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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).
3
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.
13
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
16
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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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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