chapter one commodity Futures how did the Futures Contract evolve well it evolved out of what was called the forward contract let's say you're a gold mining company and you have gold to sell well you could sell that gold in What's called the cash or spot Market that would be for immediate delivery but let's say you're also going to have gold to sell in 3 months or 6 months and you're concerned that the price is going to drop well you could enter into what's called a forward contract a forward contract is a contract between a buyer and a seller but for future delivery so we can enter into a contract where you are selling gold to let's say me but we've agreed you will deliver that gold in 3 months and what we've entered into is a forward contract well in a forward contract like a Futures Contract who has an obligation the answer is both the buyer and the seller have an obligation the buyer has the obligation to take delivery and to pay for it the seller has an obligation to make delivery and they will be paid so if we entered into a forward or Futures Contract and you sold the contract and I bought it since I bought it I have an obligation to take delivery and pay you the seller have an obligation to make delivery of that well what is the difference between Futures and forwards well let's start with forwards on the right hand side a forward contract is an individual contract between two parties for future delivery since it's an individual contract between the two parties it can be for whatever we agree to so the terms of this contract are negotiated so it could be for any amount of gold that we agree that you're going to deliver to me on whatever date we agree to that you're going to deliver so this is a variable quantity as agreed to to a location that we agree to but one of the big disadvantages of a forward is that we have individual credit risk that the other party might def fault so it's a personal contract between you and me and we have individual credit risk so if I bought the gold you sold it to me you're going to deliver to me in 3 months I have the risk that you'll default and you won't deliver the gold to me you have the risk that you'll deliver the gold and I'll fail to pay so we have this individual credit risk well because we have individual credit risk and it's a customized contract forwards are very difficult generally to offset what do I mean by that if one of us wanted to get out of Our obligation to make or take delivery usually the other party would have to agree to let us out we care who's on the other side of the contract why because we do have individual credit risk that the other party might default well this test is not about forwards it's about futures so let's turn our attention to the leftand column with Futures Futures are for a standardized contract Futures trade on exchanges and the contract is standardized some of the things that are standardized are the quantity so for example there's 100 ounces of gold in a gold Futures Contract there's 5,000 bushels of wheat in a contract and so on so it's a standardized contract delivery has to be to a location that's approved by who by the exchange it has to be delivered to an exchange approved Warehouse or depository so we can't just agree it's not a personal contract where we can just agree to a different delivery location it has to be to an approved Warehouse or depository and it's generally the seller who determines the the exact location will delivery will be made it's generally the seller who determines what exact location delivery will be made but it must be made to an exchange approved Warehouse or depository well Futures are nonpersonal what do we mean by that Futures are guaranteed by a clearing house or sometimes referred to as a Clearing Corporation so the CME Clearing Corporation guarante performance so make sure you note with Futures there's no individual credit risk between the two parties there's no individual credit risk instead who guarantees performance the Clearing House or Clearing Corporation affiliated with the exchange guarantees performance we will look at the Clearing House in much more detail in a little bit well if we think about a Futures Contract there's no individ ual credit risk it's guaranteed by the Clearing House it's a standardized contract so do we care who's on the other side of that contract the answer is not at all we do not care at all who's on the other side of that contract because the Clearing House is guaranteed performance so it's very easy to offset your obligation if you bought Futures you have an obligation to take delivery if you want to get out of that obligation all you have to do is sell the the Futures to whoever buys it and you are out of that contract if you originally sold the Futures you're obligated to make delivery if you want to get out of that obligation all you have to do is buy it back remember at the end of a Futures Contract if you didn't offset that position then you will have to either make delivery if you had sold it or take delivery and pay for it if you had bought the Futures Contract Futures don't expire like options do where if it's out of the money it just expires Futures contracts end in delivery unless you offset that position by the way the vast majority of Futures contracts are liquidated rather than delivered against roughly 98% of Futures contracts are actually offset and we'll look at that more as we go along now if you do stay in