United States National Debt and the Implications on the Futures Market

Material Information

United States National Debt and the Implications on the Futures Market
Cosola, Ryan
O'Linn, Kathleen
Hudson, Sarah
Silvermintz, David
Publication Date:


Subjects / Keywords:
Currency ( jstor )
Debt ( jstor )
Economic inflation ( jstor )
Exchange rates ( jstor )
Futures contracts ( jstor )
Futures markets ( jstor )
Interest rates ( jstor )
Investment risks ( jstor )
Investors ( jstor )
National debt ( jstor )
Debts, Public
Futures market
United States
Undergraduate Honors Thesis


The United States national debt has risen dramatically in recent years and will continue to increase in years to come. One of the many effects of the national debt is the impact on the futures exchange. This paper will analyze the implications of the United States' national debt on the futures market; more specifically currency, commodity, and single stock futures. The national debt will impact this exchange through higher interest rates and a rise in inflation. The national debt and these factors will increase trading in currency futures and single stock futures. Investors will want to hedge against riskier investments and see futures as a safe haven. Economic and political tension as well as high inflation will lead to higher prices in commodity futures. ( en )
General Note:
Ryan Cosola awarded Bachelor of Science in Business Administration; Graduated May 8, 2012 summa cum laude. Major: Finance
General Note:
Kathleen O'Linn awarded Bachelor of Science in Business Administration; Graduated May 3, 2011 summa cum laude. Major: Finance
General Note:
College/School: Warrington College of Business Administration
General Note:
Legacy honors title: Only abstract available from former Honors Program sponsored database.
General Note:
Advisor: John Banko

Record Information

Source Institution:
University of Florida
Holding Location:
University of Florida
Rights Management:
Copyright Ryan Cosola, Sarah Hudson, Kathleen O'Linn and David Silvermintz. Permission granted to the University of Florida to digitize, archive and distribute this item for non-profit research and educational purposes. Any reuse of this item in excess of fair use or other copyright exemptions requires permission of the copyright holder.

Full Text


1 United States National Debt and the Implications on the Futures Market Ryan Cosola Sarah Hudson David Silvermintz


2 Contents Introduction 3 Current Situation of National Debt 3 Introduction to Futures Exchange 4 Currency Futures 5 Overview 5 Currency Futures & Underlying Exchange Rates 6 Growing U.S. Debt 9 U.S. Debt Implications on Currency Futures 10 Conclusion 14 Single Stock Futures 15 Overview 15 Advantages of Futures Securities in the Current Economic Climate 16 Debt and Tax Implications 21 Conclusion 24 Commodity Markets 24 Background of Commodity Markets 24 A Basic Commodity Futures Contract 25 Crop & Livesto ck 27 Precious Metals 28 Conclusions 30 Conclusion 31 Works Cited 32


3 Introduction The United States national debt has risen dramatically in the recent years. This has many Americans wondering how the looming debt will affect us. One such effect is on the futures market. The national debt can impact this exchange through interest rates a nd futures market, more specifically, currency, commodity, and single stock futures. The rising national debt will increase trading in currency futures and single stoc k futures, as well as lead to higher prices in commodity futures. Current situation of National Debt Today, the United States mounting national debt raise s questions about the financial stability for the country and for the markets. 2009, the national debt was almost $12 trillion and interest on that debt was $383 billion for the year, according consists of public debt, made up of people and other coun tries who bought Treasury bills, notes and bonds, and Government Account securities, the intra governmental debt. Much government bailouts. The future of the national debt is only growing worse. Office's latest forecast, the U.S. budget deficit in 2011 is expected to reach 1.6 trillion ounting debt). The national debt poses many risks to the country and the financial markets. The


4 national debt will impact interest rates and inflation, which will impact the financial markets. With an increase in the debt, investors will decrease their con tributions in United States Treasury s ecurities. This will lead to an increase in interest rates. Inflation may also be affected by the growing national debt. It is possible that the government will print more money to finance the national debt. This would cause inflation to rise. U.S. national debt, combined with the actions of the Fed, is likely to ensure the rate of lead to a higher volume of trading in the f utures markets. Introduction to the Futures Exchange The futures market is an exchange where futures contracts are traded. The first known growth of crops to hedge their risk and stabilize their earnings. The first and now t he largest futures exchange in the United States is the Chicago Mercantile Exchange (CME). The CME standardized the futures contracts and provided stability for traders over the years. A futures contract is a contract that names a particular asset and pr ice for a specified future exchange date. A futures contract is a type of derivative contract. The underlying asset can be a wide variety of goods, which is not meant to be physically exchanged. They can be classified into two general groups: commodity fut ures and financial futures. In commodity futures the underlying asset is a commodity. Commodities are broken into classes such as crops, livestock, petroleum, industrial metals, and precious metals.


