Futures Markets Exchange Operations

Primary Functions of Futures Markets 1. Manage Price Risk for Hedgers 1. Manage Price Risk for Hedgers 2. Price Discovery 2. Price Discovery

Distinguishing Futures from Cash Cash Transactions Cash Transactions –Cash for Immediate Delivery –Cash Forward Contracts - OTC –All terms negotiated – Nothing Standardized

Distinguishing Futures from Cash Futures Contracts Futures Contracts –Standardized on time, quality, quantity and place, Only variable – Price –Traded on Organized Exchange

Distinguishing Futures from Cash Forward Contracts (CFC) Key Differences Key Differences –Organized exchange vs. One-On-One –Standardized vs. Tailored Contracts –Futures more liquid –Futures have strict trading rules vs. CFC regulated only by Contract Law. –Futures normally offset vs. CFC normally delivered –Futures involve third party vs. CFC person-to- person –Futures require margin deposit as performance guarantee vs. CFC normally do not.

Futures Exchanges Common Characteristics Futures contracts must be traded in the pits Futures contracts must be traded in the pits Are Voluntary - facilitate trading Are Voluntary - facilitate trading Membership limited and hold value as an asset. Membership limited and hold value as an asset. Most exchanges limit ownership of the membership to individuals. Most exchanges limit ownership of the membership to individuals.

Membership Values –CBOT $293,000 (8/7/12) –CME $525,000 (8/10/12) –NYMEX $275,000 (8/16/12) –COMEX $135,000 (7/30/12)

Objectives of Futures Markets Provide plan for trading Provide plan for trading Write contracts Write contracts Establish trading rules & standards of business conduct Establish trading rules & standards of business conduct Supervise and enforce rules & Standards Supervise and enforce rules & Standards Settle disputes & guarantee contract settlement Settle disputes & guarantee contract settlement Collect market information & disseminate to public Collect market information & disseminate to public

Characteristics of Commodities with Futures Contracts Homogeneity Homogeneity Capable of description Capable of description Large & uncertain demand & supply with fluctuating prices Large & uncertain demand & supply with fluctuating prices Centralized market Centralized market Storability Storability Today Today Homogeneity – Fungible Homogeneity – Fungible Capable of description Capable of description Active & Large Market – Uncertain prices Active & Large Market – Uncertain prices Available Market Info. Available Market Info. Economic need Economic need

Exchange Operations – Trading Room Room with trading pits, market monitors (regulators and reporters) around pit, and phone clerks around perimeter of room to take orders. Room with trading pits, market monitors (regulators and reporters) around pit, and phone clerks around perimeter of room to take orders. Pit – Typically polygonal with steps leading down to center. Center usually reserved for current & most active contract. Steps along each side of polygon is separate contract month. Pit – Typically polygonal with steps leading down to center. Center usually reserved for current & most active contract. Steps along each side of polygon is separate contract month. Trading hours – Limited and depend on commodity. Trading hours – Limited and depend on commodity. Bell – Begins and ends trading day with warning prior to opening and closing. Bell – Begins and ends trading day with warning prior to opening and closing.

Multiple Auction Procedure Open outcry and Hand signals – gives equal access to all bids and offers. Open outcry and Hand signals – gives equal access to all bids and offers. Outcry – Yell bids and offers for all to hear. Outcry – Yell bids and offers for all to hear. –Sellers yell quantity first, then price. –Buyers yell price first, then quantity. Hand signals – Hand signals – –Palm in is buy, –Palm out is sell, –fingers vertical (or near face) quantity, –fingers horizontal (or away from body) price.

Trade Cycle Customer Account Executive FCM Phone Clerk Runner Floor Broker Clearinghouse Time Stamp *Everyone who handles customer accounts must pass the “Series 3” exam administered by the National Association of Securities Dealers, register with the Commodity Futures Trading Commission (CFTC) and become members of the National Futures Association (NFA).

