Mechanics of Futures Markets Chapter 2 (all editions)

Futures Contracts Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract but standardized Whereas a forward contract is traded over-the- counter, a futures contract is traded on an exchange Everyday examples of futures/forwards: –Sports betting on scores with a buddy

Terminology The party that has agreed to buy has what is termed a long position The party that has agreed to sell has what is termed a short position

Examples of Futures Contracts Agreement to: –Buy (long futures position) 100 oz. of US$870/oz. in December –Sell (short futures position) CDN$/£ in September –Sell (short futures positions) 1,000 bbl. of US$100/bbl. in July

Futures and Forwards Markets Spot vs Derivatives Markets Exchange traded –Traditionally exchanges have used the open-outcry system (mosh pit), but increasingly they are switching to electronic trading –Contracts are standard there is virtually no credit risk (1 contract of corn = 5000 bushels) –Value of assets underlying the contracts: US $344 trillion as of Q Over-the-counter (OTC) –A computer- and telephone-linked network of dealers at financial institutions, corporations, and fund managers –Contracts can be non-standard and there is some small amount of credit risk –Value of assets underlying the contracts: US $684 trillion as of June 2008

Positions in Futures Contracts If you buy the contract: –you take in a long futures position –you hope the futures price will increase –profit graph If you sell the futures contract: –You take a short futures position –You hope the futures price will decrease –profit graph

Profit from a Long Futures Position Profit Price of Underlying at Maturity, S T K

Profit from a Short Futures Position Profit Price of Underlying at Maturity, S T K

US Exchanges Trading Futures Chicago Board of Trade –Corn, oats, wheat, Treasury bonds and notes – oilseed/corn_contract_specifications.htmlhttp:// oilseed/corn_contract_specifications.html New York Mercantile Exchange (NYMEX) (CME Group) –futures and options contracts for crude oil, gasoline, heating oil, natural gas, electricity, gold, silver, copper, aluminum, and platinum, etc – ract_specifications.html Chicago Mercantile Exchange (1919) –Chicago Produce Exchange (1874): butter, eggs, poultry –Chicago Butter and Egg Board (1898) –Commodities, pork bellies, live cattle, live hogs, etc –Foreign exchange trading (1972) –Merged with CBOT (2007) and acquired NYMEX (2008)

Int’l Exchanges Trading Futures London International Financial Futures and Options Exchange: EN.html EN.html Eurex: Singapore International Monetary Exchange:

Canadian Exchanges Trading Options ICE Futures Canada (formerly, Winnipeg Commodity Exchange): Established in 1887 and located in Winnipeg, Manitoba, ICE has provided a meeting place for market participants for well over 100 years and continues to play an important role in the price discovery and risk management of Canadian grain. –WCE does not trade stocks. The Exchange trades agricultural commodity futures contracts and options on futures contracts which include canola, wheat, and western barley. Montreal Exchange: –Equity derivatives (equity options) –Currency derivatives (options on the US dollar) –Index derivatives –Interest rate derivatives (bond and money markets)

Other Futures Exchanges an online trading exchange website whose members speculate on the outcomes of non-sports-related future eventstrading exchange Nadex, Inc. is a retail-orientated exchange offering simplified derivatives contracts on the world's markets. Nadex is subject to regulatory oversight by the CFTC. Hollywood Stock Exchange® ( is the world's leading entertainment stock market

Forward Contracts A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (the delivery or settlement price) It can be contrasted with a spot contract which is an agreement to buy or sell immediately Similar to futures contract but customized to investors’ needs Whereas a futures contract is traded on an exchange, a forward contract is traded over- the-counter

Forward Price The price for a contract is the delivery price that would be applicable to the contract if it were negotiated today The price may be different for contracts of different maturities

Futures Contracts Available on a wide range of underlying assets (currencies, stock indices, foreign currency, etc) Specifications need to be defined: –What can be delivered –Where it can be delivered –When it can be delivered Settled daily (Marking to Market)

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 (Marking to Market daily) Initial Margin: credit risk; margins minimize the possibility of a loss through a default on a contract Maintenance Margin: to ensure the balance never becomes negative

Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 –contract size is 100 oz. –futures price is US$400 –margin requirement is US$2,000/contract (US$4,000 in total) –maintenance margin is US$1,500/contract (US$3,000 in total)

A Possible Outcome DailyCumulativeMargin FuturesGain AccountMargin Price(Loss) BalanceCall Day(US$) ,000 5-Jun397.00(600) 3, Jun393.30(420) (1,340) 2,6601, Jun387.00(1,140) (2,600) 2,7401, Jun (1,540) 5, = 4,000 3,000 + = 4,000 <

Other 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 Examples of when a position is not closed

Delivery Contracts are usually specified by their delivery month (October oil futures contract) Delivery of the asset can take place during the delivery month (usually the whole month) Trading ceases some time during the delivery month Most contracts do not lead to delivery as investors close out their positions due to the inconvenience of delivery terms

Convergence of Futures to Spot Time (a)(b) Futures Price Futures Price Spot Price As the delivery month of the futures contract is approached, the futures price converges to the spot price of the underlying asset

Regulation of Futures Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups Objectives: guarantee performance of parties and keep track of transactions US: Commodity Futures Trading Commission (CFTC) Ontario, Canada: Ontario Securities Commission (OSC) Investor Clearinghouse Member BrokerInvestorBroker

Forward Contracts vs Futures Contracts Private contract between 2 parties (OTC)Exchange traded Non-standard contractStandard contract Usually 1 specified delivery dateRange of delivery dates Settled at maturitySettled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDSFUTURES

All editions: 2.3, 2.4, 2.11, 2.16