5 ments. A few are interest rates, currencies, and securities. Traders can take two positions on a futures contract, a short position and a long position. The short position is the side that will deliver the asset and the long position is the one who will re ceive the asset. Currency Futures Currency futures are futures contracts between buyers and sellers to exchange a specific amount of one currency for another at a particular date in the future and for a predetermined price that is fixed on the purchase d ate. As with other futures contracts, currency futures create the obligation for the buyer and seller to fulfill the contract at the predetermined end date. When currency futures contracts expire, they are settled in cash in the underlying currency. Howe ver most day traders do not hold their futures contracts until expiration and thus are not involved in settlement or delivery of the underlying currency. Currency futures are much like actual currency markets; however they are traded on exchanges and are more regulated. Because currency futures are traded through an exchange, the exchange provides centralized pricing, clearing, and ensures that market prices are the same among all different brokers. The largest exchange for trading in currency futures is the CME Group and the most popular currency future is the EUR, which is based on the US dollar to Euro exchange. The currency futures market continues to grow in popularity and has a wide variety of users. The main participants in the currency futures mar (Currency Futures, Forex


6 Futures ) Companies often use currency fu tures for hedging. They purchase currency futures for their future payables or sell futures on c urrencies for their future receivables. Individual investors often trade currency futures either for hedging against foreign exchange risk, or to speculate and try to profit from changes in exchange rates. The currency futures market is becoming increasing ly more liquid and daily turnover has grown on every exchange to around $3 billion. Figure 1 below shows the major increase in currency futures trading on the NSE and MCX in the last year Currency Futures & Underlying Exchange Rates Currency futures are essentially investments based on the underlying exchange rate being dealt with. Exchange rates specify how much one currency is worth in terms of another. Thus any factors that impact currency strength and exchange rates will therefore have an equal influence on the currency futures markets. Floating exchange rates are subject to


7 the forces of supply and demand. This means that if the demand for a currency is hig her than supply, the value of that currency will go up. The major forces that influence and drive exchange rates are intangible and several of them are affected by the growing national debt. One major force that drives exchange rates is inflation. When a country has a low level of inflation relative to other countries, the prices of the goods and services in that country are increasing at a comparatively slower pace. Thus these good and services seem cheaper for foreigners and the demand for these goods and services increases. Assuming that purchasing power parity holds, a nation with comparatively cheaper goods will see their currency appreciate to make up for the relative decrease in prices. On the other hand, countries with higher levels of inflation w countries with higher inflation typically see depreciation in their currency in relation to the currenci Bergen ). Another factor that influences exchange rates is interest rates. When one country has higher interest rates, it offers investors a higher return relative to other countries. This makes the country with higher interest rates more appealing for investors to invest in. o invest or lend in that country. This increase in demand for a currency leads to an increase in value of that currency. Thus, higher interest rates tend to attract more capital, which leads to an increase in the exchange rate. The opposite is true with lo wer interest rates; they tend to push the Interest rates, inflation and exchange ra tes are all highly


8 Bergen ) Therefore, high levels of inflation can drive a currency down and offset the effects of higher interest rates. Public debt is another force behind exchange rates. Public debt is used for a variety of government spending needs and public projects. While public debt can be used to debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheape Bergen ). As stated earlier, a high level of inflation leads to currency depreciation. Currency depreciation wi ll have a direct effect Government borrowing to finance deficit spending increases inflation, which literally eats into the val Factors Which Influence Exchange Rates ). Also when a government with high public debt resorts to printing more money to pay for part of the debt, this action increases the money supply and causes a higher rate of inflation. Public debt can affect exchange rates in other ways as well. For example, if too large, then its creditors may begin to worry that the country will default on its downward p Factors Whic h Influence Exchange Rates). Overall, high levels of public debt can have a major impact on currency and exchange rates. The biggest effect of public debt on exchange rate s is that it can cause high levels of inflation, which can lead to changes in exchange rates. Typically the general effect of


