Three types of traders in futures forward and options markets

Futures introduction

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For example, of all contracts introduced by U. Consequently, entire exchanges can become active — e. Government price supports or other such regulation can also render trading inactive see Carlton , Futures contracts succeed or fail for many reasons, but successful contracts do share certain basic characteristics see for example, Baer and Saxon , ; Hieronymus , To wit, the underlying asset is homogeneous, reasonably durable, and standardized easily describable ; its supply and demand is ample, its price is unfettered, and all relevant information is available to all traders.

For example, futures contracts have never derived from, say, artwork heterogeneous and not standardized or rent-controlled housing rights supply, and hence price is fettered by regulation. Futures markets have three fundamental purposes. The first is to enable hedgers to shift price risk — asset price volatility — to speculators in return for basis risk — changes in the difference between a futures price and the cash, or current spot price of the underlying asset.

Because basis risk is typically less than asset price risk, the financial community views hedging as a form of risk management and speculating as a form of risk taking. Generally speaking, to hedge is to take opposing positions in the futures and cash markets. Hedgers include but are not restricted to farmers, feedlot operators, grain elevator operators, merchants, millers, utilities, export and import firms, refiners, lenders, and hedge fund managers see Peck , Meanwhile, to speculate is to take a position in the futures market with no counter-position in the cash market.

Speculators may not be affiliated with the underlying cash markets. To do so, he takes a position in the futures market that is exactly opposite his position in the spot — current cash — market. Recall that to sell buy a futures contract means to commit to sell buy an amount and grade of an item at a specific price and future date.

Notice, because Hedger A has both sold and bought a July futures contract for 5, bushels of corn, he has offset his commitment in the futures market. So, in reality hedgers cannot immunize entirely their cash positions from market fluctuations and in some cases they may not wish to do so. Again, the purpose of a hedge is not to avoid risk, but rather to manage or even profit from it.

For example, lenders are relatively more likely to finance, at or near prime lending rates, hedged versus non-hedged inventories. In the absence of futures markets, hedgers could only engage in forward contracts — unique agreements between private parties, who operate independently of an exchange or clearinghouse. Hence, the collateral value of a forward contract is less than that of a futures contract.

Forecast errors are expensive, and well informed, highly competitive, profit-seeking traders have a relatively greater incentive to minimize them. Into the early nineteenth century, the vast majority of American grains — wheat, corn, barley, rye and oats — were produced throughout the hinterlands of the United States by producers who acted primarily as subsistence farmers — agricultural producers whose primary objective was to feed themselves and their families. Although many of these farmers sold their surplus production on the market, most lacked access to large markets, as well as the incentive, affordable labor supply, and myriad technologies necessary to practice commercial agriculture — the large scale production and marketing of surplus agricultural commodities.

At this time, the principal trade route to the Atlantic seaboard was by river through New Orleans 4 ; though the South was also home to terminal markets — markets of final destination — for corn, provisions and flour. Smaller local grain markets existed along the tributaries of the Ohio and Mississippi Rivers and east-west overland routes.

The latter were used primarily to transport manufactured high valued and nonperishable goods west. Most farmers, and particularly those in the East North Central States — the region consisting today of Illinois, Indiana, Michigan, Ohio and Wisconsin — could not ship bulk grains to market profitably Clark , 4, The Great Lakes provided a natural water route east to Buffalo but, in order to ship grain this way, producers in the interior East North Central region needed local ports to receive their production.

Although the Erie Canal connected Lake Erie to the port of New York by , water routes that connected local interior ports throughout northern Ohio to the Canal were not operational prior to the mids. Indeed, initially the Erie aided the development of the Old Northwest, not because it facilitated eastward grain shipments, but rather because it allowed immigrants and manufactured goods easy access to the West Clark , By the mouths of rivers and streams throughout the East North Central States had become the hubs, or port cities, from which farmers shipped grain east via the Erie.

By this time, shippers could also opt to go south on the Ohio River and then upriver to Pittsburgh and ultimately to Philadelphia, or north on the Ohio Canal to Cleveland, Buffalo and ultimately, via the Welland Canal, to Lake Ontario and Montreal By shippers carried more grain north on the Great Lakes and through Buffalo, than south on the Mississippi through New Orleans Odle , Illinois, Indiana, Michigan, and the region of modern day Wisconsin either produced for their respective local markets or relied upon Southern demand.

What are Derivatives in Finance?