a contract until you're assigned then some exchanges will force you to accept that and make or take delivery where other exchanges will allow you to still enter into a closing trade and they'll assign that delivery notice to someone else if they force you to accept that assignment once assigned that is sometimes referred to as being stopped now let's take a look at a question as we come across these questions throughout the on demand a good recommendation is to pause the video a second and try to answer the question on your own before hearing the explanation so feel free to pause to answer this question okay let's take a look at the question an investor sold a wheat Futures Contract at $516 per bushel at the end of the contract if the price of wheat has fallen to $410 per Bushell which of the following statements is true does the investor make delivery does the investor take delivery does the contract expire worthless or D the investor neither makes nor takes delivery well remember at the end of the contract if you sold you will have to make delivery if you bought you will have to take delivery so here the investor sold the wheat Futures Contract so at the end of this contract if they didn't get out of that obligation they will have to make delivery of wheat so the answer is a now let's turn our attention to the Futures exchanges the exchanges provide a place to trade the Futures notice on the bottom the exchanges don't actually trade they don't buy or sell contracts they don't own any contracts they don't set the prices of the contracts how are the prices set by the basic law of Economics supply and demand between buyers and sellers The Exchange is providing a place to trade the exchange sets the contract terms but those get approved by the commodity Futures Trading commission the cftc the commodity Futures Trading commission the cftc is the government agency that regulates Futures they are the government agency that regulates Futures they're similar to the SEC for Securities on the security side you have the Securities and Exchange Commission the SEC is the government agency on the future side you have the cftc when we cover regulations you will know the cftc inside and out what are the contract terms of this Futures Contract well the delivery size as we said before 5,000 bushels of wheat 5,000 bushels of corn 100 oz of gold 1,000 barrels of oil 42,000 gallons of gasoline now many people worry when they start studying for the series 3 do I have to actually memorize all my contract sizes and the answer is no there's only a few that we're going to ask you to memorize which you'll see on a separate slide so do not worry about the bulk of your contract sizes there's only a few we're going to ask you to memorize and by the way the 5,000 bushels of corn and wheat and soybeans is one of the ones you're going to have to memorize the basis grade the basis grade is the normal or sort of regular grade that you would expect to be delivered against the contract but here's the question that I would watch out for can exchange specifications allow for substitute grades to be delivered make sure you know the answer is yes the contract terms may allow for delivery of a superior grade sometimes called a premium grade at a stepped up price so the buyer will have to pay more or an inferior grade sometimes referred to as a discount grade at a discount Ed Price where the buyer will pay less so it does allow quite often for substitute grades to be delivered the reason the exchange will allow for that is to prevent a cornering of the market where someone tries to control maybe a limited supply of an available commodity by allowing for substitute grades to be delivered it makes it harder for an investor or investors acting together to try to Corner the market the time of delivery do not worry about memorizing delivery dates okay but the contract can't be delivered against until we reach the time of delivery the place of delivery as we said must be to an approved location that's regular for delivery who approves that the exchange does remember if they ask you who determines the specific Warehouse of those approved locations who determines the specific one where delivery will be made the seller generally determines the specific location the other thing you better know that the exchange sets is the margin requirements we will look at margin as its own topic later on but the exchange sets the margin requirements and they set both the initial or sometimes referred to as original margin which is what you have to deposit when you take on the position when you do the trade you deposit the initial margin they then allow the market to move against you a bit before they call you for more margin if you drop below maintenance you get a margin call which is sometimes referred to as a variation Margin Call variation margin or maintenance margin is what you need to maintain the position so you initially put up the initial margin you could then lose a little bit B before you get called for more well the exchange sets both the initial and variation or maintenance margin remember the exchange does not actually trade The Exchange doesn't actually go long or short the contracts they don't set the prices now a couple of exchanges that are probably worth knowing there's the CME and the Globex they're all part of the CME Globex group this includes the Chicago mertile Exchange the cbot or the Chicago Board of Trade the Kansas