Traders on the Floor Brokers Brokers –Fill orders for fee –Can’t trade in front of customer (dual trading) –Must offer all trades with open outcry Speculators (Locals) – trade own accounts Speculators (Locals) – trade own accounts –Scalper – buy (sell) one tick from market. Provide liquidity. Market makers –Day traders – Take larger positions throughout day, rarely over night –Position traders – Hold positions for days or longer in anticipation of larger moves. Hedgers Hedgers –Buy or sell to manage risk of cash position

Reading Quotations Commodity description – commodity, exchange, volume in 1 contract, how price is quoted Commodity description – commodity, exchange, volume in 1 contract, how price is quoted Listed by contract month Listed by contract month Day’s trading range – Open is first trade of day, hi is highest price for day, lo is lowest price of day and settle is price at end of day. Day’s trading range – Open is first trade of day, hi is highest price for day, lo is lowest price of day and settle is price at end of day. Lifetime Hi/Lo – Highest and lowest prices for contract over the life of contract. Lifetime Hi/Lo – Highest and lowest prices for contract over the life of contract. Change from previous day – today’s price less price of previous day. Change from previous day – today’s price less price of previous day. Open interest – total contracts that are open at close of day for a contract month and the total for all months. Open interest – total contracts that are open at close of day for a contract month and the total for all months. Previous day’s Volume and today’s estimated volume Previous day’s Volume and today’s estimated volume

Origination and Settlement of Contracts Origination occurs when a new position is established. Origination occurs when a new position is established. –Buyer is long –Seller is short –Zero Sum Game less trading costs –Don’t need a cash position, only a promise Every trade has a long and a short

Origination and Settlement of Contracts Settlement Settlement –Offsetting - Complete a transaction with exact same contract from the opposite position. If long then sell If long then sell If short then buy If short then buy –Delivery also results in settlement. Only time title changes hands Only time title changes hands

Origination and Settlement of Contracts Event Long Trader Short Trader Contracts Traded Open Inter. Trading Volume 1AB111 2DC232 3ED232 4BA121 5CE202 Net08

Placing orders – Components of an order Name & ID – Most will require a PIN. Name & ID – Most will require a PIN. Time limit – Time limit (e.g., Day) vs. Open ended. Time limit – Time limit (e.g., Day) vs. Open ended. Type of order – Buy vs. Sell Type of order – Buy vs. Sell Volume – number of contracts Volume – number of contracts Contract – Commodity, exchange, month, year. Contract – Commodity, exchange, month, year. Price – Specific price vs. market. Price – Specific price vs. market.

Types of Orders Market order – Order to take position at best possible price. Market order – Order to take position at best possible price. Price Limit Order – Order to take a position in the market as soon as possible when the price is as good or better than price limit given in order. Price Limit Order – Order to take a position in the market as soon as possible when the price is as good or better than price limit given in order. Market-if-touched – Order to fill at best price when a price has been touched. Market-if-touched – Order to fill at best price when a price has been touched. Stop Order – Could be Price Limit or Market-if- touched. Usually placed to limit loss on position. Stop Order – Could be Price Limit or Market-if- touched. Usually placed to limit loss on position.

Types of Orders Trailing Stop – Stop order which ratchets as price moves to the benefit of a position. Placed to limit losses (lost profits) on trend reversals. Trailing Stop – Stop order which ratchets as price moves to the benefit of a position. Placed to limit losses (lost profits) on trend reversals. Scale-in Order – Series of market-if-touched or price limit orders placed to add to profitable positions. Scale-in Order – Series of market-if-touched or price limit orders placed to add to profitable positions. Fill-or-Kill – Combined price limit and time limit order. Fill at X price or better in Y time or cancel. Fill-or-Kill – Combined price limit and time limit order. Fill at X price or better in Y time or cancel. Cancel – Cancels existing order. Cancel – Cancels existing order.