9 impacts exchange rates and currency futures markets. There are many other factors that influence exchange rates and therefore currency futures markets, such as current account deficits, political stability, and terms of trade. However, these exchange rate drivers are not as directly impacted by th e national debt when compared to those described in detail above. Growing U.S. Debt The current United States debt will certainly impact the currency futures market if it is allowed to continue to grow. The recent financial crisis in the U.S. coupled with the recession that followed, has caused a significant increase in U.S. public debt. Many new programs have been implemented to stimulate the economy, and each of these programs comes with a large expense. In addition, government revenues have decreased du e to tax cuts and refunds. Government costs will continue to grow as the healthcare expenses associated with the aging population continue to increase. Historically the U.S. debt averaged 45 percent of gross domestic product from 1941 to 2008. In 2009 the United States public debt jumped from 41 percent to 53 percent of GDP. According to Red Ink Rising and The Peterson 00 percent of GDP and by 2038 it will approach 200 percent. These figures are alarming and they exhibit the fact that the U.S. needs to make changes to its current fiscal policies. Red els, the United


10 States would almost certainly experience a debt driven crisis something previously viewed as almost unfathomable in this crisis would certainly be a large determinant of exchange rates in t he future. It is hard to determine what level of debt will lead to a crisis; however, one can be certain that if U.S. Debt Implications on Currency Futures If U.S. debt continues to grow, it will have an impact on exchange rates and currency startling heights, fears of inflation and a prospective decline in the value of the dollar would cause investo rs to demand higher interest rates and shift out of U.S. Treasury value o ( Aizenman & Marion ) As mentioned earlier, large public debt encourages inflation. The increase in inflation will be due to several factors stemming from the large U.S. debt. First, the rising U. S. debt would leave the U.S. with little options to service their debt. If the time comes that the U.S. is no longer able to finance its debt and bailout plans, the Do substantial risks to the U.S. economy because foreign investors might at some point refuse to finance these deficits on terms compatible with U.S. prosperity. Any sudden


11 stop in lending to the United States would drive the dollar down, push inf lation and Bergsten ) This sudden stop in lending could lead to the Federal Reserve turning to the printing press to pay off the U.S. debt. By turning to the pri nting press, there would be a rapid increase in the monetary base and supply of U.S. dollars to the public. This increase in supply would devalue the dollar and decrease its exchange value. In this case, the number and value of assets backing up the curren cy would remain unchanged. However, the total units of currency will increase making it so that each currency is backed by fewer assets. Hence the value of each dollar will decrease accordingly and our currency will weaken relative to other currencies. Thi s scenario is printing money as a way to cover government deficits. The excessive supply of money led to hyperinflation and devaluation of their currency. Already the monetary supply in the U.S. has increased dramatically in order to afford our projected budget deficit of 13 percent of GDP. According to a Wall S treet Journal The percentage increase in the monetary base is the largest increase in the past 50 years by a (Laffer). With the U.S. already turning to increasing the monetary supply it is very possible that the U.S. debt will drive inflation to very high rates Printing more money and therefore driving up inflation is a viable option for the U.S. and could be one of the better solutions to servicing the debt. However, this decision would have a major impact on the currency futures market. The


12 weaker currency, an (Laffer). The weakening of the U.S. currency will greatly influence the currency futures market because of the weaker dollar. Investors need to be aware of the fact that the U.S. may use inflation to he lp service its debt, and they should take into account the possible implications before investing. Another factor stemming from the national debt that will increase inflation is simply a ebts. The first scenario involved the government purposely allowing inflation to rise as a method to reduce the debt crisis. However, it is quite possible that inflation rates will rise due to the debt even ess. If the national debt is allowed to rise there c ould be several impacts. Firstly creditors will become more concerned about the U.S. defaulting on its obligations a nd they will sell their U.S. debt on the open market. As the supply of U.S. Treasury Bonds increases and the demand decreases, the U.S. dollar will lose significant value. In addition, even if the general public simply believes that the U.S. government wil l have to turn to the printing press; this speculation will cause inflation and drive down the value of the dollar. The technique of using hyperinflation to devalue currency and drive down the real value of public debt is expected to also influence interest rates. Interest rates are also known to have an impact on exchange rates; however, t he change in inflation will o ut power the increase in interest rates. The Red Ink Rising article noted that as the debt spirals out of