City Board of Trade and you could see other exchanges here now one thing that I would know is generally when the exchanges are part of the same group you can establish a position on one exchange and liquidate on the other and that will get rid of your position the question I think you might see is what if I established a position on the CMA floor the physical floor and I liquidated it on what's called Globex Globex is a technology platform that allows you to trade basically from anywhere okay if I establish the position on the physical floor can I liquidate that CME position on Globex know that the answer is is yes you can and we'll look at liquidation more as we go along if it still confuses you a little bit don't worry about it but I would know that CME floor traded products and Globex which is a technology platform products are interchangeable that you can establish on one and liquidate on the other there's also the Intercontinental Exchange group and here you could see some of their exchanges ice futures Intercontinental Exchange futures Europe Singapore and on these marketplaces institutional and Retail investors have access to the same prices and again each exchange is affiliated with a clearing house that's going to guarantee that performance so there's no individual credit risk on any of the Futures exchange traded products whether they be part of the CME Group or ice now what are some of the benefits of Futures exchanges well the Futures markets were actually created for hedgers we started our discussion saying you're a gold mining company maybe you have a gold find you're going to pull that gold out of the ground and sell it well some gold you have to sell today at let's say $1,700 an ounce but you're going to be pulling gold out and you're concerned that by the time we pull the gold out and sell it gold prices might have dropped if gold Falls it may eat away at our profit in fact it may make it not even worthwhile mining the gold if gold fell too much so how can we hedge well we can sell gold Futures and that sort of locks in a price that we can sell the gold at that's sort of the producer side users also have to hedge quite often so maybe you have enough corn to feed your livestock for the next little bit but you don't have enough corn to feed your livestock down the road you're fearful that corn prices are going to go up you want to lock in a price you could buy corn at so what you might do is buy corn Futures to lock in a price this is really why Futures will cre created to allow producers and users to hedge by establishing a Futures position that's opposite to their cash position now you could rest assured we're going to spend a lot of time on hedging problems through this program but this will substantially reduce the risk of adverse price moves because we're reducing risk it may allow producers and users to obtain credited more favorable rates lenders won't won't charge you as much interest why because there's a lower risk that you'll default because you've hedged that position this could also have the effect of reducing the price of the commodity to the public since if there's less risk entities will operate for smaller profits if there was more risk they would need to build in a bigger profit margin Futures exchanges also provide a central point to channel risk capital for spec cators How can there be someone willing to take the other side of this hedger trade right at that exact moment so when I wanted to hedge my risk I had in the gold market or the corn Market or the wheat Market or whatever it is how could there be someone willing to take the other side of that trade at that very moment well this is where speculators come in the specul ators will often be the other side of the trade quite often speculators are using the Futures markets not to try to reduce risk but to just try to profit what speculators add to the Futures Market is liquidity they're adding liquidity to the market by being willing to take the other side of the trade that will narrow the spread between the bid and the ask it will make it easier for people to get in and out of positions whether they be speculators or hedgers so speculators increase liquidity which tends to reduce the volatility of the contract now it also provides a focal point where all buy and sell orders can be sent then we find out the price that the Futures are trading at and the exchanges do disseminate these prices so that the world knows what these contracts are trading at and although most people don't use it as an alternative channel for making or taking delivery of the commodity okay it can be used to make delivery or take delivery of the commodity if you stayed in the Futures Contract till delivery now there are several exchange committees and we'll cover regulations in chapter two but a few exchange committees that are worth mentioning now there's an arbitration committee arbitration make sure you know is a means for settling disputes it's not for handling violations it's a means for settling disputes that could be disputes between members disputes between firms or disputes between the the firm and their public customers we will look at arbitration more in detail when we look at regul ations there's a business conduct committee that investigates complaints against members it acts to prevent price manipulation it supervises members and their employees so here they will handle violations of members again we will