MKTG 3961: Week 5 - Understanding Futures Contracts and Hedging

Comprehensive vocabulary flashcards covering futures contract terminology, market mechanisms, order types, margin requirements, and hedging strategies as presented in the lecture.

Futures Contract

A legally binding agreement to buy or sell a specified quantity and quality of a commodity (or financial instrument), at a specified price at some time in the future.

Discovery of Prices

The primary function of a futures market where supply meets demand and prices reflect deferred delivery.

Risk-shifting Mechanism

The concept that futures markets establish prices for deferred delivery and allow speculators to sell insurance to hedgers.

Clearinghouse

The regulator of a futures exchange that stands as a ‘guarantor’ for the trades.

Brokers

Entities that often have membership with the exchange and facilitate trades.

Daily Price Limits

Restrictions on the maximum amount a price can move up or down in a single day.

Tick Size

The minimum value a contract can move.

Settlement Price

The last price paid (or an average of prices) for a given futures contract on a given day.

First Notice Day

The timeframe in which a seller issues notice to the clearing house indicating an intention of physical delivery in fulfillment of the futures contract.

Novation

A process that allows buyers or sellers to liquidate or close their position with a different party.

Carrying Charge

A set of inter-temporal prices where the more distant month has a higher price than the nearby month, reflecting a return for storage.

Nearby Contract

The nearest active trading month of a futures contract.

Deferred Contract

A futures contract traded further away from expiration than the nearby contract.

Contango

A market condition where deferred contracts trade at a premium to nearby contracts.

Backwardation

A market condition where nearby contracts trade at a premium to deferred contracts.

Initial Margin

The amount required to initiate a trade, set by the clearinghouse and influenced by liquidity, recent volatility, and divergence between cash and futures.

Maintenance Margin

The minimum amount of equity or cash that must be maintained in an account once a position has been initiated.

Margin Call

A demand by a broker to cover losses in a trading account.

Variation Margin

The amount of additional funds required to keep up with current trading losses.

Market Order

An order filled at the prevailing bid/offer market price.

GTC (Good till Cancelled)

An order with a specified price that remains active until it is cancelled.

Stop Loss

An order that becomes a market order when prices trade or are offered at a specified price.

OCO (Once Cancels Another)

An order where two prices are specified, and one part of the order is cancelled when the other is filled.

Short Position

A commitment to sell futures contracts, which rise in value as prices fall.

Long Position

A commitment to buy futures contracts, which rise in value as prices rise.

Hedging

The practice of taking a position in the futures market equal, but opposite, to a position held in the cash market to minimize financial risk from adverse price changes.

Arbitrage Hedge

A category of hedging used to profit from basis fluctuations.

Operational Hedge

A hedge used by a merchant to establish the price of an input or output for a regularly traded commodity.

Anticipatory Hedge

A hedge performed by merchants expecting a future sale or purchase.

Cross Hedge

Hedging in a commodity market different from the actual cash product of interest.

Derivative

An instrument derived from an underlying physical commodity or financial instrument.

Roundturning

Closing out an original futures position by the assignment of an equal number of opposite futures contracts.

Short Hedge

The combination of a long cash position with a short futures position to minimize the risk of prices falling.

Long Hedge

The combination of a short cash position with a long futures position to minimize the risk of prices rising.

Basis

The difference between the cash price and the futures price, calculated as $\text{Basis} = \text{cash} - \text{futures}$.

Basis Risk

The risk that the basis will change unfavorably and unpredictably during the lifetime of a hedge.