DRRM

Speculation in the Financial Futures Market

Introduction
This case illustrates the returns and risks faced by financial speculators in futures market. John Park the protagonist of the case is a 27 years old speculator. John was a member of GLH Derivatives. He was a local or a self employed trader. An expert in the Bund market, John was one of the heaviest players amongst the locals at GLH. He had around 1 Mn as deposits with Griffin. GLH was an association of locals, who cleared their trades through Griffin. Griffin was a clearing house, a member of LIFFE (London International Financial Futures and Options Exchange Member). However Griffin was not a Eurex member. Griffin was the clearing house for all locals at GLH and they operated a common Omnibus account for margin deposits of all locals. Griffin acted as a clearing house for John Park. However John did not trade directly through Griffin. John executed his trades through Tullett and Tokyo, a Japanese money broking firm. Also he traded on Eurex exchange rather than Liffe. Johns trades were routed to Griffin for clearing through Eurex general clearing member ICS Mees Pierson by Tullett and Tokyo. Trade volumes were low before Christmas as most of the traders had squared off their positions in the market. In such a thin market, John planned to influence the exchange by holding an extremely large position. He planned to buy in a falling market, halt the fall and force the prices up. Then sell at a profit. Park was a big trader and Griffin had permitted him to trade up to 1000 lots per day on a margin of 1 million. However as on 21st December, Park owned 11,200 lots of future contracts. Although he alleged that he had only 940 Bund contract lots (that is, within his limit of 1000 lots). Contrary to his expectations the market did not stabilize or rise. It continues to fall. A major player sold at a rate as which Park was buying. John Park was trapped in a already thin market. As the news broke the market fell sharply. John lost 6.25 million. Margin accounts of all local traders were maintained in a single omnibus account by Griffin. Johns margin was recovered from this common account. As a result most of the local traders at GLH suffered.

Q1: Highlight the key factors which drive futures prices, making the distinction between contango and backwardation.
Contango is a condition when the futures price of commodity is higher than expected future spot price. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time as new information brings them into line with the expected future spot price. Backwardation is the opposite condition when the futures price of a commodity id lesser then the expected futures price. A contango results if there is a general perception of supply surplus for a commodity. In a surplus condition, investors wont be willing to pay premium for the commodity currently, but as the conditions are expected to stabilize in the future, the future prices are higher than the spot prices. Inventory carrying costs also lead to conditions of contango. The various carrying costs include warehousing fees, interest foregone on money tied up etc. If carrying costs are high the investors will compare the futures prices with the spot prices plus the carrying costs and choose the better option. Hence in this case investors are ready to pay a premium for futures. Expectation that there will be a near term shortage of a commodity can lead to investors wanting to buy and hold the commodity. This condition may lead to Backwardation. In this case the near prices are higher than far-future prices.

Q2: How does a Hedger use futures market?

Hedging is the act of taking equal and opposite positions in the futures markets to protect a market position against loss due to price fluctuation. In anticipation of buying or selling the commodity, the hedger buys or sells futures contracts. Because spot and futures prices tend to rise and fall together, the futures market provides the medium for financial instrument/commodity owners and users to hedge against adverse price risk. With opposite positions in the spot and futures markets, price losses in one market will be approximately offset by gains in the other. There are two types of hedges: The long hedge and the short hedge. In a long hedge, futures contracts are bought in anticipation of a later purchase in the spot market. A buying or long hedge is used by individuals to protect against an increase in the price of the commodity that they will buy (or expect to buy) at a future date. The selling or short hedge is used by those who are trying to protect against declines in the price of the commodity they own or will produce for sale at a later date.

For example, if a company has sold futures contracts, it has established opposite positions in the spot and futures markets. It is long in the spot market because it owns allowances and it is short in the futures market because it has sold futures contracts for delivery in the future. If prices decline, the hedger will realize a lower price in the spot market when it sells the allowances. However, this loss will be offset by the profit realized when it buys back the futures contract at a lower price. In short, Hedging is like insurance. Hedgers transfer price uncertainty and risk to, and spread it among, many speculators who are present in the futures markets.

