Mechanics of Futures Markets

1
Mechanics of Futures Markets

• Week 2

2
Futures Contracts

• Available on a wide range of underlyings
• Exchange traded
• Specifications need to be defined
• What can be delivered
• Where it can be delivered
• When it can be delivered
• Futures price

3
Default Risk

• Two investors agree to trade an asset in the
  future
• One investor may
• regret and leave
• not have the financial resources
• Margins and Daily Settlement

4
Margins

• A margin is cash deposited by an investor with
  his broker
• The balance in the margin account is adjusted to
  reflect daily settlement (Marking to Market)
• Margins minimize the possibility of a loss
  through a default on a contract

5
Example of a Futures Trade

• An investor takes a long position in 2 December
  gold futures contracts on June 5
• contract size is 100 ounces
• futures price is US400
• margin requirement is US2,000/contract (US4,000
  in total)
• maintenance margin is US1,500/contract (US3,000
  in total)

6
A Possible OutcomeTable 2.1, Page 27

Daily
Cumulative
Margin
Futures
Gain
Gain
Account
Margin
Price
(Loss)
(Loss)
Balance
Call
Day
(US)
(US)
(US)
(US)
(US)
400.00
4,000
5-Jun
397.00
(600)

(600)

3,400
0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
13-Jun
393.30
(420)

(1,340)

2,660
1,340

4,000


.
.
.
.
.
.
.
.
.
.
.
3,000
lt
.
.
.
.
.
.
19-Jun
387.00
(1,140)

(2,600)

2,740
1,260

4,000


.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
26-Jun
392.30
260

(1,540)

5,060
0
7
Example Possible Outcomes

• A company enters into a short futures contract to
  sell 5,000 bushels of wheat for 250 cents per
  bushel. The initial margin is 3,000 and the
  maintenance margin is 2,000.
• What price change would lead to a margin call?
• Under what circumstances could 1,500 be
  withdrawn from the account?

8
Example Possible Outcomes

• What price change would lead to a margin call?
• If 1,000 is lost on the contract, i.e. the price
  of wheat futures rises by 20 cents (from 250 to
  270) per bushel.
• Under what circumstances could 1,500 be
  withdrawn from the account?
• If the futures price falls by 30 cents (from 250
  to 220) per bushel.

9
Other Key Points About Futures

• Closing out a futures position involves
  entering into an offsetting trade
• Most contracts are closed out before maturity

10
Delivery

• If a contract is not closed out before maturity,
  it 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) are settled in cash

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Winnipeg Commodity Exchange Feed Wheat Futures
12
WCE Feed Wheat Futures Delivery Regions
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Some Terminology

• Open interest the total number of contracts
  outstanding
• equal to number of long positions or number of
  short positions
• number of contracts that are not closed or
  delivered on a particular day.
• Volume of trading the number of trades in 1 day

19
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?

20

• On Jan 1, A buys an option, which leaves an open
  interest and also creates trading volume of 1.
• On Jan 2, C and D create trading volume of 5 and
  there are also 5 more options left open.
• On Jan 3, A takes an offsetting position and
  therefore open interest is reduced by 1, and
  trading volume is 1.
• On Jan 4, E simply replaces C and therefore open
  interest does not change, trading volume
  increases by 5.

21
Convergence of Futures to Spot

Futures Price
Spot Price
Futures Price
Spot Price
Time
Time
(a)
(b)
22
Basis, Contango and Backwardation

• Basis is F-S
• Contango if FgtS
• Observed almost uniformly for precious metals and
  index futures
• Backwardation
• Many foreign currency futures and oil have strong
  backwardation, i.e. FltS.

23
Normal vs Inverted Markets
24
Forward Contracts

• A forward contract is an agreement to buy or sell
  an asset at a certain time in the future for a
  certain price
• There is NO daily settlement. At the end of the
  life of the contract one party buys the asset for
  the agreed price from the other party

25
Forward Contracts

• 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)

26
Forward Contracts (II)

• The contract is an over-the-counter (OTC)
  agreement between 2 companies
• No up-front payment (no margin, no premium)
• The initial value of the contract is zero
• The contract is settled at maturity

27
Payoff and Profit/Loss Diagrams

• Payoff Diagram a graph relating the value of a
  derivative position to the price of its
  underlying asset on the same future date.
• Profit/Loss Diagram a graph relating the value
  of a derivative position to the price of its
  underlying asset on the same future date.
• The specified date is termed
• Payoff date (most generally)
• Maturity date (bonds)
• Delivery date (futures/forwards)
• Expiration date (options)

28
Long Asset Profit/Loss Diagram
25
125
75
-25
Loss
29
Short Asset Profit/Loss Diagram
25
125
75
-25
Loss
30
Long Forward Profit/Loss Diagram
25
ST
125
75
Loss
-25
31
Short Forward Profit/Loss Diagram
25
125
75
-25
Loss
32
Example

• Investor A enters into a long FORWARD contract to
  buy 1,000,000 _at_ 1.8381 US/ in 90 days
• Investor B enters into a long FUTURES contract to
  buy 1,000,000 _at_ 1.8381 US/ in 90 days
• Spot exchange rate is 1.8600 US/ in 90 days
• Investor A makes a profit of 21,900 on day 90
• Investor B makes a profit of 21,900 over the
  90-day period

33
Forward vs. Futures Contracts Comparative Cash
Flows