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CHAPTER 4 Using Futures MarketsIn this chapter, we discuss the different ways that futures markets serve different members of society. This chapter is organized into the following sections: 1. Price Discovery 2. Speculation 3. Hedging

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Price DiscoveryBecause the futures market incorporates the collective opinion of many buyers and sellers, the futures market can be used to reveal information about future spot prices. The usefulness of forecasting future spot prices, based on current futures prices, depends upon three factors:1. Information: the need for information about future spot prices. 2. Accuracy: the accuracy of the futures market forecasts of those prices. 3. Performance: the performance of futures market forecasts relative to alternative forecasting techniques.

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InformationInterest Rates and Home Buying You are in the market for a new home and you want to have an idea of how interest rates will behave in the next year. By examining the WSJ, you can discover what the market as a whole thinks about the future course of interest rates. If the interest rate (yield) on bonds to be delivered in six months is three percentage points lower than current interest rates, then there is good reason to expect that interest rates will fall over the next six months. Furniture Manufacturer A furniture manufacturer needs to print its catalog for the next year and needs to include prices. Furniture prices will depend in part upon next years lumber prices. The furniture manufacturer can review the lumber futures market to estimate the costs of the wood. The person using the futures market to estimate the future course of interest rates or the future course of lumber prices is using the futures market for its price discovery benefit.

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AccuracyWe would like the estimator of the expected future spot price to be accurate. If it is not accurate, its usefulness is limited. A forecast estimate is unbiased if, on average, the forecast is correct. However, even if a forecast estimate is unbiased, the range might be so wide that its usefulness is limited. Example I predict that the points scored by the winner in the NBA finals game will be between 50 and 150 points. On average, I might be right, but the range is so wide that it not particularly useful. Futures prices sometimes have large errors and these may differ across commodities.

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Evidence suggests that while futures markets have large errors, they are generally better at predicting the future than any other available methods of forecasting. Because of this property, military researchers have suggested using futures contracts to predict terrorist attacks.

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Forecasting Oil Prices A Case StudyTable 4.1 illustrates a case of a large forecast error.Table 4.1 Forecast Errors for Alternative ForecastsCommodity Crude Oil Horizon 1 Month 2 Month 3 Month 6 Month Heating Oil 1 Month 2 Month 3 Month 6 Month Leaded Gasoline 1 Month 2 Month 3 Month 6 Month Futures Error .0148 .0268 .0456 .1057 .0074 .0182 .0284 .0628 .0129 .0261 .0397 .0956 No--Change Error .0268 .0499 .0720 .1469 .0085 .0196 .0305 .0553 .0155 .0281 .0440 .0893

Source: Cindy W. Ma, Forecasting Efficiency of Energy Futures Prices, The Journal of Futures Markets, 9:5, October 1989, pp. 393-419.

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Forecasting Performance for Different CommoditiesQuality of forecasts differ across commodities.Table 4.2 Forecasting P ow er of C om m odity FuturesForecasting Power for All Maturities Broilers Eggs Hogs Oats No Forecasting Power Lumber Soyoil Cocoa Corn Wheat Coffee Copper Cotton Gold Platinum Silver

Forecasting Power for Most Maturities Cattle Pork bellies Soybeans Soymeal

Forecasting Power for Some Maturities Orange juice Plywood

Source: Eugene F. Fama and Kenneth R. French, Commodity Futures Prices: Some Evidence on Forecast Power, Premiums, and the Theory of Storage, Journal of Business, 60:1, 1987, pp. 55-73.

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SpeculationA speculator is a trader who enters the market to profit from short term price changes. In doing so, he/she assumes risk that other individuals are trying to dispose of. Most individuals have no heavy exposure in the futures market. As such when they enter the futures market it is for speculation. There are three kind of speculators:1. Scalpers 2. Day Traders 3. Position Traders

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ScalpersA scalper is an individual that enters the futures market to profit from very short term price movements. A scalper is generally trying to guess the short term psychology of the market. How Long of Intervals? From the next few seconds to the next few minutes. Requires the scalper to be in the trading pit to observe the behavior of other buyers and sellers. Generally involves a great many trades earning a small profit on each trade. One study shows that scalpers make about 70 trades per day.