Spread Orders Spread Orders – simultaneous buy and sell of different contracts Spread Orders – simultaneous buy and sell of different contracts –Inter-delivery – Spread on same commodity at same exchange, just different months. –Inter-market – Spread on same commodity and month, but different exchanges. –Inter-commodity – Spread on same month for different commodities, e.g., Soybeans, Soy Oil, and Soybean Meal

Clearing Operations Responsibilities of the Clearinghouse 1. Clear all trades 1. Clear all trades 2. Collect & Maintain Margin Monies 2. Collect & Maintain Margin Monies 3. Regulate Delivery 3. Regulate Delivery 4. Settle All Accounts 4. Settle All Accounts 5. Report Trading Data 5. Report Trading Data

Membership in Clearinghouse All trades must be cleared by a Clearinghouse member All trades must be cleared by a Clearinghouse member Most members are companies, but can be individuals. Most members are companies, but can be individuals. Capital requirements for membership vary, but are considered rigid to maintain the integrity of the Clearinghouse Capital requirements for membership vary, but are considered rigid to maintain the integrity of the Clearinghouse

Clearing Trades Clearinghouse is 3 rd party to all trades Clearinghouse is 3 rd party to all trades –Have no net positions, they take a long and short position on all trades –It is the Guarantor on all trades. Member firms guarantee the funds of the clearinghouse. All trades reconciled at end-of-day. All trades reconciled at end-of-day. –Errors reconciled with ‘Out Trades’ –All trades must be reconciled before trading resumes following day.

Clearing Operations Responsibilities of the Clearinghouse 1. Clear all trades 1. Clear all trades 2. Collect & Maintain Margin Monies 2. Collect & Maintain Margin Monies 3. Regulate Delivery 3. Regulate Delivery 4. Settle All Accounts 4. Settle All Accounts 5. Report Trading Data 5. Report Trading Data

Members Margining Trades With Clearinghouse Clearinghouse margins set by Clearinghouse Margin Committee and then approved by Clearinghouse Board of Directors. Clearinghouse margins set by Clearinghouse Margin Committee and then approved by Clearinghouse Board of Directors. Margins set to guarantee the integrity of all trades. Margins set to guarantee the integrity of all trades. Margins may be satisfied with cash, interest bearing government securities, and letters of credit from a bank. Margins may be satisfied with cash, interest bearing government securities, and letters of credit from a bank.

Customer margin requirements with an account executive Initial Margin – Amount required to establish a position. For most commodities, it is 5% - 8% of commodity value depending on inherent price risk of the commodity. Initial Margin – Amount required to establish a position. For most commodities, it is 5% - 8% of commodity value depending on inherent price risk of the commodity. Maintenance Margin – Minimum balance required in your account to maintain a position. Generally about 75% of initial margin. Maintenance Margin – Minimum balance required in your account to maintain a position. Generally about 75% of initial margin. Excess funds can be drawn down to the initial margin level. Excess funds can be drawn down to the initial margin level. Broker can liquidate any position not meeting margin requirements. Broker can liquidate any position not meeting margin requirements.

Mark-To-Market The Clearinghouse and Account Executive compute balances in margin accounts to the settlement price at the close of each trading day. The Clearinghouse and Account Executive compute balances in margin accounts to the settlement price at the close of each trading day. –Losers are debited –Gainers are credited

Margin Calls Call for additional funds if the margin account balance falls below the maintenance margin level. Call for additional funds if the margin account balance falls below the maintenance margin level. Customer will be required to deposit funds to bring the margin account back to the initial margin level. Customer will be required to deposit funds to bring the margin account back to the initial margin level.

Distinguishing Clearinghouse Margin Accounts (FCM) from customer margin accounts For FCM, initial margin equals maintenance margin. For customer, initial margin is larger than maintenance margin. For FCM, initial margin equals maintenance margin. For customer, initial margin is larger than maintenance margin. FCM’s profit by posting margins only on ‘Net Positions’ of all clients. Customers hold only net positions. FCM’s profit by posting margins only on ‘Net Positions’ of all clients. Customers hold only net positions. FCM’s profit from income earned on excess margin cash they hold on total positions over net positions. FCM’s profit from income earned on excess margin cash they hold on total positions over net positions.