13 sing interest rates are associated with increases in investment and therefore strengthening of currency. However, these rising interest rates will not be enough to compensate for high risks associated with U.S. Treasury Bonds as the U.S. gets seemingly clo ser to defaulting. In a recent Wall Street Journal Article the author explained how the rising interest rates would Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation a nd higher interest rates. The higher interest rates themselves will also further reduce the demand for money, thereby exacerbating inflationary pressures. It's a catch (Laffer). The overall effect of the growing U.S. national debt will therefore increa se the rate of inflation, which is a major determinant of exchange rates. Unless the U.S. is able to create a plan to significantly reduce its public debt, inflation will be a direct implication of the rising debt. Figure 2 Morgan Stanley exhibits how high U.S. debt correlates with high inflation:


14 Figure 2 If any of these scenarios were to play out in the United States today, the relative value of the dollar would decrease due to the higher rate of inflation. This wo uld have a huge impact on the currency futures market because the value of the U.S. dollar is critical to the currency futures market. The U.S. debt will have both short term and long term implications on the currency futures market. Conclusion The rising U.S. debt could have serious implications on currency futures markets. In the short term and long term, companies and individual investors must take into account future inflation due to the U.S. debt. Companies that will receive revenues in other currenci es and need to convert them to U.S. dollars should be particularly interested in hedging right now. With U.S. debt continuing to rise, inflation and weakening of the U.S. dollar should be expected. This means that future cash inflows that must be converted


15 into U.S. dollars will lose value when converted. Investors can enter into an offsetting currency futures position with an expiration date on the date of the expected cash flow to insure that they will receive the current exchange rate. Therefore, they ar e locking in the value of their transaction at the current exchange rate. USD / CAD futures contract is identified that offers an exchange rate of 1.01084 and expire s in six months. Therefore, in order to lock in this forward rate, 123 Corp would sell (i.e. short) $5 million CAD worth of futures contracts then, when 123 Corp receives payment from its Canadian subsidiary, it can use those funds to provide payment for the contract which is also due, thus ensuring an effective exchange rate of 1.01084 for the $5 million Canadian dollars. If 123 Corp had failed to hedge this payment and the exchange rate decreased by just 3% for example, 123 Corp would have lost over $14 (Exchange Rate Hedge). Thus, as the value of the U.S. dollar becomes more volatile due to the debt, companies should become increasingly interested in hedging with currency futures. The currency futures market is a highly speculative market in which many of the transactions are by individuals attempting to profit from changes in exchange rates. The rising U.S. debt policy will drive many investors to speculate future inflation and thus a weakening currency. The implication that this will have on the currency futures market is that investors likely will speculate that the U.S. dollar is going to become weaker compared to other currencies at a future date. Some investors will use currency futures to


16 attempt to profit from their expectations of the If investors become very worried about the future value of the dollar, we could see a large increase in the volume of trading in the currency futures market. Single Stock Futures Overview A single stock future (SSF) is a contract to buy or sell 100 shares of a specific stock at a future date. Unlike stock options, there is no strike price. The price the investor pays for the stock at expiration date is equal to the price of the stock at the contract date. Like commodities futures, SSF contracts include the right and the obligation to exchange the stock at the expiration date. Currently, OneChicago has the largest exchange for these derivative securities. The exchange includes futures with f our different expiration dates that generally follow a quarterly cycle; March, June, September, and December. However, many investors trade futures before their expiration date. Most importantly, SSF prices track the prices of their underlying assets almos t exactly and therefore provide great opportunities for different investment strategies. These opportunities, along with the changes in market conditions due to the mounting United States federal debt, provide reasons to expect an increase in the trade vol ume of SSFs in the near future. Advantages of Futures Securities in the Current Economic Climate Single stock f utures securities have gained substantial interest recently after partially falling out of investment circles for a short period. Trading volume started out low for the first few years, but then saw a rise of trading in 2007 followed by a sharp dip in 2008.


