Mechanics of Futures Markets Chapter 2 Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull 20081

Futures Contracts Available on a wide range of assets Exchange traded Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered Settled daily Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

Opening and Closing Futures Position An investor could instruct a broker to buy for exp. one October oil futures contract. There is period of time during the delivery month when delivery can be made. Trading usually ends some time during the delivery period. The party with the short position chooses when delivery is made. However majorty of the futures contracts that are initiated do not lead to delivery. The reason is that most investors choose to close out their positions perior to the delivery period. Closing a position is entering into an opposite trade. Most contracts are closed out before maturity

Specification of Futures Contracts The Asset Contract size Delivery arrangements Delivery months Price Quotes Price limits & position limits

Convergence of Futures to Spot (Figure 2.1, page 26) Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull Time (a)(b) Futures Price Futures Price Spot Price

The Operation of 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 Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

Example of a Futures Trade (page 26-28) An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 oz. futures price is US$600 per oz margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total) Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

A Possible Outcome Table 2.1, Page 28 Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull DailyCumulativeMargin FuturesGain AccountMargin Price(Loss) BalanceCall Day(US$) ,000 5-Jun597.00(600) 3, Jun593.30(420) (1,340) 2,6601, Jun587.00(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. Min. Levels of initial and maintenance margin are set by the exchange. Margin requirements may depend on the objective of the trader. Day trades and spread transaction often give rise to lower margin requirement. Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

The clearing house and clearing margins The clearing house acts as an intermediary. It guarantees the performance of the two parties. It has a number of members who must post funds with the exchange. The main task of it is to keep track of all the transactions and calculate the net positions of its members.

A clearing house member is required to maintain a margin with the clearing house (clearing margin). The main purpose of the margining system is to reduce default (credit) risk. Credit risk is a feature of the OTC market.

Collateralization in OTC Markets A collateralization agreement btw two parties require them to value the contract each day. It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week) They were used by a hedge fund (LTCM) in 1990s. Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

The credit crisis and the use of Clearing houses in OTC markets Credit crisis causes a systemic risk. Failure by a large fin. inst. will lead to failures by other large fin. insts. So that politiciants and regulators have looked at ways of making the OTC market more like the futures market.

Newspaper Quotes Settlement price: the price just before the final bell each day. Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions used for the daily settlement process Volume of trading: the number of trades in 1 day Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

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. Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

Futures Prices for Gold on Jan 8, 2007: Prices Increase with Maturity (Figure 2.2a, page 33) Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

Futures Prices for Orange Juice on January 8, 2007: Prices Decrease with Maturity (Figure 2.2b, page 33) Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

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 position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

Types of Traders Traders: Futures Commission merchants Locals Traders: Speculators Scalpers: Hold positions for a few minutes Day traders: Hold positions for less than one day. Position traders: Hold positions for longer periods Hedgers Arbitrageurs

Types of Orders Market Order: A trade be carried out immediately at the best price available in the market. Limit order: Specifies a particular price. If the limit price is $30 for an investor wanting to buy, the order will be executed at a price of $30 or less. Stop order (Stop loss order): Suppose a stop order to sell at $30 is issued when the market price is $35. It becomes an order to sell when and if the price falls to $30.

Orders cont. Stop limit order: Two prices must be specified. Suppose that at a price of $35, a stop limit order to buy is issued with a stop price of $40 and a limit price of $41. Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

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 Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

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 attempts to achieve Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull

Forward Contracts vs Futures Contracts Options, Futures, and Other Derivatives, 7th International Edition, Copyright © John C. Hull Contract usually closed out TABLE 2.3 (p. 39) Private contract between 2 partiesExchange traded Non-standard contractStandard contract Usually 1 specified delivery dateRange of delivery dates Settled at end of contractSettled daily Delivery or final cash settlement usually occursprior to maturity FORWARDSFUTURES Some credit risk Virtually no credit risk