Sunday, August 22, 2010
Tuesday, April 20, 2010
WHAT IS A MOVIE FUTURE?
Let’s pretend we have a movie, Hannah Montana Battles the Smurfs, and the Cantor Exchange (CX) has listed a movie future for it at a price of $100. This price may change (think of a stock price changing), but for now in our example, it is $100. That $100 represents $100 million of domestic box office revenue (U.S. + Canada). The key thing to understand about movie futures is that when you buy or sell a movie future, you are not literally buying or selling something. Instead, you are entering into a contract.
If I buy the movie future for Hannah Montana Battles the Smurfs, I am entering into a contract where I promise to pay $100, not now, but four weekends from the time Hannah Montana Battles the Smurfs (HMBS) debuts in theaters. (Technically, the time after debut may differ, but we’ll cover that later). In exchange for my $100, I will receive the final cash value of the HMBS movie future. This value will be set in stone and finalized four weekends from the time HMBS debuts, that is, at the same time as I make my $100 payment. Buying the HMBS future is also known as taking a “long position” in the movie future, or “going long.”
On the other hand, if I sell an HMBS movie future (instead of buying one), I am entering into a contract where I promise to deliver a cash amount equivalent to the final value of the HMBS movie future. (Again, this final value is set four weekends from the time HMBS has been released.) In exchange for delivering such a cash amount, I will receive $100 from the buyer of the future. Selling the HMBS future is also known as taking a “short position” in the future, or “going short.”
Continuing with our example, let’s say that Jack Nicholson (JN) buys one HMBS movie future for $100 and Elton John (EJ) sells one HMBS movie future for $100. They do so on January 1st, with Hannah Montana Battles the Smurfs scheduled to release domestically on June 4th. As June 4th approaches, the HMBS movie future fluctuates in price, moving up and down and up and down. Finally, Friday, June 4th arrives and the movie debuts at 4,000 theaters. Four weekends from release, on Sunday, June 27th, it has grossed a whopping $500 million domestically, and as a result, the final value of the HMBS movie future is $500. This timeline will summarize:
After the fourth weekend of release, Jack Nicholson boldly steps up, honors his side of the contract, and pays $100 in exchange for the final cash value of the HMBS movie future, $500. The final value of the HMBS movie future ($500) equates to how many millions of dollars the movie generated in domestic box office ($500 million) through its first four weekends of release (we’ll go over exceptions later). Where does the $500 owed to Mr. Nicholson come from? Well, Elton John trots up, takes Mr. Nicholson’s $100 and, per the futures contract, hands over $500, the final cash value of the HMBS future.
At the end of our example, we see that Jack Nicholson made $400 off his futures transaction – he paid $100 and was delivered $500. We also see that Elton John lost $400 – he delivered $500 in exchange for $100 from Mr. Nicholson.
What if the result had been different? What if Hannah Montana Battles the Smurfs had only grossed $40 million after four weekends of release? Mr. Nicholson would still have delivered his promised $100. Only this time he would have received a mere $40 in return ($40 being the final value of the HMBS future) for a net loss of $60 (i.e., $40 – $100 = –$60). Mr. John, on the other hand, would be singing for joy. He would have received Mr. Nicholson’s $100 and delivered to him the promised final cash value of the HMBS future, or $40, netting Mr. John $60 (i.e., $100 – $40 = $60).
It bears mentioning, these two examples ignore several important features of the Cantor Exchange, and all futures exchanges for that matter, namely margins, marking to market, reversing trades, and the clearinghouse. We will touch on most of these as we go along.
GETTING CHOSEN FOR THE EXCHANGE: THE BIRTH OF A MOVIE FUTURE
It’s really up to the financial company that runs the exchange, Cantor Fitzgerald, to decide whether a movie will be offered by the exchange for futures trading. According to the terms and conditions on their website, before making a decision, the Cantor Futures Exchange (CX) will take into account factors such as “sufficient economic interest” in a film, whether it has been designated for release by one of the major box office tracking services, and how far into production a film might be.
From public statements and press reports, it appears unlikely that films will be listed for futures trading unless they have plans to open at well over 650 domestic theaters. Also, based on the CX movie futures listing standards, it appears unlikely that a film will be listed if the film’s release date is scheduled for more than one year, or less than one month, from the date of consideration. In the end, however, there is no hard set of rules.