By trading very frequently, scalpers provide liquidity to the market.

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Scalpers Behavior Study

Table 4.3 M r. X's Trades O ver 31 Trading D aysTotal Transactions Number of Contracts Traded (Round turns-buy and sell 1 contract) Number of Trades (Zero net position to a zero net position) Profitable Unprofitable Scratch 2,106 2,178

729 353 (48%) 157 (22%) 219 (30%)

Source: William L. Silber, Marketmaker Behavior in an Auction Market: An Analysis of Scalpers in Futures Market, Journal of Finance, September 1984, 39:4, pp. 937B953.

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Services Provided by Scalpers1. Provide a party willing to take the opposite side of a trade for an off-the-floor trader. 2. Actively trade, thereby generating price quotations and allowing the market to discover prices more effectively. 3. By competing for trades, help to close the bid-asked spread, thereby reducing execution costs for other traders. 4. Attract hedging activity, because hedgers know their orders can be executed.

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Day TradersDay traders attempt to profit from trades that occur during a single trading day. Day traders close all of their positions before the end of the trading day. As such, day traders have no position in the futures market overnight. By closing all of their positions at the end of the day, day traders are able to reduce their risk. Holding a position overnight is a risky proposition as the supply of many commodities is driven by weather. Example: orange juice concentratedTraded by the Citrus Associates of NY Cotton Exchange Florida. Weather is crucial to orange juice prices.

In November, a trader holds a short position in orange juice futures. The trader checks the Florida Weather two days before trading closes, and no evidence of damaging weather exists, so the trader holds his position overnight. Overnight, a strong cold front damages a large portion of the orange crop. This trader suffers a large loss.Chapter 4 12

Position TradersA position trader is a speculator that holds a position overnight. Sometimes they may hold them for weeks or months. There a two types of position traders: Outright Position Spread Position

These two types of trades will be discussed in turn.

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Outright PositionsThis is simply taking a naked position in a commodity. For example, a trader thinks that long-term interest rate will increase, and consequently futures prices for bonds will fall. Therefore, the trader sells a futures contract on U.S. Treasury bonds. If long-term interest rates rise as the trader expected, the trader will earn a profit. The risk is that the long-term interest rate will decline rather than increase. In which case the position trader will lose money.

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Spread PositionsSpread positions involve trading multiple contracts on the same or related commodities. The idea is to profit when the difference in prices between the two related commodities changes. There are two basic types of spreads: 1. Inter-commodity spreadIn an inter-commodity spread, a trader takes a position in two or more different but related commodities.

2. Intra-commodity spreadIn an intra-commodity spread, a trader takes a position in two or more maturity months for the same good.

Example: Wheat and corn are substitutes for each other for certain uses (e.g., ethanol production and cattle feed). Therefore, we would expect a certain relationship to exist between the prices of the two commodities. That is, the prices of these two commodities should follow some pattern.Chapter 4 15

Spread Position Inter-Commodity CaseTable 4.5 illustrates the case of a spread speculator who believes that the difference between futures price of wheat and corn is too high.Table 4.5 A n Inter-C om m odity S preadThe wheat and corn contracts are both for 5,000 bushels. Date February 1 June 1 Futures Market Sell 1 JUL wheat contract at 329.50 cents per bushel. Buy 1 JUL corn contract at 229.00 cents per bushel. Buy 1 JUL wheat contract at 282.75 cents per bushel. Sell 1 JUL corn contract at 219.50 cents per bushel. Corn Loss: B$.095 per bushel x 5,000 bushels = B$475.00 Wheat Profit: $.4675 per bushel x 5,000 bushels = $2,337.50 Total Profit: $1,862.50

Notice that the spread has narrowed as expected resulting in a profit on the transactions.

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Spread Position Inter-Commodity CaseInsert figure 4.1 and 4.2 below

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Spread Position Intra-Commodity CaseTables 4.6 and 4.7 will be used to illustrate a more complex spread, the butterfly spread.

Table 4.6 Copper Futures Prices on November 10Delivery Month (of following year)JUL SEP DEC

Price (cents per pound)67.0 67.5 70.5