D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 1 Chapter 8: The Structure of Forward and Futures Markets It is like watching your favorite soap opera. You know all the characters. You know the plot. But you never really know how the day is going to end. Turk Ozdek Futures, July 2001, p. 86

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 2 Important Concepts in Chapter 8 n Definitions and examples of forward and futures contracts n Institutional characteristics of forward and futures markets n Futures contracts available for trading n Placing an order, margins, daily settlement n The role of the clearinghouse n Accessing futures price quotations n Magnitude and effects of transaction costs

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 3 The Development of Forward and Futures Markets n Chicago Futures Markets n The Development of Financial Futures n The Development of Options on Futures Markets n The Parallel Development of Over-the-Counter Markets u interbank market u growth of forward markets

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 4 The Over-the-Counter Forward Market u customized u private u essentially unregulated u credit risk u market size: $18 trillion face value, $400 billion market value at year-end 2001

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 5 Organized Futures Trading n Contract Development n Contract Terms and Conditions u contract size u quotation unit u minimum price fluctuation u contract grade u trading hours n Delivery Terms u delivery date and time u delivery or cash settlement

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 6 Organized Futures Trading (continued) n Daily Price Limits and Trading Halts u limit moves u circuit breakers n Other Exchange Responsibilities u minimum financial responsibility requirements u position limits u rules governing the trading floor

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 7 Futures Exchanges n See Table 8.1, p. 279 for list of exchanges. Table 8.1, p. 279Table 8.1, p. 279 n Global and after-hours trading n Estimated world-wide volume in 2001 was 1.8 billion contracts.

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 8 Futures Traders n General Classes of Futures Traders u futures commission merchants u locals u dual trading n Classification by Trading Strategy u hedger/speculator u spreader u arbitrageur

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 9 Futures Traders (continued) n Classification by Trading Style u scalpers u day traders u position traders n Off-Floor Futures Traders u individuals u institutions u Others: Introducing Broker (IB), Commodity Trading Advisor (CTA), Commodity Pool Operator (CPO), Associated Person (AP)

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 10 Futures Traders (continued) n The Cost and Profitability of Exchange Membership u seats u See Figure 8.1, p. 283 for history of CBOT, CME, and NYMEX seat prices. Figure 8.1, p. 283Figure 8.1, p. 283 u leasing a seat at around %/mo. of seat price u profitability of membership n Forward Market Traders u over-the-counter u primarily institutions

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 11 The Mechanics of Futures Trading n Placing an Order u pit u open outcry u electronic systems n The Role of the Clearinghouse u See Figure 8.2, p Figure 8.2, p. 285Figure 8.2, p. 285 u margin deposits

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 12 The Mechanics of Futures Trading (continued) n Daily Settlement u initial margin u maintenance margin u concept of “margin” vs. performance bond u settlement price u variation margin u See Table 8.2, p. 287 for example. Table 8.2, p. 287Table 8.2, p. 287 u open interest

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 13 The Mechanics of Futures Trading (continued) n Delivery and Cash Settlement u three-day delivery process u alternative deliverable grades u offsetting u exchange for physicals u forward market procedures

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 14 Futures Price Quotations n Newspapers and web sites

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 15 Types of Futures Contracts n Agricultural Commodities n Natural Resources n Miscellaneous Commodities n Foreign Currencies n Treasury Bills and Eurodollars n Treasury Notes and Bonds n Equities n Managed Funds n Hedge Funds n Options on Futures

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 16 Transaction Costs in Forward and Futures Trading n Commissions n Bid-Ask Spread n Delivery Costs

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 17 The Regulation of Futures Markets n Regulation is nearly always at the federal level; e.g., u Commodity Futures Trading Commission (U.S.) u Financial Services Authority (U.K.) u Financial Services Agency (Japan) n Objective of most federal regulation F ensuring public information available F authorization and licensing of contracts and exchanges F contract approval F market surveillance

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 18 The Regulation of Futures Markets (continued) n Arbitration of disputes is sometimes done through the federal government and the courts but often through self- regulatory organizations such as the National Futures Association in the U. S. n Note: Forward markets are regulated only indirectly and, thus, are largely unregulated.

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 19 Summary

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 20 Appendix 8: Taxation of Futures Contracts n Treated as 60 % capital gains and 40 % ordinary income. n Capital gains subject to 28 % maximum. n Must be marked to market at year end. n New single stock futures are taxed the same as individual stocks. n Hedge transactions covered in Chapter 10.

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 21 (Return to text slide)

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 22 (Return to text slide)

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 23 (Return to text slide)

D. M. ChanceAn Introduction to Derivatives and Risk Management, 6th ed.Ch. 8: 24 (Return to text slide)