1. Copyright © 2001 by Harcourt, Inc. All rights reserved.1 Chapter 8: The Structure of Forward and Futures Markets An exchange floor is a crucible of ideas, markets, events. Eventually ideas sprout from that for improving a market or for whole new markets. Without ideas and the interchange of ideas, you’re never going to get an innovative process to work. Leo Melamed Futures, October 1996

2. Copyright © 2001 by Harcourt, Inc. All rights reserved.2 Important Concepts in Chapter 8 n Definitions and examples of forward and futures contracts n Institutional characteristics of forward and futures markets n Information on the futures contracts available for trading n Placing an order, margins, daily settlement n The role of the clearinghouse n Futures price quotations n Magnitude and effects of transaction costs

3. Copyright © 2001 by Harcourt, Inc. All rights reserved.3 The Development of Forward and Futures Markets n Chicago Futures Markets n The Development of Financial Futures n The Parallel Development of Over-the-Counter Markets u interbank market u growth of forward markets

4. Copyright © 2001 by Harcourt, Inc. All rights reserved.4 The Over-the-Counter Forward Market u customized u private u essentially unregulated u credit risk u market size: $17 trillion face value, $430 billion market value at year-end 1999

5. Copyright © 2001 by Harcourt, Inc. All rights reserved.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

6. Copyright © 2001 by Harcourt, Inc. All rights reserved.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

7. Copyright © 2001 by Harcourt, Inc. All rights reserved.7 Futures Exchanges n See Table 8.1, p. 320 for list of exchanges. n Global and after-hours trading n See Figure 8.1, p. 321 for volume of futures trading. n See Table 8.2, p. 322 for volume by exchange.

8. Copyright © 2001 by Harcourt, Inc. All rights reserved.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

9. Copyright © 2001 by Harcourt, Inc. All rights reserved.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 Introducing Broker (IB) u Commodity Trading Advisor (CTA) u Commodity Pool Operator (CPO) u Associated Person (AP)

10. Copyright © 2001 by Harcourt, Inc. All rights reserved.10 Futures Traders (continued) n The Cost and Profitability of Exchange Membership u seats u See Figure 8.2, p. 326 for history of CBOT and CME seat prices. u leasing a seat at around 1.0 - 1.5%/mo. of seat price u profitability of membership n Forward Market Traders u over-the-counter u primarily institutions

11. Copyright © 2001 by Harcourt, Inc. All rights reserved.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 8.3, p. 329. u margin deposits

12. Copyright © 2001 by Harcourt, Inc. All rights reserved.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 8.3, p. 331 for example. u open interest

13. Copyright © 2001 by Harcourt, Inc. All rights reserved.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

14. Copyright © 2001 by Harcourt, Inc. All rights reserved.14 Futures Price Quotations n See Figure 8.4, p. 336

15. Copyright © 2001 by Harcourt, Inc. All rights reserved.15 Types of Futures Contracts u See Table 8.4, p. 338. n Grains and Oilseeds n Livestock and Meat n Food and Fiber n Metals and Energy n Miscellaneous n Foreign Currency n Treasury Bills and Eurodollars n Treasury Notes and Bonds n Economic Indices n Stock Indices

16. Copyright © 2001 by Harcourt, Inc. All rights reserved.16 Types of Futures Contracts (continued) n Managed Funds n Hedge Funds n Indices of Futures Market Activity See Table 8.5, p. 343 for most active U. S. contracts

17. Copyright © 2001 by Harcourt, Inc. All rights reserved.17 Transaction Costs in Forward and Futures Trading n Commissions n Bid-Ask Spread n Delivery Costs

18. Copyright © 2001 by Harcourt, Inc. All rights reserved.18 The Regulation of Futures Markets n The Commodity Futures Trading Commission u Established 1974 u Responsibilities of CFTC F ensuring public information available F authorization and licensing of contracts and exchanges F contract approval F market surveillance u Does not regulate forward market

19. Copyright © 2001 by Harcourt, Inc. All rights reserved.19 The Regulation of Futures Markets (continued) n The National Futures Association u Self-regulatory organization u Responsibilities include F prevention of fraud and manipulation F protection of the public interest F encouragement of free markets F arbitration of disputes n Regulation of Futures Markets Worldwide n The Regulation of Futures Markets versus the Over-the- Counter Market

20. Copyright © 2001 by Harcourt, Inc. All rights reserved.20 Summary

21. Copyright © 2001 by Harcourt, Inc. All rights reserved.21 Appendix 8A: Selected Financial Futures Contract Specifications Appendix 8B: 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 Hedge transactions covered in Chapter 10.