Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 1 Futures Contract

Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 2 What is A Futures Contract? A futures contract is a price-fixing mechanism that involves a legally binding commitment to buy or sell a specified quantity of a specified asset at a specified date in the future. The futures contract is like a forward contract in the sense that the futures contract is also a means of contracting in advance of delivery. With either of the contracts, we contract to buy or sell at a future date at a price agreed today. However, forward contracts have the significant limitation of being pure credit instruments. A futures contract is designed to deal directly with the credit(default) risk borne by the contracting parties. A futures contract is like a bundle of forward contracts.

Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 3 Ways to lower credit risk for a Futures Contract : daily settlement, margin requirement, and clearinghouse. Daily Settlement With a forward contract, the performance period is the same as the maturity of the contract: “ On May 1, Party A enters into a forward contract with Party B such that Party A agrees to purchase 125,000 DM on September 21 at a price of 61cents per DM($0.6100) ” “ On May 2, the market price of September 21 DM-that is DM for delivery on September 21-rises to $ ” Party A ’ s position in the forward contract now has a positive value: Party A has the right to buy DM more cheaply than the prevailing market price. However, with this forward contract, Party A will not receive the value until contract maturity, in 82 days.

Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 4 With A Futures Contract While the maturity of the contract is 83 days, the performance period is not 83 days but is instead one business day. With the reduced performance period, default risk declines accordingly. A futures contract is a bundle of forward contracts. Each day the forward contract originated on a previous day is settled and replaced with a new contract with a delivery price equal to the settlement price for the previous day ’ s contract. Regarding to the example in page 3, the futures contract can be viewed as follows: “ On May 1, a forward contract was purchased with a maturity of 83 days and a delivery price of $0.61/DM. “ “ On May 2, the May 1 forward contract was settled at a price of $0.6150/DM and was replaced with a new forward contract that has a maturity of 82 days and delivery price of $0.6150/DM

Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 5 Implementing Daily Settlement On May 1, Party A agrees to buy from Party B 125,000DM for delivery on September 21 at a price of $0.61/DM Suppose that on May 2, the price of September 21 DM rises to $0.6150/DM. Party A ’ s contract now has a net present value of $ ,000($0.615 – ) = $625 The contract is settled by Party B making a payment to Party A in the amount of $625.

Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 6 Margin Requirement Daily settlement reduces the performance period to one day, but for this one- day period the probability that the counterparty will default still exists. The surest way to deal with the interday credit risk is to require the contracting parties to post a surety bond, which is referred to as the margin. At the time the contract is bought or sold, the trader posts the initial margin. The initial margin varies wit the type of futures contract. The initial margin is generally enough to cover the largest changes in the value of the contract that have occurred historically. For most of contracts, the initial margin is less than 5%. On each trading day, gains are credited or losses debited to customer ’ s margin account-in cash-as the futures position increases or decreases in value. In the previous example, on May 2 $625 would be transferred from Party B ’ s margin account to Party A ’ s margin account:

Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 7 Continued ……. If, as a result of the value of the customer ’ s position declining, the balance in the margin account declines below a specified level- referred to as the maintenance margin- the customer is required to replenish the margin, returning it to its initial level. If the customer ’ s margin account falls below the maintenance margin level and is not replenished, the position is closed.

Kim, Gyutai, Dept. of Industrial Engineering, Chosun University 8 Tracing Margin Balance Suppose that Parties A and B agreed that the initial margin for a contract on 125,000 DM will be $2,050 and that the maintenance margin will be $2,000 On May 1, the futures contract between Party A and B is originated: both Parties will be required to post the initial margin of $2,025. On May 2, the price of September 21 DM rises from $0.610 to $ Consequently, at the close of business on May 2, $625 will be transferred from the margin account of Party B to Party A. Party A now has a margin account balance of $2,650, but Party B has a margin account balance of $1,400. Since Party B ’ s margin account is now below the maintenance margin, Party B will be requested to replenish the margin account, returning it to the initial margin. If Party B replenish the margin account, the contract continues. If, however, Party B does not add the required $625 to the margin account, Party B ’ s position is closed. In this case, Party B will no longer have the futures position and will be reimbursed the balance of $1,400 in the margin account. To continue to buy DM for a September 21 delivery, Party A must find another party to accept the sell position: In truth, Party A will not actually have to search for a counterparty. The clearinghouse performs this task.