-----ONCE A FILM IS CHOSEN, THEN WHAT?
CX will designate a “First Trading Day” upon which people, institutions, studios, etc. will be able to take part in an auction that decides the beginning price of the movie future. Between 9AM and 3PM of the First Trading Day, interested people will enter prices for how much they would like to buy a movie future (a.k.a. establish a long position in the movie future) or for how much they would like to sell a movie future (a.k.a. establish a short position in a movie future). They will also detail how many futures contracts they would like to enter into.
Because the final price of the movie future many weeks from now will directly correspond to the movie’s domestic box office total after four weekends of release, buyers and sellers of movie futures will want to take into consideration what that domestic box office gross might be.
Turning back to our Hannah Montana Battles the Smurfs example, let’s pretend we are at the very beginning of the movie futures process and that it is the First Trading Day’s auction. If I believe the movie will gross $900 million (and grind the Avatar record into dust), then I might bid $500 for the long position in one HMBS futures contract. In doing so, I would hope to profit by $400 once the movie future price becomes set four weekends after HMBS is released ($900 – $500 = $400). Conversely, if I feel the movie will suffer the fate of Weekend at Bernie’s II (i.e., an abysmal box office result), I might offer to sell an HMBS future for $300 – in other words, take the short position in a HMBS contract. Then, if the movie only grosses $15 million by weekend #4, I only have to deliver $15 in exchange for receiving $300.
Once all the bids and offers are in, the auction closes and a price is set for the movie future to begin trading. If you end up participating in the auction, you may very well end up with a futures contract priced far differently from what you had hoped for. You may also end up with one that is in the ballpark of, or even equivalent to, your desired price. Yet a third possibility is that you end up with no futures contract, and your bid or offer goes into post-auction trading as a limit order (read two paragraphs down to see what a “limit order” is). Regardless, if you are entered into a contract as a result of the auction, then the price assigned to your contract becomes the one you are obligated to fulfill. (For more details on the opening auction, see Rule IV-21 in the Cantor Futures Exchange Rules and Chapter II-11 of the Domestic Box Office Receipts: Contract Terms and Conditions.)
AFTER TRADING HAS BEGUN: A MOVIE FUTURE GROWS UP
Once trading has begun, people will be able to buy or sell the movie future at the price listed on the exchange. If I see the HMBS movie future trading at $150 and I think that that is a good price at which to take a long position, then I can buy the future for $150. Remember, “buying” here means agreeing to pay $150 four weekends from the time the film debuts in exchange for an amount of money equal to the final value of the future. On the flip side, I might instead see $150 as a good price at which to enter the short side of the contract, so I would sell the future for $150.
You might also have the opinion that, “You know what? I’d like to sell the future when it hits $170, but I don’t wanna have to wait by my computer monitoring the price.” In such a case, you could place what is called a “limit order,” whereby you say, “I’d like to sell the future only when the price hits $170 or greater.” Then, if the price hits $170 or more, your order executes and you are locked into a short position for that price. This works in the other direction as well. If you want to place a limit-buy order, you might say, “I’d only like to buy the HMBS future when it hits $130 or less.” Then if it does so, you are locked into a long position at that particular price.
The combination of some people placing limit orders and some people buying or selling at the current market price (a.k.a. placing “market orders”) leads to the price of the movie future fluctuating. If, all of a sudden, many people believe a particular film will do well, this will drive the price of the movie future up. And if, all of a sudden, they believe the opposite, this will drive the price down. Of course, if people’s opinions on a film’s performance do not change, then the futures price will remain largely unchanged as well.
An interesting thing to note is that in any one day the price for a movie future listed on the Cantor Exchange (CX) is not permitted to move more than 10% of the price it settled at the previous business day. Settlement on the CX occurs every day at 5PM New York City time and is known as “daily settlement.” So, if the futures contract for Hannah Montana Battles the Smurfs settled at $100 at 5PM Tuesday, it would not be permitted to rise by more than $10 or fall by more than $10 on Wednesday. (Keep in mind, though settlement occurs daily at 5PM, the price will continue to move after 5PM, as the contract is traded 24 hours a day.)
