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Mechanics of Futures Markets

Chapter 2

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Chapter Outline2.1 Trading Futures contracts2.2 Specifications2.3 Convergence of futures price to spot price2.4 Operation of margins2.5 Newspaper quotes2.6 Keynes and Hicks2.7 Delivery2.8 Types of traders2.9 Regulation2.10 Accounting and tax2.11 Forward contracts vs. futures contracts

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2.1 Trading Futures contracts

• The Chicago Mercantile Exchange (CME) is by far the largest.

• Others include:– The Philadelphia Board of Trade (PBOT)– The MidAmerica Commodities Exchange– The Tokyo International Financial Futures

Exchange– The London International Financial Futures

Exchange

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The Chicago Mercantile Exchange

• Expiry cycle: March, June, September, December.

• Delivery date 3rd Wednesday of delivery month.

• Last trading day is the second business day preceding the delivery day.

• CME hours 7:20 a.m. to 2:00 p.m. CST.

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CME After Hours

• Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST.

• Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts.

• There’s other markets, but none are close to CME and SIMEX trading volume.

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2.2 The Specification of the futures contract

• The Asset• The Contract Size• Delivery Arrangements• Delivery Months• Price Quotes• Daily Price Movement Limits• Position Limits

– Limits on speculators, but not hedgers.

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2.2 The Specification of the futures contract

• Standardizing Features:– Contract Size– Delivery Month

• Daily resettlement– Minimizes the chance of default

• Initial Margin – About 4% of contract value, cash or T-bills

held in a street name at your brokerage.

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Selected Futures Contracts

Contract Contract Size ExchangeAgricultural

Corn 5,000 bushels Chicago BOTWheat 5,000 bushels Chicago & KCCocoa 10 metric tons CSCE

OJ 15,000 lbs. CTNMetals & Petroleum

Copper 25,000 lbs. CMX Gold 100 troy oz. CMX

Unleaded gasoline 42,000 gal. NYMFinancial

British Pound £62,500 IMMJapanese Yen ¥12.5 million IMM

Eurodollar $1 million LIFFE

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Basic Futures Relationships

• Open Interest refers to the number of contracts outstanding for a particular delivery month.

• Open interest is a good proxy for demand for a contract.

• Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

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2.3 Convergence of futures price to spot price

• At maturity, it must be the case that the futures price converges to the then-prevailing spot price.

• If not, an arbitrage occurs.

maturity

spot

futures

maturity

spot

futures

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maturity

spot

futures

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2.4 Operation of margins

• Margins help us avoid contract defaults.

• To enter into a futures contract, the investor must deposit money into a margin account.

• At the end of each day, the margin account is adjusted to reflect the trader’s gain or loss.

• This daily resettlement is referred to as marking to market.

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Daily Resettlement: An Example

Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate).

Currently $1 = ¥140.

Currency per U.S. $ equivalent U.S. $

Wed Tue Wed TueJapan (yen) 0.007142857 0.007194245 140 1391-month forward 0.006993007 0.007042254 143 1423-months forward 0.006666667 0.006711409 150 1496-months forward 0.00625 0.006289308 160 159

The 3-month forward price is $1=¥150.

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Daily Resettlement: An Example

• Currently $1 = ¥140 and it appears that the dollar is strengthening.

• If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates. The contract size is ¥12,500,000

• Your initial margin is 4% of the contract value:

¥150

$10¥12,500,00.04 $3,333.33

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Daily Resettlement: An Example

If tomorrow, the futures rate closes at $1 = ¥149, then your position’s value drops.

Your original agreement was to sell ¥12,500,000 and receive $83,333.33:

¥149

$10¥12,500,0062.892,83$

You have lost $559.28 overnight.

But ¥12,500,000 is now worth $83,892.62:¥150

$10¥12,500,00 $83,333.33

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Daily Resettlement: An Example

• The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05

• This is short of the $3,355.70 required for a new position.

¥149

$10¥12,500,00.04 $3,355.70

Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.