17 After this dip in trading, investing specialists are seeing renewed interest following the credit crisis. ed that 385,125 security futures Also, the total trade volume so far in 2010 was 1,046,737, up 104 percent from the first quarter of 2009. The leverage advantage of these fut ures is the main reason for the for securities, SSFs require a 20 percent collateral. This means less capital requirements and the potential for larger gains in a time when money and credit is hard er to locate. With this leverage, investors need less capital to hedge their positions in the market. Therefore, the stocks present enormous hedging power when compiled with stocks and options. Another advantage of thes e futures securities is the ability to short sell using the futures as a front. Using an SSF, you can short sell the underlying security by simply selling a futures contract for the security. This is essentially the SSF trading version of buying a put opti on for a security. These derivatives have no uptick rule when shorting, as traditional stocks include. This rule provides that short sale transactions be entered at a price higher than the previous stock trade so that the shorting does not add downward mom entum to an already falling stock. Because SSFs provide derivatives of the underlying security, shorting them does not include this danger. Shorting using these futures also provides savings due to the costs and inefficiencies of the stock loan process. Al so, interest rates entrenched in futures contracts are usually lower then loan broker


18 rates. This savings on interest and the free cash flows from lower margin requirements of SSFs make them a much cheaper alternative then traditional stock trading. One o f the major concerns that the U.S. debt poses is the effect debt will have on interest and borrowing rates. Mainly, obligations, the U.S. government may be forced to pay out higher interest on i ts own debt (Treasury Bills) This increase in T Bill interest rates will most likely create inflation and the rise of other interest rates. When interest rates rise, investors tend to invest their money in banks, T bills, and low risk bonds because they e arn increased rates of return but carry low risk. Overall, the i nterest rat e volatility will also make investors wary of investing large sums of money into stocks. As the volatility in interest rates increases, the lower risk profile of SSFs makes them esp ecially attractive. Also, the ability to use SSFs as a low cost hedging instrument makes them a key tool for investors looking to diversify their portfolio risk. As the risk of the market increases and availability of capital decreases, investors will grav itate toward investments that provide lower risk and greater leverage. As interest rates increase, investors must pay more to borrow capital and consequently, leveraging capital becomes more necessary. This generates a likely increase in the volume trading for SSFs as the U.S. debt escalates. These derivative securities also provide a great way to reduce exchange rate risks for foreign investors. As the U.S. debt continues to increase, many expect the value of the dollar to become more volatile and decline With this change in value of the U.S. currency, many foreign investors will be cautious of investing in securities in U.S.


19 markets with the added risk of varying exchange rates. Because SSFs allow investors to control a position in an underlying security without paying full price for the security, they present less risk toward changes in exchange rates. Also, foreign investors can keep a large portion of their money in their own currency until the date comes to purchase the stock. By using this method, th ese investors do not have to worry about the exchange rate changing as they hold on to a long position in a security. This is very important because foreign investors are much less likely to invest in U.S. markets during an economic climate with a weakenin g currency. The ability for them to avoid shifting exchange rates marks the opportunity for continued investment without the added risk posed by the general U.S. stock market. Therefore, foreign investors may shift to these securities as well. This provide s another reason why the volume of SSF trading is likely to increase with the increasing U.S. debt. SSFs provide an even better hedge for investments then traditional options trading. These trade derivatives provide a perfect hedge as the delta (equation shown in Figure 3) is almost exactly 1.0 for SSFs. For options, the delta varies depending on the strike price and time to expiration. The main difference is that SSFs commit the buyer and seller to exchange the security at the end of the time period as op tions give you the right, but not the obligation, to exchange the security. However, many futures traders buy and sell the SSF before the time period ends because, when holding the futures contract, they are committed to purchase the underlying asset. Beca use of these characteristics, SSFs provide better liquidity and usually have closer bid/ask spreads then traditional options. This means that many traders are essentially trading a cheaper version of the security,


