Mechanics of Futures Markets

Important questions What is a futures contract? Distinguish with forward contract and option contract. Marked to market Specification of contracts Regulation of markets The way in which quotes are made The treatment of futures transactions for accounting and tax purposes. Buy – take long position – buyer is said to be long Sell – take a short position – seller is said to be short Short – commit to sell Long – Commit to buy Prices determined by laws of demand and supply

Futures Contracts It is a legally binding agreement to buy or deliver a certain quantity of a standardized good by a specific date. Available on a wide range of underlying Exchange traded Specifications need to be defined: (What, where, when) What can be delivered, Where it can be delivered, & When it can be delivered Also, the grade of the asset to be delivered. Settled daily

Specification of Futures Contracts Asset: For commodity products, there should be specifications of the grade. E.g. ICE specifies Orange juice as frozen US Grade A with Brix value of not less than 62.5 degrees. Financial assets in futures contracts are generally well defined and unambiguous. Contract size: Specifies the amount of the asset that has to be delivered under one contract e.g. 100 shares is one equity index contract. Should not be too large lest it closes out investors with small exposures or too small making trading expensive. An exchange should balance this…some have introduced mini….e.g. S & P 500 and E-Mini S & P 500, Nikkei 225 & Nikkei 225 mini etc

Specification of Futures Contracts Delivery arrangements: Place where delivery will be made must be specified by the exchange…especially for commodities with significant transportation cost. Price tends to be higher for delivery locations that are relatively far from the main sources of the commodity. Delivery month: Futures contract are referred by their delivery months (e.g. March, May, July, September, December etc. ) Delivery months vary from contract to contract and are chosen by the exchange to meet the needs of markets participants. Exchange must specify the precise period when delivery will be made…. Exchange should specify when trading will begin and the last day when trading will take place Contracts usually trade for the closest delivery month and a number of subsequent delivery months. Trading generally ceases a few days before the last day on which delivery can be made.

Specification of Futures Contracts Price quotes: How will the price be quoted? Which currency and in what cents? E.g. in US, T. bonds and T. notes future prices are quoted in dollars and thirty- seconds of a dollar. Price limits and position limits: Daily price movement limits are specified by the exchange – if it price moves down(up) by the price limit, the contract is said to be limit down (up). In most cases, trading for the contract ceases for the day although the authority may step in and change the limits. E.g. Most exchanges limit the prices to +- 10% the previous day’s price This helps reducing speculative behaviors. Position limits are the maximum number of contracts that a speculator may hold.

Delivery 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 (selling) position chooses. Critical days of a contract includes; 1st notice day – 1st day notice on intention to make delivery is submitted to exchange Last notice day – last such day Last trading day – few days before the last notice day Investor with long position should close their contract prior to first notice day.

Cash settlement A few contracts (for example, those on stock indices and Eurodollars) are settled in cash. Some financial futures are settled in cash instead of physical delivery because its inconvenient or impossible to deliver the underlying asset. When a contract is settled in cash, all outstanding contracts are declared closed on a predetermined day. The final settlement price is set equal to the spot price of the underlying asset at either the opening or close of trading on that day.

Convergence of futures price to spot price As delivery period for a futures contract approaches, the future 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. This occurs due to arbitrage profits that exist which traders take advantage of leading to convergence of prices.

Convergence of Futures to Spot Price Spot Price Futures Price Spot Price Time Time (a) (b)

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 Margins minimize the possibility of a loss through a default on a contract. Margin account: The broker requires an investor to deposit funds in the account. The amount that must be deposited at the time the contract is entered into is called initial margin. 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.

Margins The daily settlement in not a mere agreement between the investor and the broker. When there is a decrease in the futures price, the investor’s broker has to pay the exchange and the exchange passes the money on to the broker of an investor with a short position and vice versa. The investor is entitled to withdraw any balance in the margin account in excess of the initial margin.

Margins To ensure that the balance in the margin account is not a negative, a maintenance margin - which is lower than the initial margin – is set. (around 70% - 80% of initial margin) If the balance goes below the maintenance margin, an investor receives a margin call. Once the investor receives the margin call, they are expected to top up the margin account by the end of next trading day. The extra funds deposited are know an variation margin. If they fail to top up, broker then closes his/her account. They are normally set the exchange for the broker who subsequently sets the margin for the clients.

Margins To satisfy the initial margin requirements, but not subsequent margin calls, an investor can usually deposit securities with the brokers. T. bills are accepted in lieu of cash at 95% of the face value Shares are also acceptable at 50% of their market value. Forward contracts are usually settled at the end of the its life but a futures contract are settled daily with gain (loss) being added (subtracted) to the margin account. Minimum levels for initial and maintenance margins are set by the exchange but the broker can set higher(not lower) rates than those set by exchange. Margin requirements are determined by the variability of the underlying asset.