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2.5 Wall Street Journal Price Quotes

OpenOpen High Low Settle Change High Low Interest

July 179 180 178¼ 178½ -1½ 312 177 2,837Sept 186 186½ 184 186 -¾ 280 184 104,900Dec 196 197 194 196½ -¼ 291¼ 194 175,187

Sept 117-05 117-21 116-27 117-05 +5 131-06 111-15 647,560Dec 116-19 117-05 116-12 116-21 +5 128-28 111-06 13,857

Sept 11200 11285 11145 11241 -17 11324 7875 18,530Dec 11287 11385 11255 11349 -17 11430 7987 1,599

Lifetime

Corn (CBT) 5,000 bu.; cents per bu.

TREASURY BONDS (CBT) - $1,000,000; pts. 32nds of 100%

DJ INDUSTRIAL AVERAGE (CBOT) - $10 times average

Expiry month

Opening price

Highest price that day

Lowest price that day

Closing price Daily Change

Highest and lowest prices over the lifetime of the contract.

Number of open contracts

Nor

mal

mar

ket

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2.6 Keynes and Hicks

• Argued that if hedgers tend to hold short positions and speculators tend to hold long positions, the futures price of an asset will be below its expected future spot price.– This is because speculators require compensation for

bearing risk and hedgers are willing to pay to reduce risk.

• When the futures price < expected future spot price, the situation is known as normal backwardation.

• The opposite situation is called contango.

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2.7 Delivery

• Most futures contracts are closed out early.• The delivery period is specified by the

exchange and varies from contract to contract.

• The short makes the decision on when to deliver and his broker issues a notice of intention to deliver to the exchange clearinghouse.

• The exchange then chooses a party with a long position to accept delivery.

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2.7 Delivery

• In the case of a commodity, taking delivery usually means accepting a warehouse receipt in return for immediate payment.

• In the case of financial futures, delivery is usually made by wire transfer.

• For all contracts, the settlement price is usually the settlement price immediately preceding the date of the notice of intention to deliver.– It can be adjusted up or down for location, grade et c.

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3 critical days

• There are three critical days for a contract.1. The first notice day

– The first day on which a notice on intention to make delivery can be submitted to the exchange.

2. The last notice day

3. The last trading day– Generally a few days before the first notice day.

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2.8 Types of traders

• Commission brokers– Follow the instructions of their clients and

charge a commission for doing so.

• Locals– Trade on their own account.

• Individuals taking positions– Scalpers– Day traders– Position traders

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Types of Orders

• Limit order• Stop-loss order• Stop-limit order• Market-if-touched order• Discretionary order (market-not-held order)• Fill-or-kill

– Unless specified, an order is a day order and expires a the end of the trading day.

– An open order or good-till-cancelled order is in effect until executed or the expiry.

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2.9 Regulation

• In the U.S. futures markets are currently regulated by the CFTC.– Licenses futures exchanges– Approves contracts– Licenses individuals who offer their services to

the investing public.

• NFA• SEC• Treasury department

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Trading irregularities

• Market corner– Take a big long position in the futures contract.– Gain control of the underlying supply.– At maturity, the shorts will have to pay any

price to satisfy their obligations

• Futures Markets are also a great place to launder money– The zero sum nature of futures is the key to

laundering the money.

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James B. Blair outside counsel to Tyson Foods Inc., Arkansas' largest employer, gets Hillary’s discretionary order.

Robert L. "Red" Bone, (Refco broker), allocates trades ex post facto.

Submits identical long and short trades

winners

losers

Money Laundering: Hillary Clinton’s cattle futures

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2.10 Accounting and tax

• Comprehensive treatment is far beyond the scope of this course.

• Accounting treatment is different for hedgers and speculators.

• Tax – Gains and losses – Timing or recognition of the gain or loss.

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2.11 Forward contracts vs. futures contracts

• A futures contract is like a forward contract:– It specifies that a certain commodity will be exchanged

for another at a specified time in the future at prices specified today.

• A futures contract is different from a forward:– Futures are standardized contracts trading on organized

exchanges with daily resettlement (“marking to market”) through a clearinghouse.