20 improving their ability to hedge. Figure 4 below shows the almost perfect tracking of the underlying asset price with the SSF price. They can buy the security and hold a long position but also sell and trade an SSF with the same underlying security. Also, the breakeven for SSFs is the price from the sale or purchase at the end date, while the breakeven for options is the above the strike price (call) or below the strike price (put). Figure 3 Figure 4 Figure 5 below shows the equation for SSF prices provided by OneChicago. It shows the difference between the factors for pricing traditional options and SSFs. Pricing SSFs does not include any factors for volatility. However, the SSF pricing doe s account for changes in the federal funds rate (Rho) and for the amount of time until expiration date, or time decay (Theta). However, the pricing model for SSFs uses these factors to provide the interest rate carrying effect on the futures contract. Thes e factors are also included in the pricing of traditional options.


21 Figure 5 When compared with options, SSF prices do not change with changes in volatility as options do. Therefore, investors do not have to worry about the Vega of the future or the change in price of the future due to changes in volatility of the underlying asset. The prices of SSFs change in unison with the prices of their underlying assets. Therefore, when evaluating SSF pricing, investors do not have to take into account the volatility of the asset as they would for traditional options. This makes SSFs more liquid when the volatility of the market is high. With the increasing U.S. debt and likely increase in market volatility, this liquidity is very attractive. With the r ecent credit cris is, the advantages of SSFs look even better to investors. However, in the future, the rising U.S. debt will force domestic investors to look for investment strategies which help to negate or hedge against volatility in the market. Also, it will force foreign investors to look for strategies which help counteract changes in exchange rates and the weakening of the U.S. dollar. As interest rates and inflation creep up and become more volatile, and therefore the value of the dollar falls SSFs will provide an attractive investment alternative. The trade volume of these hybrid securities has increas ed over the last few years as a result of changes in the market, and this trend will continue as the rising U.S. debt pl ays a larger role.


22 Debt and T ax Implications One of the biggest problems facing SSFs is that they are a novelty in U.S. markets. This makes them a relative anomaly to professional and individual investors. Mainly, investors are uncertain about the tax laws regarding SSFs. BusinessNet states that many brok ers are position will be considered a constructive sell, requiring the client to pay capital gains tax This means that investors are unaware of what they will have to pay in taxes if they sell a SSF that they are using to hedge against another stock position. This point is raised mainly because SSFs and traditional stocks are in separate categories and therefore may not be considered as a portfolio for tax purposes. Currently, the IRS law show s similar treatment to gains and losses of SSFs as for the underlying assets. The IRS (SSF) contract to sell property will be considered short term, regardless of the holding period this past year (2009). Other futures contracts are taxed at 40 percent short term capital gains and 60 percent long term capital gains. This difference has potentially confused investors and kept them from trading SSFs. With rising U.S. debt, we expect overall tax laws to change in the coming years. The high taxes will force a reduction in spending, a nee d for increased revenue, or a combination of both. Income taxes are likely to increase to help fund some of the mountainous debt. With recent income tax numbers, an investor in the 35 percent tax bracket would pay 35 percent on gains from SSF, but only 23 percent on gains from commodity futures. This


23 means that SSFs have to overcome the hurdle of short term capital gains taxation. When used as a hedging instrument, this problem is relatively solved by mixing the gains or losses from SSFs with the gains or l osses from stocks in the portfolio. Because the price provides a great reason for investors to use SSFs as a hedging tool. The IRS taxing SSFs in the same manner as trad itional stocks actually provides an easy way for investors to hedge their positions using SSFs. However, because many investors are unaware of the tax implications of trading SSFs, they have not noticed this opportunity. With these futures, traders can hed ge their positions with low cost, highly leveraged assets. The prices of SSFs move almost simultaneously with the prices of the underlying assets. Therefore, if they trade the futures before the expiration day, they are essentially receiving the same price fluctuation as the underlying asset, but with a lower price total. Using this as a hedging mechanism, investors can basically buy a lower cost futures with regard s to hedging, they will gravitate toward them. Along with the tax implications on investors in the U.S., there are also implications on foreign investors. Non resident aliens are not obligated to pay a capital gains tax to the U.S. government on stock tra ding in U.S. markets. They most likely will pay a different capital gains tax on this money in their own country. However, they do have to pay a 30 percent dividend tax on dividends paid out by U.S. companies. Because SSFs do not include dividends, foreign investors can avoid paying taxes on these gains by buying


