Chapter One: Commodity Futures

Evolution of Futures Contracts

• Forward Contract Origin:
  • Developed from forward contracts.
  • Example: Gold mining company selling gold.
  • Forward contracts are used for future delivery to mitigate price drop risks in commodities like gold.

Forward Contracts

• Obligations:
  • Both buyer and seller have obligations.
  • Buyer must take delivery and pay; seller must deliver.
• Characteristics:
  • Individual contracts between two parties.
  • Terms are negotiated (quantity, delivery date, location).
  • High individual credit risk; difficult to offset.

Futures Contracts

• Standardization:
  • Traded on exchanges, standardized contracts.
  • Specific quantities (e.g., 100 oz of gold, 5,000 bushels of wheat).
  • Delivery to exchange-approved locations.
• Clearing House Role:
  • Guarantees performance, eliminating individual credit risk.
  • Easy to offset obligations by selling or buying back the futures.

Comparison: Forwards vs. Futures

• Forwards:
  • Customized, higher credit risk, difficult to offset.
• Futures:
  • Standardized, clearing house guarantee, no personal credit risk.

Futures Trading Mechanics

• Contract End:
  • Obligation to deliver or receive unless offset.
  • Most contracts (98%) are offset before delivery.

Futures Exchanges

• Role:
  • Provide trading venues, but don't trade/own contracts.
  • Prices are determined by supply and demand.
• Regulation:
  • Commodity Futures Trading Commission (CFTC) oversees futures, similar to SEC for securities.
  • Exchanges set contract terms (e.g., delivery size, margin requirements).

Hedging and Speculation

• Hedgers:
  • Use futures to lock in prices, manage risk (e.g., gold, corn).
• Speculators:
  • Add liquidity, willing to take opposite sides of trades.

Market Benefits

• Liquidity:
  • Provided by speculators and floor traders.
  • Reduces volatility and spreads.

Exchange Committees

• Arbitration: Settle disputes.
• Business Conduct: Prevent price manipulation.
• Floor: Establish rules for trading on the floor.

Trader Types

• Floor Brokers: Execute orders for others.
• Floor Traders: Trade for their own accounts.

Clearing House

• Function:
  • Ensures contract performance, eliminating counterparty risk.
  • Exchange members collect and clear trades through the house.

Key Concepts to Remember

• Standardized Contracts: Futures are not modified; standardized for exchange.
• Grade Delivery: Superior grades can be delivered at premium prices.
• Regulatory Focus: Committees ensure fair trading practices.

Practice Questions

• Reflect on key concepts and test understanding through practice questions or exams.