MBF1243 | Derivatives Prepared by Dr Khairul Anuar

L1 – Mechanics of Futures Markets

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Specification of Futures Contracts

Available on a wide range of assets

Exchange traded

Specifications need to be defined in the

agreement:

What can be delivered (specifying the asset)

How much will be delivered (contract size),

Where it can be delivered, &

When it can be delivered

Settled daily

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Specification of Futures Contracts-The Asset

• When the asset is a commodity, there may be

variation in the quality.

• NYBOT specify concentrated orange juice

futures contract as

orange solids from Florida and/or Brazil that

are US Grade A with Brix value of not less

than 62.5 degrees

• Financial assets in futures contract are

generally well defined and unambiguous (eg.

no need to specify Japanese Yen).

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Specification of Futures Contracts- Contract Size

• Specifies the amount of the asset that has to be

delivered under one contract

If too large, those who to hedge small exposures

will be unable to use the exchange

If too small, trading may be expensive as cost

associated with each contract traded.

• The size of the contract depends on the likely user.

For agri products it might be $10,000 to $20,000,

but for financial futures it might higher.

• Eg. Treasury bond futures on the CBT, face value

would be $100,000

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Specification of Futures Contracts- Delivery

Arrangement and Months

• Place of delivery must be specified by the exchange

• Important when it involves transportation costs.

• Eg for NYBOT frozen concentrate orange juice

contract, delivery is to Florida, New Jersey or

Delaware.

• The exchange must specify the precise period during

the month when delivery can be made.

• For corn futures on CBOT, delivery months are

March, May, July, September and December.

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Convergence of Futures to Spot (Figure 2.1, page 29)

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As the delivery period for a futures contract is approached, the

futures price converges to the spot price of the underlying asset.

When the delivery period is reached, the futures price equals—or

is very close to—the spot price.

To see why this is so, we first suppose that the futures price is

above the spot price during the delivery period. Traders then have

a clear arbitrage opportunity:

1. Sell (i.e., short) a futures contract

2. Buy the asset

3. Make delivery.

Convergence of Futures to Spot (Figure 2.1, page 29)

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Time Time

(a) (b)

Futures

Price

Futures

Price Spot Price

Spot Price

• These steps are certain to lead to a profit equal to the amount by which the futures price

exceeds the spot price.

• As traders exploit this arbitrage opportunity, the futures price will fall.

• Suppose next that the futures price is below the spot price during the delivery period.

Companies interested in acquiring the asset will find it attractive to enter into a long futures

contract and then wait for delivery to be made. As they do so, the futures price will tend to

rise.

• The result is that the futures price is very close to the spot price during the delivery period.

Figure 2.1 Relationship between futures price and spot price as the delivery period is

approached: (a) Futures price above spot price; (b) futures price below spot price.

The Operations of Margins

• If two investors get in touch with each other directly

and agree to trade an asset in the future for a certain

price, there are obvious risks.

One of the investors may regret the deal and try to

back out.

Alternatively, the investor simply may not have the

financial resources to honor the agreement.

• One of the key roles of the exchange is to organize

trading so that contract defaults are avoided.

This is where margins come in.

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Margins

• A margin is cash or marketable securities

deposited by an investor with his or her

broker

• The balance in the margin account is

adjusted to reflect daily settlement – referred

to as marking to market

• Margins minimize the possibility of a loss

through a default on a contract

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Illustration how margins work

• Consider an investor who contacts his or her broker to buy

two December gold futures contracts. Suppose that the

current futures price is $1,250 per ounce.

• Because the contract size is 100 ounces, the investor has

contracted to buy a total of 200 ounces at this price.

• The broker will require the investor to deposit funds in a

margin account. The amount that must be deposited at the

time the contract is entered into is known as the initial

margin.

• We suppose this is $6,000 per contract, or $12,000 in total.

• At the end of each trading day, the margin account is

adjusted to reflect the investor’s gain or loss. This practice is

referred to as daily settlement or marking to market.

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Illustration how margins work

• Suppose, for example, that by the end of the first day the futures

price has dropped by $9 from $1,250 to $1,241.

• The investor has a loss of $1,800 (= 200 x $9), because the 200

ounces of December gold, which the investor contracted to buy at

$1,250, can now be sold for only $1,241.

• The balance in the margin account would therefore be reduced by

$1,800 to $10,200.

• Similarly, if the price of December gold rose to $1,259 by the end of

the first day, the balance in the margin account would be increased

by $1,800 to $13,800.

• A trade is first settled at the close of the day on which it takes place.

It is then settled at the close of trading on each subsequent day.

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Margin Cash Flows

• A trader has to bring the balance in the margin

account up to the initial margin when it falls below the

maintenance margin level

• A member of the exchange clearing house only has

an initial margin and is required to bring the balance

in its account up to that level every day.

• These daily margin cash flows are referred to as

variation margin

• A member is also required to contribute to a default

fund

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Example of a Futures Trade

Table 2.1 illustrates the operation of the margin account for

one possible sequence of futures prices in the case of the

investor considered earlier.

The maintenance margin is assumed to be $4,500 per

contract, or $9,000 in total.