Before the mids, a network of banks, grain dealers, merchants, millers and commission houses — buying and selling agents located in the central commodity markets — employed an acceptance system to finance the U. The merchant extended this line of credit in the form of sight drafts, which the merchant made payable, in sixty or ninety days, up to the amount of the line of credit. With this credit line established, commission agents in the hinterland would arrange with grain dealers to acquire the necessary grain.

The commission agents would use these banknotes to advance — lend — grain dealers roughly three quarters of the current market value of the grain. The commission agent would pay dealers the remainder minus finance and commission fees when the grain was finally sold in the East. That is, commission agents and grain dealers entered into consignment contracts. The system was reasonably adequate if grain prices went unchanged between the time the miller procured the credit and the time the grain bulk or converted was sold in the East, but this was rarely the case.

The fundamental problem with this system of finance was that commission agents were effectively asking banks to lend them money to purchase as yet unsold grain. To be sure, this inadequacy was most apparent during financial panics, when many banks refused to discount these drafts Odle , The canal enabled farmers in the hinterlands along the Illinois River to ship their produce to merchants located along the river. These merchants accumulated, stored and then shipped grain to Chicago, Milwaukee and Racine. At first, shippers tagged deliverables according to producer and region, while purchasers inspected and chose these tagged bundles upon delivery.

Differences between forward and futures market prices

Commercial activity at the three grain ports grew throughout the s. Chicago emerged as a dominant grain primarily corn hub later that decade Pierce , Amidst this growth of Lake Michigan commerce, a confluence of innovations transformed the grain trade and its method of finance. By the s, grain elevators and railroads facilitated high volume grain storage and shipment, respectively. Consequently, country merchants and their Chicago counterparts required greater financing in order to store and ship this higher volume of grain. For example, because a bushel of grade No.

Merchants could secure these larger loans more easily and at relatively lower rates if they obtained firm price and quantity commitments from their buyers. So, merchants began to engage in forward not futures contracts. It specified that 3, bushels of corn were to be delivered to Chicago in June at a price of one cent below the March 13 th cash market price In the s and s these exchanges emerged as associations for dealing with local issues such as harbor infrastructure and commercial arbitration e.

By the s they established a system of staple grades, standards and inspections, all of which rendered inventory grain fungible Baer and Saxon , 10; Chandler , As collection points for grain, cotton, and provisions, they weighed, inspected and classified commodity shipments that passed from west to east.

They also facilitated organized trading in spot and forward markets Chandler , ; Odle , The largest and most prominent of these exchanges was the Board of Trade of the City of Chicago, a grain and provisions exchange established in by a State of Illinois corporate charter Boyle , 38; Lurie , 27 ; the exchange is known today as the Chicago Board of Trade CBT. For at least its first decade, the CBT functioned as a meeting place for merchants to resolve contract disputes and discuss commercial matters of mutual concern.

Participation was part-time at best. However, in the CBT became a state- of Illinois chartered private association. By the s traders sold and resold forward contracts prior to actual delivery Hieronymus , A trader could not offset, in the futures market sense of the term, a forward contact. Nonetheless, the existence of a secondary market — market for extant, as opposed to newly issued securities — in forward contracts suggests, if nothing else, speculators were active in these early time contracts. On March 27, , the Chicago Board of Trade adopted its first rules and procedures for trade in forwards on the exchange Hieronymus , The rules addressed contract settlement, which was and still is the fundamental challenge associated with a forward contract — finding a trader who was willing to take a position in a forward contract was relatively easy to do; finding that trader at the time of contract settlement was not.

The CBT began to transform actively traded and reasonably homogeneous forward contracts into futures contracts in May, At this time, the CBT: restricted trade in time contracts to exchange members; standardized contract specifications; required traders to deposit margins; and specified formally contract settlement, including payments and deliveries, and grievance procedures Hieronymus , The inception of organized futures trading is difficult to date. This is due, in part, to semantic ambiguities — e. However, most grain trade historians agree that storage grain elevators , shipment railroad , and communication telegraph technologies, a system of staple grades and standards, and the impetus to speculation provided by the Crimean and U.

Nonetheless, futures exchanges in the mids lacked modern clearinghouses, with which most exchanges began to experiment only in the mids. The earliest formal clearing and offset procedures were established by the Minneapolis Grain Exchange in Peck , 6. Even so, rudiments of a clearing system — one that freed traders from dealing directly with one another — were in place by the s Hoffman , That is to say, brokers assumed the counter-position to every trade, much as clearinghouse members would do decades later. Brokers settled offsets between one another, though in the absence of a formal clearing procedure these settlements were difficult to accomplish.