Price limits are not unusual for futures contracts, though they are a bit odd when one considers that in large price swings price limits will simply delay the inevitable. What I mean by this is that if HMBS is trading at $200 (representing an impressive yet-to-happen domestic box office gross of $200 million through release weekend #4) and suddenly news comes out that the studio has replaced Miley Cyrus with Mike Tyson, people’s estimates of the box office total through weekend #4 would plummet. Let’s say their estimates fell to the $50 million range. The futures price for HMBS would drop each day by 10% of the previous business day’s settlement price, as you had tons of people willing to sell the HMBS future and no one willing to buy it, at least until the futures price approached $50 million. So, in effect, what would normally happen all in one day, takes numerous days because of the price limit, thus delaying the inevitable.
By the way, the 10% price limit, except under exceptional circumstances, is not allowed to be smaller than 2.5. So any films trading at futures prices less than $25, will be allowed to move up by 2.5 or down by 2.5 in one day, even if the futures price is as low as $5.
-----AFTER YOU HAVE BOUGHT OR SOLD A FUTURE
Once you have either entered into the long or short position of a movie futures contract, be it by auction, limit order, or buying it at the market price (a “market order”), the price of the future will, in all likelihood, begin to fluctuate. Then, at 5PM every day (daily settlement), until the contract terminates, you will be required to pay or receive an amount equal to the price difference between the current futures price and the price at which you entered into the contract (or equal to the difference between the current price and the price at which the contract last settled). Whether you pay or receive will depend on which side of the contract, long or short, you are on. This daily affair is known as “marking to market” and is central to all futures trading, movie or otherwise.
Let’s go back to our Hannah Montana Battles the Smurfs example. Suppose that during a bout of insomnia I buy the HMBS future for $100 at 2AM Tuesday, New York City time. At the time of my purchase, in addition to any fees, I would have to pay the full price of the future, which is $100. Paying this 100% of the price is known as “posting a margin.” Then at daily settlement (5PM that day), the 5PM price of the futures contract would be used to figure out whether I am making money or losing money on my futures contract. Let’s say the settlement price (i.e., the price at 5PM) is $90 (and for example’s sake, let’s pretend there are no price limits). Then $10 would be deducted from my account, because, if the futures price remained unchanged until the final day of the contract, I would be paying $100 in exchange for the final value of the HMBS movie future, which would be $90, in effect giving someone $100 so I could get back $90, resulting in a loss of $10. As a result, this $10 is taken out of my account at daily settlement (i.e., at 5PM). By the way, the account I am speaking of is a “clearing account” held at the exchange’s clearinghouse.
Suppose, instead of having bought the futures contract, I had sold it, or, in other words, established a short position in the contract. The rules for selling it are actually a little different than the rules for buying it. To sell a contract, you only have to pay 50% of the most recent daily settlement price (with a minimum of $25); in other words, you are posting a margin of 50% of the most recent 5PM price. In our Tuesday example, let’s say that the future had settled at $96 at 5PM on Monday, the business day before (and again, for the example’s sake, we’re assuming no price limits). That would mean paying $48 (i.e., $96 x 50% = $48) at 2AM Tuesday for the right to deliver someone the full cash value of the futures contract when it comes due approximately four weeks after the film is released. (Of course, per the futures contract, I will also receive $100 when I deliver, in cash, the final value of the futures contract.) Then, at daily settlement at 5PM on Tuesday, because the price in our example has dropped to $90, I would receive $10 into my account at the exchange’s clearinghouse (the clearing account). This is because, were the price of the movie future to remain at $90 until final settlement (about four weeks after film release), I would receive $100 from the long position (the buyer) and be required to deliver $90 (the value of the contract), netting me a gain of $10. Let’s summarize our two daily settlement positions with the following timeline:
If the daily settlement in our Tuesday HMBS example were $110 instead of $90 (i.e., the futures price had climbed to $110), a long position in the contract at $100 would mean that I would receive $10 into my clearing account soon after 5PM. A short position would require me to pay $10 from my account. Also, because a short position requires me to always keep 50% of the most recent settlement price in my clearing account (not just when I paid $48 to establish my short position) and the latest settlement price now sits at $110, the new margin requirement would be 50% of $110, or $55. So, I would have to pay another $17 from my pocket into my account to maintain the margin requirement (a.k.a. “maintaining the margin”). Summarizing the short position’s obligation, I paid $48 into my account to establish the contract (50% of $96), $10 was deducted because the futures price rose to $110 at 5PM (leaving $38 in my account), and then I had to add another $17 into my account to maintain the margin (leaving a total of $55 in my account, or 50% of the Tuesday 5PM HMBS futures price). So in the case of the short position, if the price of the future begins rising immediately, I’m literally paying any daily losses, plus new margin requirements, as I go. Let’s summarize the short position’s predicament with another time line:
There are three points to take away from these last three messy paragraphs. (1) After your first time of paying up or being paid (i.e., marking to market), the process continues daily, except that the previous day's settlement price is what you use to determine whether your position is making money or losing money. For instance, if the price settled at $90 yesterday and $95 today, I would receive $5 for a long position, even if I had originally entered into the contract at $125 two weeks ago. (2) Marking to market ensures that when the movie future reaches its final value, the losing person has completely paid, or almost completely paid, what he or she owes. The person has been doing so on a daily basis via marking to market. (3) If you establish a short position (a.k.a. sell a future), make sure you maintain your margin. That is, make sure you satisfy your daily margin requirement by keeping enough money on deposit in your clearing account. This becomes especially important during sustained price increases and price increases that occur immediately after entering a contract.