24 stock futures. With the ability to reduce exchange rate risks and avoid dividend taxation, SSFs provide a great way for foreign investors to minimize their overall risk and maximize their returns w hile still investing in U.S. companies. This gives them the opportunity to diversify their portfolios without taking on unnecessary risks due to the level of U.S. debt and its effects on U.S. markets. Conclusion With the advantages of SSF as the U.S. debt increases, investors will begin to look for new prospective trading markets. As they educate themselves more in the nuances of SSFs, they will see the opportunities provided by these futures in the changing marke t due to U.S. federal debt. These opportunities will pull many investors into the SSF market and the volume of trading will increase. The U.S. debt poses too many potential problems for investors to stay immobile in their current trading behaviors. This po tential search for new investment opportunities, along with the continued growth of the SSF market, produces a combined effect. BusinessNet confusion and possible regulatory flaws, trading volume in SSF is increasing, and SSF Between the first month of trading SSFs on OneChicago in December 2002 and September 2003, the total trade volume more than doubled. This improved trading volume, even before the credit crisis and potential market volatility from the rising national debt, is a strong indicator of a growing market. The changes brought on U.S. markets due to the U.S. debt will help continue this increasing volume trend for SSFs in the near future.


25 Commodity Futures Background of Commodity Markets A commodity as it is defined in our market is any good or service for which there is no qualitative differentiation across the market. They are broken into such classes as crops, livestock, petroleum, industrial metals, and precious metals. There are enormous differences in the nuances of these different markets even though they are all commodities due to their various usage, availability, cost & method of production, etc. Because they are no t differentiated in a qualitative way, they cannot compete on qualitative grounds. As such they must compete on quantitative grounds, through means such as supply and demand. This results in the commodities competing on price in times of abundance, which can drive the price very low; som etimes below the cost of production. On the other hand, commodities such as precious metals, can sometimes command extremely prices due to their perceived value as currency. The fiat currency dominated modern economy increases this affect because there are few true safe haven assets and a huge amount of wealth. This is part of what makes commodity prices highly volatile and this is why both public and private means of mitigating this risk has emerged. Government has used mechanisms such as subsidies while private markets have created insurance and futures contracts to manage the volatile commodity market. A Basic Commodity Futures Contract


26 Billy Bob corn farmer has a healthy yield of 5000 bushels of corn and he decides that he wants to make sure that it ge ts bought by somebody before it goes bad and is willing to sell at $350 per bushel. Beef Okeef, a cattle rancher, decides that he wants to buy 5000 bushels of corn for $350 per bushel to feed his cows. Billy Bob will sell and Beef Okeef will buy this futur es contract. This is usually done through a futures exchange and will lock in 5000 bushels of corn at $350 apiece to be delivered in 6 months. The total value of this contract is then 5000 350 = $1,750,000, which means Beef Okeef is in control of this am ount of corn. During the term of the contract, Beef is in a long position because he agrees to buy the commodity. He profits when the price goes up. For example, if the price goes up to $352 per bushel, he will still be able to purchase 5000 bushels at $ 352 so the contract has profited him ($352 $350)*5000 = $10,000. On the other hand, Billy Bob is in a short position because he agrees to sell the commodity. If this same price change occurs, his loss will be $10,000 dollars because he still has a legal ob ligation to sell 5000 bushels at $350 each. He misses out on the higher prices. This contract will rarely result in the physical delivery of the commodities, while instead the profit or loss of the contract will be realized in dollar terms. If the previou s price change occurred and both players held the contract through its life, Billy Bob would pay Beef $10,000. Beef would then physically purchase the corn at its current price of $352 at the spot price, but would essentially pay the $350 he locked in due to the profits from the contract. He is essentially hedging his risk against increased prices.


