases demand and prices in the spot market but raises future supply, leading to lower future prices.

Backwardation bullish or bearish

• Backwardation in the commodities market implies that it costs more to buy the commodity now than to buy it through a futures contract for future delivery.
• The occurrence of backwardation may indicate desperation in the market, as rational actors would usually wait and opt for a cheaper future delivery.
• People willing to pay more now than for future delivery suggest a potential shortage or disruption in the supply of the commodity.
• Backwardation is generally perceived as a bullish signal because it signifies increased demand due to market desperation.
• While backwardation can be less irrational if driven by storage concerns, it might be considered more irrational if it reflects an immediate desire to possess the commodity.
• In cases like gold, backwardation might be driven by irrational factors, such as a belief in an imminent societal collapse.
• Investors could take advantage of backwardation by selling the commodity at a higher spot price now and agreeing to buy it back for a cheaper price in the future, making risk-free profits.

Futures curves II

Q so they put a margin first or what?