look at regulations in a lot more detail in the regulations chapter there's also a floor committee that establishes rules rules regarding trading on the floor of the exchange and it settles disputes related to transactions on the floor and the transactions on the floor we will look at orders as its own section we'll look at the handling of orders but you're not supposed to be making just side agreements the trading should take place in a fair and Equitable way on the floor now when it comes to trading there's types of Traders there are floor Brokers and Floor Traders down on the floor floor Brokers execute orders on behalf of others they work for firms or maybe they're an independent floor broker but let me give you an example a client of Goldman Sachs or Morgan Stanley or JP Morgan or whatever firm a client wants to buy or sell let's say crude oil Futures they give their order to their Associated person or registered commodity representative that order gets sent down to the floor it will be handled by let's say Goldman's floor broker who will execute that order for the client now sometimes firms might not be H able to handle all the orders they're receiving so they might use an independent floor broker to handle some of their orders for them but the key thing again with floor Brokers is that executing orders for others Floor Traders on the other hand are trading for their own account they're trading for their own account they're sometimes called locals so they're down on the floor trading for their own account or maybe for their firm's account for proprietary account meaning the firm's own account but they're not handling orders for public customers they're handling orders for themselves now what do these Floor Traders add again make sure you know they add liquidity again these Floor Traders add liquidity the fact that they're on the floor being willing to take the other side of the trade is adding to the liquidity of Futures Trading which again when you have more liquidity generally dampens or cuts down on volatility especially that whip saring of prices now know that the Floor Traders are trading for their own account but they're not actually obligated to take the other side of a trade they're not actually obligated to take the other side of the trade okay but they are down on the floor trading and that does add liquidity now some people do day trading some people do position trading what does day trading mean it means if you establish the position you also liquidate it on the same same day so if you establish the position you'll also liquidate the position on the same day you'll offset that position where position Traders will carry positions overnight so they'll hold on to positions longer than just the one day now let's take a closer look at the Clearing House each exchange is affiliated with a clearing house so for example we have CME clearing which clears trades for the Chicago mertile exchange each trade has to be cleared through the Clearing House and effectively the Clearing House becomes the buyer for every seller and the seller for every buyer and guarantees performance of the contract that's how we eliminate the counterparty risk in a Futures Contract remember Futures unlike forwards Futures you do not have individual counterpart risk why remember we stated the Clearing House guarantees performance so how does this work the exchange members so the fcms collect margin from their customers the fcms clear the trades through the Clearing House the firms the fcms put up Margin with the Clearing House and the Clearing House guarantees performance so if the customer were to default The Firm firm who that client is a customer of the firm would still be liable if that put the firm under the Clearing House would still make good on that contract that's why we don't worry about the individual credit risk it's really the Integrity of the Clearing House which is basically almost the Integrity of the system that's behind each trade so the Clearing House becomes that ultimate guarantor a minating the counterparty risk now let's take a look at an activity read each statement and determine whether the statement is true or false now feel free to pause the video while you answer the questions let's take a look at how you did number one Futures contracts may be modified to fit specific hedger needs that is false forwards are customized contracts but Futures remember are standardized contracts question two delivery of a superior grade of a commodity will give the seller a premium price that is true exchange specifications generally do allow for substitute grades to be delivered Superior grades at a premium price or infer area grades at a discounted price question three the floor committee is concerned with preventing side agreements between floor Brokers that is true they want fair and Equitable trading on the floor and that would be a potential uh a grievance number four the buyer determines which grade will be delivered that is false the seller determines the specific grade and the location where delivery will be made what's next the cftc and NFA rules and regulations a very important chapter remember you have to pass regulations on its own and customer accounts but before moving along what you may want to do is pause create a custom exam on this chapter of maybe like 10 questions just to get your feet wet in applying this information to sample questions then move on to the next chapter