Direct settlements were simple enough.

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Here, two brokers would settle in cash their offsetting positions between one another only. Nonetheless, direct settlements were relatively uncommon because offsetting purchases and sales between brokers rarely balanced with respect to quantity. For example, B1 might buy a 5, bushel corn future from B2, who then might buy a 6, bushel corn future from B1; in this example, 1, bushels of corn remain unsettled between B1 and B2. Of course, the two brokers could offset the remaining 1, bushel contract if B2 sold a 1, bushel corn future to B1.

But what if B2 had already sold a 1, bushel corn future to B3, who had sold a 1, bushel corn future to B1? Brokers referred to such a meeting as a ring settlement. Finally, if, in this example, B1 and B3 did not have positions with each other, B2 could settle her position if she transferred her commitment which she has with B1 to B3. Brokers referred to this method as a transfer settlement.

In either ring or transfer settlements, brokers had to find other brokers who held and wished to settle open counter-positions. Often brokers used runners to search literally the offices and corridors for the requisite counter-parties see Hoffman , Finally, the transformation in Chicago grain markets from forward to futures trading occurred almost simultaneously in New York cotton markets. Forward contracts for cotton traded in New York and Liverpool, England by the s. And, like Chicago, organized trading in cotton futures began on the New York Cotton Exchange in about ; rules and procedures formalized the practice in Data on grain futures volume prior to the s are not available Hoffman , Indeed, Chart 1 demonstrates that trading was relatively voluminous in the nineteenth century.

An annual average of 23, million bushels of grain futures traded between and , or eight times the annual average amount of crops produced during that period. By comparison, an annual average of 25, million bushels of grain futures traded between and , or four times the annual average amount of crops produced during that period. In , futures volume outnumbered crop production by a factor of eleven. On the other hand, the seller incurs a loss in the same scenario. For a detailed understanding, you can read our exclusive post on Forward Contract.

Swap can be defined as a series of forward derivatives. It is essentially a contract between two parties where they exchange a series of cash flows in the future.

One party will consent to pay the floating interest rate on a principal amount while the other party will pay a fixed interest rate on the same amount in return. Currency and equity returns swaps are the most commonly used swaps in the markets. Exchange traded forward commitments are called futures. A future contract is another version of a forward contract, which is exchange-traded and standardized. Unlike forward contracts, future contracts are actively traded in the secondary market, have the backing of the clearinghouse, follow regulations and involve a daily settlement cycle of gains and losses.

Contingent claims are contracts in which the payoff depends on the occurrence of a certain event. Unlike forward commitments where the contract is bound to be settled on or before the termination date, contingent claims are legally obliged to settle the contract only when a specific event occurs. Contingent claims are also categorized into OTC and exchange-traded contracts, depending on the type of contract.

DERIVATIVES

The contingent claims are further sub-divided into the following types of derivatives:. Options are the type of contingent claims that are dependent on the price of the underlying at a future date. Unlike the forward commitments derivatives where payoffs are calculated keeping the movement of the price in mind, the options have payoffs only if the price of the underlying crosses a certain threshold.

Options are of two types: Call and Put. A call option gives the option holder right to buy the underlying asset at exercise or strike price. A put option gives the option holder right to sell the underlying asset at exercise or strike price. Options where the underlying is not a physical asset or a stock, but the interest rates.

It includes Interest Rate Cap, floor and collar agreement. Further forward rate agreement can also be entered upon. Warrants are the options which have a maturity period of more than one year and hence, are called long-dated options. These are mostly OTC derivatives. Convertible bonds are the type of contingent claims that gives the bondholder an option to participate in the capital gains caused by the upward movement in the stock price of the company, without any obligation to share the losses.

Callable bonds provide an option to the issuer to completely pay off the bonds before their maturity. Asset-backed securities are also a type of contingent claim as they contain an optional feature, which is the prepayment option available to the asset owners. In addition to the categorization of derivatives on the basis of payoffs, they are also sub-divided on the basis of their underlying asset. Since a derivative will always have an underlying asset, it is common to categorize derivatives on the basis of the asset.

Contract: A legally enforceable agreement between two or more parties for performing, or refraining from performing, some specified act; e. Contract market: Designated by the CFTC, a contract market is a board of trade set up to trade futures or option contracts, and generally means any exchange on which futures are traded. See Board of trade and Exchange.

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