What happens if, like this article/posting, it all becomes too much to bear and you want to exit your movie futures contract before it has reached its final value?
Easy, you enter the opposite side of the position you currently have. If I’m long in a movie future, I enter into a short position at the current futures price, which cancels out my long position. If I’m short, I go long. In each case I’m performing a reversing trade. Any gains or losses not yet accounted for are credited to/debited from my account, and then I’m done. You might be wondering what happens to the poor sap on the opposite side of my original contract. If I was originally long, this would be the person expecting my money upon final settlement. If I was originally short, this would be the person expecting me to deliver the final value of the movie future in cash. Well, they are just fine, because when I do my reversing trade to liquidate my position (a.k.a. get the heck out of there), the person on the other side of my reversing trade replaces me in the original contract from which I am escaping. Now, I know there was not much easy about this last paragraph, but the easy part is that when you want to exit your contract, you do the opposite of what you originally did when you got into the contract – you sell if you bought and you buy if you sold. And it doesn’t matter that you’re doing it a different price than what you initiated the contract with.
THE HOME STRETCH: A MOVIE FUTURE RETIRES
The Cantor Exchange (CX) calls this time in a movie future’s life the DBOR Determination Period. Don’t let this fancy name scare you. DBOR stands for “Domestic Box Office Receipts,” and the determination period stands for the time period during which any domestic box office dollars generated by the movie are counted toward the final settlement price of the movie future. Final settlement is the same thing as daily settlement, except it occurs at 9AM on the business day after trading in the future is complete. This part of a movie future’s life carries such importance it’s worth taking a look at the language provided by the DBOR: Contract Terms and Conditions in Chapter II-3(b) ([ ]’s are my insertions):
The DBOR Determination Period for each DBOR Contract shall begin on the First Release Date [basically, when it plays in at least one domestic theater and reports those revenues to Rentrak] and conclude at the end of the fourth (4th) Release Week after the underlying film title achieves Wide Release status [at least 650 domestic theaters]. In the event that the underlying film title fails to achieve Wide Release status prior to the end of the twelfth (12th) Release Week, then the DBOR Determination Period shall conclude at the end of such twelfth (12th) Release Week.
The CX’s press coverage, and even some language in their terms and conditions, suggests that the CX will only be working with widely released movies at first. That is, those opening at typically 2,000 theaters or more. By dealing with such films, it is clear how the final settlement price of the future will be determined after four weekends of release. Were the CX to begin issuing futures contracts for smaller films (i.e., films opening at fewer than 650 theaters), it would almost be a foregone conclusion, per the language above, that such films would not settle on a final futures price until their 12th week of release. This is because most films opening at fewer than 650 theaters never even reach 300 theaters at the height of their release.
After the determination period described above, the final price of the movie future is set and all people holding a contract must pay up or be paid for the final time. Because the losses and gains have been posted to accounts on a daily basis through marking to market at daily settlement, nothing terribly dramatic should happen at this conclusion to the movie future’s life.
LIFE AS A MOVIE FUTURE: WHAT’S THE POINT?
There are two purposes that movie futures serve: hedging and speculation. All of us hedge regularly in our daily lives. If we own a car, we might pay a little bit of money each month to an insurance company so that the insurance company can pay us a lot of money if the car becomes significantly damaged. Obviously, we do the same kind of thing with houses, boats, etc. In the case of movie futures, the studio releasing Hannah Montana Battles the Smurfs might seek to hedge, or insure, its box office returns.