27 Another important point to note is that speculators and hedgers of indirect risks will often buy these contracts from the original issuers in these exchanges. As such, they exchange ownership often and the futures market is a liquid and high volume atmosphere. Crop & Livestock Crop and Livestock markets are a somewhat unique commodity market in that they are needed in constant supply globally to keep humanity clothed, fed, and secure in their ability to survive. As such, the demand of these commodities changed rapidly and cyclically, and accounts for these price changes. The U.S. government has set policies with the goal of protecting the supply side of this market, perhaps in part due to the systemic risks involved in the supply side of this market. During the Great Depression, the U.S. created the Commodity Credit The pu rpose of this corporation is to aid commodity producers through loans, purchases, payments, and other operations and makes available materials and facilities required in the production and marketing of agricultural activities. These subsidies for a long t ime have paid producers of these crops & livestock when their costs of producing their goods exceeded the revenue that it fetched. Many economists


28 that could store overp roduced goods in times of abundance and draw upon these stores in times of famine. Regardless of whether this is a noble goal, the price of livestock & crops has fallen over the last century whether it is due to increased supply or the efficiency of produc tion. artificially drives their price down through increasing the supply. This actually promotes poverty in developing countries, where agricultural is one of their only eco nomic strengths, by making them less likely to create their own food supply while instead buying food from developed countries. Mark Malloch Brown, the former head of the United Nations Development Program estimates that farm subsidies cost developing nati ons about $50 billion per year in lost agricultural exports. On top of this, over 75% of U.S. farm subsidies go to the wealthiest 10% of American farmers on big commercial farms that do not need these subsidies to be profitable. With the U.S. building up an unprecedented amount of debt, many argue that there are better ways of mitigating the risks through means that are used in other industries such as insurance and futures contracts. Precious Metals Another commodity class for which futures are traded is precious metals. One of the reasons that they are described by the word precious is because of their rarity, novelty, and culturally perceived value. Metals like gold, silver, and platinum are large players in


29 the precious metal market and as broad surges in prices for these metals have occurred metals such as copper are being viewed as some to have similar characteristics as these metals ha ve been traded as currency for thousands of years and this tradition is deeply ingrained in our culture and continues today. In fact, as many economies in the 20 th century have moved toward a fiat monetary system these metals acted as a safe haven asset during times of financial crisis. Thus their value is generally negatively correlated with stock and bond markets and provides good diversification against the risk of financial crises. Precious metal prices generally correlate moderately with inflation. T he following graph shows how commodity prices move in unison and with inflation: Figure 6 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 Inflation C&L PM ChangeDebt


30 C&L represents crop & livestock prices and PM represents precious metal prices. ChangeDebt represents gross national debt. All of these are of nominal % changes an d are scaled using their standard deviation to fit better graphically. All categories except inflation are also 3 year moving averages. We can clearly see some correlation between commodity prices, inflation, & the change in debt. The following table is o f correlations between each category and inflation. Category: Inflation Crop & Livestock Precious Metals Gross Debt Correlation: 1 0.58274901 0.5754726 0.545071 Figure 7 Conclusions The commodity futures market is a highly volatile and risk laden market, but it is pinned to underlying assets whose assets follow predictable patterns that have been around as long as any. Their prices tend to move in cycles that hit their low points in periods of economic and political stability and their high points in periods of economic and political tension. The recent increases in U.S. spending sparked by the financial crisis have created a sense of tension among many investors, and during this time we have seen a rise in commodity prices continuing up until today The recent increases in U.S. government debt are unprecedented in nominal terms. Since long term inflation and spending are related empirically, many expect that this increased spending will lead to inflation. Since inflation and commodity prices are corre lated,


31 commodity prices should move up with increased inflation making commodity futures a good investment to go long on. Unfortunately for many small investors, the value of a futures contract is too large to take a risk on given the volatility of t he mar ket. Luckily for them mini futures are smaller versions of these contracts that allow investors to risk a smaller amount. There are also commodity index funds and exchange traded funds that allow investors to capture commodity prices in their portfolio. Conclusion The rise of the United States national debt will affect the futures market. This market was originated to promote stability for farmers by hedging their crop risk. The national debt will impact this exchange through higher interest rates and a r ise in inflation. The national debt and these factors will increase trading in currency futures and single stock futures. Investors will want to hedge against riskier investments and see futures as a safe haven. Economic and political tension as well as hi gh inflation will lead to higher prices in commodity futures.


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