On Day 7, the balance in the margin account falls $1,020

below the maintenance margin level.

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A Possible Outcome (Table 2.1)

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The Clearing House and Clearing Margins

• A clearing house acts as an intermediary in futures

transactions. It guarantees the performance of the parties to

each transaction.

• The main task of the clearing house is to keep track of all the

transactions that take place during a day, so that it can

calculate the net position of each of its members.

• A broker is required to maintain a margin account with a

clearing house member and the clearing house member is

required to maintain a margin account with the clearing house.

The latter is known as a clearing margin.

• The margin accounts for clearing house members are

adjusted for gains and losses at the end of each trading day in

the same way as are the margin accounts of investors

The whole purpose of the margining system is to ensure that

funds are available to pay traders when they make a profit. 15

The Clearing House and Clearing Margins

-Margin Cash Flows When Futures Price Increases

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Long Trader

Broker

Clearing House

Member

Clearing House

Clearing House

Member

Broker

Short Trader

The Clearing House and Clearing Margins

-Margin Cash Flows When Futures Price Decreases

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Long Trader

Broker

Clearing House

Member

Clearing House

Clearing House

Member

Broker

Short Trader

Some Terminology

• : This is the price used for calculating daily gains and

losses and margin requirements. the price just before

the final bell each day

• used for the daily settlement process

• Trading volume is the number of contracts traded.

• Open interest is the number of contracts outstanding,

that is, the number of long positions or, equivalently, the

number of short positions.

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Key Points About Futures

• They are settled daily

• Closing out a futures position involves entering into an offsetting trade

• Most contracts are closed out before maturity

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Crude Oil Trading on May 14, 2013

(Table 2.2, page 36)

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Open High Low Prior Settle

Last Trade

Change Volume

Jun 2013 94.93 95.66 94.50 95.17 94.72 −0.45 162,901

Aug 2013 95.24 95.92 94.81 95.43 95.01 −0.42 37,830

Dec 2013 93.77 94.37 93.39 93.89 93.60 −0.29 27,179

Dec 2014 89.98 90.09 89.40 89.71 89.62 −0.09 9,606

Dec 2015 86.99 87.33 86.94 86.99 86.94 −0.05 2,181

Collateralization in OTC Markets

It is becoming increasingly common for transactions

to be collateralized in OTC markets

Consider transactions between companies A and B

These might be governed by an ISDA Master

agreement with a credit support annex (CSA)

The CSA might require A to post collateral with B

equal to the value to B of its outstanding transactions

with B when this value is positive.

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Collateralization in OTC Markets continued

If A defaults, B is entitled to take possession

of the collateral

The transactions are not settled daily and

interest is paid on cash collateral

See Business Snapshot 2.2 for how

collateralization affected Long Term Capital

Management when there was a ―flight to

quality‖ in 1998.

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Clearing Houses and OTC Markets

Traditionally most transactions have been cleared

bilaterally in OTC markets

Following the 2007-2009 crisis, the has been a

requirement for most standardized OTC derivatives

transactions between dealers to be cleared through

central counterparties (CCPs)

CCPs require initial margin, variation margin, and

default fund contributions from members similarly to

exchange clearing houses

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Bilateral Clearing vs Central Clearing House

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New Regulations

New regulations for trades between dealers

that are not cleared centrally require dealers

to post both initial margin and daily variation

margin

The initial margin is posted with a third party

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Delivery

• As mentioned earlier in this chapter, very few of the

futures contracts that are entered into lead to delivery of

the underlying asset. Most are closed out early.

• Nevertheless, it is the possibility of eventual delivery

that determines the futures price. An understanding of

delivery procedures is therefore important.

• If a futures contract is not closed out before maturity, it

is usually settled by delivering the assets underlying the

contract. When there are alternatives about what is

delivered, where it is delivered, and when it is delivered,

the party with the short position chooses.

• A few contracts (for example, those on stock indices

and Eurodollars) are settled in cash

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Types of Orders

Limit

Stop-loss

Stop-limit

Market-if touched

Discretionary

Time of day

Open

Fill or kill

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Regulation of Futures

In the US, the regulation of futures

markets is primarily the responsibility of

the Commodity Futures and Trading

Commission (CFTC)

Regulators try to protect the public

interest and prevent questionable trading

practices

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Accounting & Tax

Ideally hedging profits (losses) should be recognized at the same time as the losses (profits) on the item being hedged

Ideally profits and losses from speculation should be recognized on a mark-to-market basis

Roughly speaking, this is what the accounting and tax treatment of futures in the U.S. and many other countries attempt to achieve

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Forward Contracts vs Futures Contracts

(Table 2.3, page 43)

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Contract usually closed out

Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash settlement usually occurs prior to maturity

FORWARDS FUTURES

Some credit risk Virtually no credit risk

Foreign Exchange Quotes

Futures exchange rates are quoted as the

number of USD per unit of the foreign currency

Forward exchange rates are quoted in the same

way as spot exchange rates. This means that

GBP, EUR, AUD, and NZD are quoted as USD

per unit of foreign currency. Other currencies

(e.g., CAD and JPY) are quoted as units of the

foreign currency per USD.

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