Margins Most brokers pay interest on the balance in a margin account. Forward contracts are not marked to market (settled daily) but at the end of the contract. Margin requirements depend on the objectives of the trader: For hedgers, the margins are lower than the speculator. Day traders and spread transactions have lower margins than hedgers. Day trade announces intent to close out the same day Spread transaction, trader simultaneously buys a contract on an asset for one maturity month and sells a contract on the same asset for another maturity month. Margin requirements are the same on short futures as with long futures positions

Example 1 An investor takes a long position in TWO December gold futures contracts on 1st September Contract size is 100 oz. Futures price is US$1,250 per ounce. The margin requirement is 4.8% while the maintenance margin is 75%. The closing prices for Days 1 to 16 when the investor decides to close the position is as given in US$; 1,241; 1,238.30; 1,244.60; 1,241.30; 1,240.10; 1,236.20; 1,229.90; 1,230.80; 1,225.40; 1,228.10; 1,211; 1,211; 1,214.30; 1,216.10; 1,223; 1,226.90

Day Trade Price ($) Settlement Price ($) Daily Gain ($) Cumulative gain/loss ($) Margin A/ct Bal ($) Margin Call ($) 1 1,250.00 12,000 1,241.00 (1,800) 10,200 2 1,238.30 (540) (2,340) 9,660 3 1,244.60 1,260 (1,080) 10,920 4 1,241.30 (660) (1,740) 10,260 5 1,240.10 (240) (1,980) 10,020 6 1,236.20 (780) (2,760) 9,240 7 1,229.90 (1,260) (4,020) 7,980 4,020 (12,000 - 7980) 8 1,230.80 180 (3,840) 12,180 9 1,225.40 (4,920) 11,100 10 1,228.10 540 (4,380) 11,640 11 1,211.00 (3,420) (7,800) 8,220 3,780 (12,000 - 8220) 12 - 13 1,214.30 660 (7,140) 12,660 14 1,216.10 360 (6,780) 13,020 15 1,223.00 1,380 (5,400) 14,400 16 1,226.90 780 (4,620) 15,180 The margin requirement is $12,000 (4.8% * 1,250 * 2*100) while the maintenance margin is Kes. 9,000 (75% * 12,000)

Margins When the investor decides to close out the position, the closing price is US$ 1,226.90 and hence the investor makes a cumulative loss of US $ 4,620 ( (1,226.90 - 1,250) * 100*2)

Example 2 of a Futures Trade (Shihom) An investor takes a long position in TWO December gold futures contracts on June 5 contract size is 100 oz. futures price is US$400 per ounce. margin requirement is 5% => US$2,000/contract (US$4,000 in total) maintenance margin is 75% US$1,500/contract (US$3,000 in total) Settlement price on 6th, 7th, and 8th June was $397, $393.30, $387. The investor closed out on June 9th , when the price was $ 392.30.

Operations of margins Day (June) Trade price Settlement price ($) Daily gain / loss($) Cumulative gain / loss ($) Margin A/ct bal ($) Margin call ($) 5 400 4,000 6 397 -600 (3*100*2) -600 3,400 7 393.3 -740 -1340 2,660 8 387 -1260 -2600 1,400 2,600 9 392.3 1060 -1540 5,060

Example 3 of a Futures Trade (main Shihom) An investor takes a short position in 3 of KOSPI 200 futures contracts Contract size is 200 shares. Futures price is 1,520won per share. margin requirement is 5% (15,200won per contract or 45,600won in total) Maintenance margin is 80% (36,480won in total). Settlement price ($) on day 1 to 5 is as follows; 1,521.40; 1,520.80;1,518; 1,519.60; 1,517.10; The investor closed out on day 6, when the price was Won 1,516.70

Day Trade Price ($) Settlement Price ($) Daily Gain ($) Cumulative gain/loss ($) Margin A/ct Bal ($) Margin Call ($) 1 1,520.00 45,600 1,522.40 1,440 47,040 2 1,510.00 (7,440) (6,000) 39,600 3 1,505.00 (3,000) (9,000) 36,600 4 1,506.60 960 (8,040) 37,560 5 1,500.10 (3,900) (11,940) 33,660 11,940 6 1516.7 9,960 (1,980) 55,560

Types of traders and orders There are two main types of traders Locals – trading in own account Futures commission merchants (FCMs) – Follow the instructions of their clients and charge a commission for doing so. The can be hedgers, speculators or arbitrageurs Speculators can be classified into; Scalpers – watching for very short-term trends and attempt to profit from small changes in contract price Day traders – close the same day Position traders – Hold positions for much longer periods of time and hope to make significant profits from major movements in the market.

Types of traders and orders Market order – at the best possible price at the earliest opportunity. Limit order – client specifies a time and a price. Stop order – have a stop price at which to either buy or sell. It becomes a market order once the stop price is touched. With a “buy stop”, the stop price is below the current price. With a “sell stop”, the stop price is above the current price.

Patterns of future prices Normal (contango) markets - markets where the future price is an increasing function of the time to maturity. Inverted (backwardation) markets – markets where futures price decreases with the maturity of the futures contract. Sometimes, markets show a mixture of normal and inverted markets, maybe coz of seasonality. Expectations hypothesis – it states that the futures price of a commodity is what the marketplace expects the cash price to be when the delivery month arrives.

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

OTC Markets Credit risk is usually common in the OTC markets. Most OTC markets therefore has turned to other features to minimize credit risk e.g. Collateralization, use of clearing houses etc. They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)

Some Terminology Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the daily settlement process Volume of trading: the number of trades in a day

Questions When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest?

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

Accounting & Tax It is logical to recognize hedging profits (losses) at the same time as the losses (profits) on the item being hedged It is logical to recognize profits and losses from speculation 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 attempts to achieve

Forward Contracts A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price There is no daily settlement (unless a collateralization agreement requires it). At the end of the life of the contract one party buys the asset for the agreed price from the other party 10

Profit from a Long Forward or Futures Position Price of Underlying at Maturity 14

Profit from a Short Forward or Futures Position Price of Underlying at Maturity 15

Forward Contracts vs Futures Contracts FORWARDS FUTURES Private contract between 2 parties Exchange traded Not standardized Standard contract Usually 1 specified delivery date Range of delivery dates Settled daily Settled at maturity Contract usually closed out prior to maturity Delivery or final cash settlement usually occurs Virtually no credit risk Some credit risk 16

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 USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD. 17