Closing out Future's Contract

[hsuwang]

Hello David,
To close out a short position on a futures contract (with say, party A who's long on the position), one would enter into a long position on a futures contract (with Party B, who's now short on the position). To my understanding, although the position has been closed out, you are not actually selling off the original contract, so my question is, if you are simultaneously holding a short futures position and long futures position (to neutralize/close out the position), will you still be obligated to make delivery for the short position when it comes to maturity date?

Thanks,
Jack

 

[hsuwang]

I'm sorry, I think I have figured it out. Just to clarify, please check if I'm correct on this:
Suppose that:
- A is short on futures
- B is long on futures (counter-party)
A wants to close out on its position, so it engages in another contract (long position) with C (who is short)
so in a way, C will now be making delivery to B, and A neutralizes its position in the contract.

Thanks!

 

[David Harper CFA FRM]

Hi Jack,

You are close, just substitute the futures exchange

- A is short on futures with exchange
- B is long on futures with exchange
- A wants to close out on its position, so it engages in another contract (long position; on same contract; e.g., Dec corn) with exchange. Exchange matches A's short with A's long, obligation is cancelled.

Or, in the case of Metallgesellschaft (I am making up numbers)

June 1st
Spot = $35
MG takes long position in July Futures= $30
(i.e., backwardation as F < S)

June 15th
Spot stable to $35
July Futures increase to $32
(i.e., the futures is converging to the spot)
MG closes out position by offsetting sell (short) July futures contract
The long is matched to the sell, and the obligation is cancelled.
MG profited sell $32 - buy $30 = $2 profit

Further, in MG stack-and-roll:
MG buys August future

(and, in backwardation, the "roll return" is producing profits for MG as the futures price is increasing to converge with the spot. The problem they encountered was the spot started dropping into contango)

So this does get to key difference between forward and future:

* forward is between two counterparties
* futures is exchange-traded forward; the exchange is the counterparty (see http://www.usfe.org/new-york-mercantile-exchange.asp "Transactions executed on the exchange avoid the risk of counterparty default because the exchange clearinghouse acts as the counterparty to every trade.")

For our purposes, the other key difference is the daily mark-to-market of the futures which creates volatility in the margin account, and this gives rise to the pricing difference (convexity) in Hull.

David

 

[hsuwang]

Hello David,
if Exchange matches A’s short with A’s long, and obligation is canceled, then what happens to B's long position with Exchange? (ie. who will be making delivery to B?) I'm not sure if what I said about C was correct in the previous thread.
and also thanks for the MG example, that really helped!
Thanks!

 

[David Harper CFA FRM]

Hi Jack,

When A offsets (reverses out), Party A needs to "find" a short. So,

A goes long and a "new" C somewhere is going short
(so, it a way, the C is matched to the long B. Although this is the function of the exhange, so it is not direct like OTC)

I *think* (sorry i am not certain) all trades need to match a long with a short - how can this be? The bid-ask pricing mechanism, the funciton of prices a liquid market is to clear trades. A only gets to go long at the price that is essentially set by the "new Cs" that are willing to short at their price. It falls apart without liquidity that enables prices to adjust and clear trades.

(I may be incomplete "at the margin" - it may be that some exchanges assume some of the marginal obligations, given cash settlement etc. I just don't know if the typical exchange is like a pure gambling bookie - having no skin in the game - or if they maybe do "make their own book" in some cases)

David

 

[sinth]

Hi David,

Could you help me out with this question please:

On March 1 the spot price of a commodity is $20 and the July futures price is $19. On June 1 the spot price is $24 and the July futures price is $23.50. A company entered into a futures contracts on March 1 to hedge the purchase of the commodity on June 1. It closed out its position on June 1. What is the effective price paid by the company for the commodity?​

My interpretation is that the company enters into a Long contract on March 1 which secures a price of $19 for each commodity in July. So regardless of the spot price of the commodity in July the company can purchase it for $19 each.

Come the first of June and the company closes out the position with a short contract. Since the future price in July is now $23.5, they have made a $4.5 profit. (23.5 - 19).

The company then purchases the commodity for spot price on of $24 on June 1 and uses it most likely as an input in their business. Subtract the $4.5 profit to find out the effective price paid (24.5 - 4.5) = $19.5

The effective price paid is $19.5