Q3: How would a speculator use futures markets? Illustrate the risks and rewards available in the futures market, using the examples in the case.
Speculators are the market participants who do not aim to minimize risk but rather to benefit from the inherently risky nature of the commodity market. They aim to profit from the very price change that hedgers are protecting themselves against. Speculators want to increase their risk and therefore maximize their profits. In the commodity market, a speculator buying a contract low in order to sell high in the future would most likely be buying that contract from a hedger selling a contract low in anticipation of declining prices in the future. R The speculator do not actually transact in the financial instrument underlying the futures contract. Rather, they often take very short term positions in an attempt to exploit perceived anomalies or speculative opportunities. Risks and Rewards available in the futures market 1. The risk could be gauged by the fact that the fluctuation of even with a tenth of a percentage point of the market, Park Stood to gain or lose 1 mn Pound on his position. The risk involved in trading in futures market was huge due to large position created in the futures market. 2. In this particular case, there was a loophole that existed: There was a delay in the spreading of information because of the regulatory procedures- Griffin was a Liffe Clearing member but not a Eurex Clearing member. But, Park was trading on Eurex. The Trade would finally be settled by Griffin, However, until that final reckoning; there would be no record of them on their screens. This implies that there is a risk of manipulation due to lax in regulations in the futures markets. Had the regulatory authorities made it mandatory to install the 3. The reward of a futures contract is the assurance of the price in the future for a particular commodity. It eliminates the price risk.

Q4: How could John Park have made some serious money?
John Park incurred huge losses on account of his speculative trading in Bund market. However this loss could have been minimized either by adherence to strict regulatory framework by various parties involved or by maintaining high level of discipline while trading in futures market as a speculator by John. John had made some serious assumptions while formulating his speculation strategy, failure of occurrence of these events lead to his collapse. John expected that the market will rebound due to his buying in large quantity at lower prices which inturn will lead to increase in price and thus will give an opportunity to make huge profits by selling at higher prices. He assumed that as he was the one of the most influential speculator in the Bund market he will be able to guide the market by his action on a thinly traded day. Park did not consider the thought that another speculator might do complete opposite to his strategy in order to trap him. Also he assumed that he will be easily able to offload all his long position without leading to a further drop in price on a thinly traded day. Thus had all the assumptions and events expected by john had fallen in place he would have made some serious money. As a speculator John was trying to take the advantage of the market price movements. There was nothing wrong in expecting a particular movement in the prices and adopting a strategy accordingly. However creating positions which are beyond the risk appetite of the trader was something which was critical. Following measures from John could have ensured that the losses incurred by him were within the control: 1. Defining the risk limit and strict adherence to that- John had a certain limit because of his margin of $1m, however he traded to the extent which required margin amount of $6.25m. 2. Outguessing market will not always work- John tried to outguess the market, but however was in turn trapped due to strategy adopted by another trader. It is observed that outguessing market is a matter of luck. 3. Diversification helps- John being an expert on Bund market did not diversified his portfolio and took a very huge position in one market leading to concentration of portfolio which in turn lead to huge losses as he did not reduced his risk through diversification. Thus disciplined trading from John could have at least ensured the capital being intact if not profit.

Q5: To what extent do margin calls influence both short and long positions. Highlight who makes/ receives these calls, illustrating when, where and why they occur.
When a contract is entered into, an amount is deposited with the broker. This is called initial margin. The balance in this margin account varies according to the daily changes in market prices of the commodity. If the balance in the margin account reduces below the minimum maintenance level specified by the broker, a margin call occurs. When the investor gets a margin call he is expected to top up the margin account to initial level. If the investor does not deposit the variation margin in his account, the broker closes the investors position. The broker takes a position opposite to the one taken by the investor. If the investor has a short position, and he does not respond to margin call then the broker will sell commensurate amount of investors securities that were purchased on margin, or buy back the shorted securities at the market rate to bring back the level of margin account to initial level. Who, when, where and how: The broker makes a margin call, when the balance in the margin account falls below the maintenance level to demand top up of the margin account to initial level.

Q6: Update the case using Euro Futures instead of Bund Futures
John Park was a speculator in Bund futures. This Bund futures market was considered comparatively illiquid or low volume market in comparison to other market. Hence John thought of speculating in the market on a thinly traded day by guiding the moment of the market. He tried to dominate the moment of the market by taking huge positions on a thinly traded day. However while considering Euro futures (Euro currency market) which is highly liquid market with large volumes, a single speculator of size John Park could have not been able to influence the market moments. In fact no one of size John Park will even think of dominating the moment in Euro futures. Also the procedural or regulatory framework guiding the Euro market is different from Bund market. John Park exploited the opportunity of speculating much more than allowed by his margin limit account in Bund market by adopting a complex chain of settlement which delayed the details with respect to the position created on account of margin money. However there might be no such scope of manipulation or time delay in Euro market thus making it difficult to create a position above your margin limit.

References:
http://www.wisegeek.com/what-is-backwardation.htm http://futures-investing.suite101.com/article.cfm http://www.oxfordfutures.com/futures-education/futures-fundamentals/players.htm