Suppose that the studio liked the fact that the futures price for HMBS was at $100, and it wanted to lock in that amount of box office receipts. Then it would go short in 1 million futures contracts. That is, the studio would be guaranteed to receive $100 million (1 million x $100 = $100 million) in exchange for the studio delivering in cash the final value of those 1 million movie futures. That way, any increases or decreases in the actual box office total (through four weekends) would be offset by any gains or losses in the futures contracts, and the studio would be guaranteed $100 million roughly four weeks after opening wide. How you say? Take a look at the following:
As you can see, no matter how much money the studio collects from the box office, and no matter what the corresponding final price of the futures contract, the studio’s gains or losses from each will always total $100 million. The studio has hedged the value of its box office receipts.
This example is illustrative, not true to life. First of all, Cantor Exchange movie futures rules stipulate that no one is allowed to enter into more than 300,000 futures contracts. Even without the 300,000 limit, there would still be the considerable short position margin requirement to consider – 50% of the most recent daily settlement price – which in this example would be in the ballpark of $50 million, with additional payments required should the futures price begin rising immediately. That would mean $50 million in cash would not be available for the studio to use in other capacities. Of course, there is also the obvious fact that a studio does not collect but some 50% of box office receipts, and thus, the studio would at most like to hedge only $50 million in this case. But even so, 500,000 short positions would be required, far above the maximum limit. (This example also excludes the CX fees.) A more likely hedging scenario might be a theater chain trying to hedge its portion of overall box office receipts.
Another more likely hedging scenario might be a cable television channel that is required to pay 10% of a movie’s domestic box office receipts to a studio. If the movie future for the movie in question was trading at $100 and stayed at that price until final settlement, this would mean that the movie will have earned $100 million through the fourth weekend of release, which would mean the cable TV channel would owe at least $10 million (10% of $100 million) to the studio. If the channel was comfortable locking in this $10 million (a.k.a. hedging its position), it could establish a long position in 100,000 futures contracts. Upon final settlement of the future, that would mean the channel would be required to pay $10 million (100,000 x $100 = $10 million) to the short position in exchange for receiving the value of the 100,000 movie futures. Any variation in box office total to that point would be offset by a corresponding variation in the value of the movie future, as the following shows:
All the negative amounts above reflect cash paid by the cable TV channel (CX fees have not been included). This type of position is conceivable. However, the margin requirement for long movie futures positions on the CX is 100% of the price of the contract. Thus, upon taking the long position, the TV channel would be required to pay $10 million into the channel’s clearing account, and it would have to be comfortable giving up the use of this amount until the contract terminated.
As you can see, hedging via movie futures on the CX is not exactly seamless and without considerable cost, which takes us to the other use of CX movie futures: speculation.
Throughout the beginning of this article, I demonstrated how you could speculate on the domestic box office gross of a movie. If you felt a movie future price indicated too low a box office result, you could buy the movie future and profit from it if the actual box office indeed proved higher. On the other hand, if you felt the futures price was too high, you could sell the future and profit if the box office total came in lower.
Many people have a serious problem with CX movie futures (and other movie futures, as well) because they feel that the word “speculate” can be more accurately replaced with the word “gamble” and all of its negative connotations. They feel that the exchange will essentially be a legitimate form of gambling, with any hedging functions at a minimum. Many also feel that people with inside information on a movie (i.e., material information not available to the public) will be able to profit off this information by betting one way or the other on a movie future, much to the detriment of the people taking the other side of the bet. They feel that the law, which classifies insider trading as illegal, will not be able catch such perpetrators.
Only time, and the birth and death of many movie futures, will prove the legitimacy of these concerns.
PLEASE NOTE: I have provided this information as a service to filmmakers, financiers, and others in the movie industry. It is not a legal interpretation, statement of investment advice, or statement of the policies of Cantor Fitzgerald. If you have questions concerning the meaning or application of information contained in this blog posting, please consult with a registered investment adviser and Cantor Fitzgerald.
THE AUTHOR: Jeremy Juuso is author of Getting the Money: A Step-by-Step Guide for Writing Business Plans for Film (available nationwide) and The AKA Report, a first-of-its-kind survey of specialty films and their financing sources. Jeremy graduated cum laude in economics from Harvard College.