Money, Banking, and International Financegovernment bond one year from now. Futures contract is a legal document that assigns rights. A
buyer’s right obligates you to buy the government bond, called the long position. Seller’s right
obligates him or her to sell you the government bond, called the short position.
Derivatives market determines the price of the futures contract. Futures price reflects the
expectations of investors and savers. For example, you bought a futures contract for petroleum,
and you negotiated a price of $80 per barrel. Seller will deliver the oil within six months. You
could sell your futures contract on the derivatives market if you no longer want the contract. If
investors and savers believe that oil will be $90 per barrel, then the market value of your futures
contract rises. You could either sell your futures contract for a higher price or wait until you
receive the oil and sell the oil for $10 per barrel profit. However, the opposite could occur. If
investors and savers believe the price of oil will be $70 per barrel, then the market value of your
futures contract drops. You must buy oil for $80 per barrel that costs $70 in the future.
Speculators buy derivatives because the market value of the derivatives could experience
wide swings. As the date of the delivery approaches for a futures contract, the futures contract
market price will converge to the spot price. On the day of delivery, the market value of a
derivative must equal the spot price. A buyer never purchases a futures contract if the market
price of the futures contract exceeds the spot price. For example, if petroleum costs $90 per
barrel today, then a buyer would never buy a contract today for a petroleum price of $91 or
higher. Furthermore, a seller would never sell a futures contract, when the market price of the
futures contract is lower than the spot price. For instance, if the spot petroleum market price
were $90 per barrel today, then no one would sell a derivatives contract that matures today for a
price below $90.
Buyers and sellers do not know each other when they buy or sell a futures contract through
an exchange. Consequently, a buyer or seller deposits money with a broker to cover possible
losses from a futures contract. As the spot market price changes for a commodity daily, either
the buyer or seller will lose money if the exchange occurs today. However, the loser deposits
money into a margin account. A margin account helps guarantee the parties will honor the
contract. Usually the market price must exceed some threshold before a buyer or seller must
deposit money. (A forward contract may not have a margin account).
Example 1: A petroleum refinery buys 10 futures contracts of petroleum that matures in six
months. Contract size is 10,000 barrels of petroleum with a contract price of $75 per barrel.
Who pays the margin if the spot petroleum price equals $90 per barrel today? Seller
deposits^10 ^10 ,^000 $^90 $^75 =$^150 ,^000 with his broker. If this contract matured today, then
a buyer would purchase this oil for $75 and sell it for $90, earning a large profit of $15 per
barrel. If a speculator bought 10 petroleum contracts, he or she could earn $150,000 if the
derivatives contracts matured today.
Who pays the margin if the petroleum price falls to $60 per barrel? Buyer deposits
10 10 , 000 $ 75 $ 60 =$ 150 , (^000) with his broker. If this contract matured today, then the
seller would buy oil on the spot market for $60 per barrel and sell it to the buyer for $75, earning
a large profit of $15 per barrel. If a speculator bought 10 contracts, subsequently, he or she
would earn a $150,000 loss if the contracts matured today. Thus, speculators could earn
enormous profits or experience massive losses from the derivatives markets.