Distinguish Futures Contract Margins from Securities Trading Margins Ownership is transferred with securities, but not with futures contracts. Ownership is transferred with securities, but not with futures contracts. Securities margins considered down payment whereas futures contract margins considered performance guarantee. Securities margins considered down payment whereas futures contract margins considered performance guarantee. Margins generally larger for securities. Margins generally larger for securities.

Margining Futures Example IM=$550, MM=$450. Initial trade at $3.02 on 5,000 bu. Day/Closing Price Value Change Buyer Acct. Balance Seller Acct. Balance Thurs/$3.04 (.02X5000) =$100 $550+$100 = $650 $550-$100 = $450 Fri/$$3.00 (.04X5000) =$200 $650-$200 = $450 $450+$200 = $650 Mon./$2.95 (.05X5000) =$250 $450-$250 = $200 $650+$250 = $900 Buyer Margin Call =$550-$200 =$350 $200+$350 = $550 $900

Clearing Operations Responsibilities of the Clearinghouse 1. Clear all trades 1. Clear all trades 2. Collect & Maintain Margin Monies 2. Collect & Maintain Margin Monies 3. Regulate Delivery 3. Regulate Delivery 4. Settle All Accounts 4. Settle All Accounts 5. Report Trading Data 5. Report Trading Data

Regulating Delivery All futures contracts are either offset or end in ‘delivery’. All futures contracts are either offset or end in ‘delivery’. Delivery option helps insure that futures contract price follows cash market price. Delivery option helps insure that futures contract price follows cash market price. –Why? Arbitrage Most commodities pass delivery with a ‘cash settlement. Most commodities pass delivery with a ‘cash settlement.

Clearinghouse regulates the delivery process. Receives and makes payments. Receives and makes payments. Passes delivery notices. Passes delivery notices. Transfers titles Transfers titles Insures commodity meets contract specifications. Insures commodity meets contract specifications. Gets the commodity in the right location Gets the commodity in the right location

Process for delivery First Position Day First Position Day –Clearing firm representing longs declare all open positions and report to clearinghouse and to customers. Usually 2 days before first day allowed for delivery. Day 1 Position Day Day 1 Position Day –Clearing firm of seller notifies Clearinghouse that their customer wishes to deliver.

Process for delivery (cont.) First Position Day First Position Day Day 1 Position Day Day 1 Position Day Day 2 Position Day Day 2 Position Day –Prior to opening on day following Day 1 Position Day, Clearinghouse matches seller with oldest reported long position and notifies both. On many exchanges, buyers can re- tender these notices to find another buyer.

Process for delivery (cont.) First Position Day First Position Day Day 1 Position Day Day 1 Position Day Day 2 Position Day Day 2 Position Day Day 3 – Delivery Day Day 3 – Delivery Day –Buyers clearing firm presents check to sellers clearing firm and title passes. Cash settlement procedures tie payments to cash market prices with no change in product or title.

Clearing Operations Responsibilities of the Clearinghouse 1. Clear all trades 1. Clear all trades 2. Collect & Maintain Margin Monies 2. Collect & Maintain Margin Monies 3. Regulate Delivery 3. Regulate Delivery 4. Settle All Accounts 4. Settle All Accounts 5. Report Trading Data 5. Report Trading Data

Settling Accounts Mark-To-Market all margin accounts at the end of each trading day. Mark-To-Market all margin accounts at the end of each trading day. Offsetting positions of customers and settling margin accounts. Offsetting positions of customers and settling margin accounts. Delivery of product and settling of margin accounts. Delivery of product and settling of margin accounts.

Clearing Operations Responsibilities of the Clearinghouse 1. Clear all trades 1. Clear all trades 2. Collect & Maintain Margin Monies 2. Collect & Maintain Margin Monies 3. Regulate Delivery 3. Regulate Delivery 4. Settle All Accounts 4. Settle All Accounts 5. Report Trading Data 5. Report Trading Data

Reporting Trading Data Report settlement prices at the close of each day. Report settlement prices at the close of each day. Post price limits for the next day’s trading. Post price limits for the next day’s trading. Report Volume and Open Interest for the previous day’s trading. Report Volume and Open Interest for the previous day’s trading.