2_Mechanics of Futures Markets

8/4/2019 2_Mechanics of Futures Markets

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Mechanics of Futures Market

Mechanics of Futures Market 2

Mechanics of Futures Markets

1. Specifications of a Futures Contract

2. Convergence of Futures Price to Spot Price

3. Safeguards in the Futures Market

4. Closing a Futures Position

5. Open Interest

6. Pay-off from a Futures Contract

7. Transaction on a Futures Exchange


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Specifications of a Futures Contract

A futures contract is a standardised contract. Defined (specified) in terms of:

Underlying asset

Contract size

Delivery arrangements

Delivery month

Price quotes

Daily Price Movement Limits


Underlying Asset

In case of Commodity Futures, the Exchange stipulates thegrade(s) of the commodity.

E.g.: Lumber Futures - standard length of 8by 20.Juice Futures in terms of Brix value

A range of grades may be delivered with adjustment inprice based on the grade delivered.

In case of Financial assets - Futures contracts are welldefined & unambiguous.

E.g.: Enough to say Futures on BSE Sensex or Futureson Infosys.


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Contract Size

Contract size specifies the amount of the asset that has tobe delivered under a Futures contract.

If the Contract size is set too high, it will keep away many

investors, while if set too small, it will make trading

expensive as transaction cost are linked to no. of contracts

traded.

E.g.: Futures on S&P CNX Nifty have a contract size of

200 & multiples thereof.


Delivery Arrangements

Place where the delivery will be made, is specified by theexchange, especially in case of Commodity Futures.

Delivery may be made at alternative site with dueadjustments in the delivery prices.


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Delivery Month

Futures contract is referred to by its Delivery month.

The exchange specifies the precise period during themonth when delivery is to be made.

Vary from contract to contract

At any given time, contracts trade for the closest deliverymonth & a number of subsequent delivery months.

NSE futures 1, 2, 3 month futures.

Exchange also specifies the last day on which trading cantake place for a given contract


Price Quotes

The exchange defines how price will be quoted

In a way that is convenient and easy to understand.

E.g.: Crude Oil NYMEX - $/per barrel

Minimum price movement that can occur in trading isalso set by the exchange tick size

E.g.: Crude Oil ($0.01 or 1 cent per barrel)


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Daily Price Movement Limits

Maximum movement in prices during a day (in eitherdirection) so as to prevent large price movements due tospeculative trading.

Exchange may change the limits to counter excessivespeculation.


Convergence of Futures to Spot Price

As the delivery month approaches, the Futures priceconverges to the Spot price of the underlying asset.

At the delivery date, the Futures price equals ( or is veryclose to ) the Spot price.

If the prices differ substantially, arbitrageur shall takeappropriate position to drive away any benefits.

Eventually the two prices will converge.


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Convergence of Futures to Spot Price

Futures Price

Spot Price

Spot Price

Futures Price

Time Time

Price

Price

Safeguards in the Futures Market

Clearing House

Margin Requirements

Daily Settlement (Mark-to-Market)


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Clearing House

To ensure smooth functioning, each Futures Market has aClearing House (CH) associated.

CH guarantees ALL trades on the Exchange.

This is achieved by CH adopting the position of a Buyerfor every Seller & that of a Seller for every Buyer.

Each trader has obligations only to the CH & hopes thatCH will execute its side of the trade as well.

CH substitutes its own credibility for the promise of eachtrader.

CH, however, does not take ACTIVE position but

interposes itself between all parties to every transactions.


Buyer Seller

ClearingHouse

Buyer Seller

Goods

Funds

GoodsGoods

Funds

Obligations without Clearing House

Obligations with Clearing House

Funds

Clearing House (Contd.)


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Clearing House (Contd.)

Without CH, both parties would deal with each other-directobligation to each other.

With CH, each party has obligation to the CH which

ensures that both parties perform.

Because of the CH, the two parties need not trust or know

each other.

They need to be concerned about the reliability of the CH.

Hence, CH is a large, well-capitalised Institution.

US Futures trading history, CH have never faulted. Default

Risk of CH is very small.


Operation of Margins

When investors contract, there are various risks one party may backout or

may not have the financial resources to honour his commitments.

The exchange organises trades as as to avoid such defaults thru a system of

Margins.

Futures trading is guided by the need to eliminate the payments crises- Default

Risk or Credit Risk

Besides the role of the Clearing House, the system of Margins protects from a

payments problem.

Different types of margins are maintained:

Initial Margin (IM)

Maintenance Margin (MM)

Variation Margin (VM)


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Operation of Margins (Contd.)

Initial Margin (IM):Good faith deposit paid by the traderat the time of entering the contract to ensure

performance.

IM may vary from contract to contract & from trader to

trader.Typically set at 5% of the contract value.

Trader retains title to the deposit.

Usually equal to Maximum Daily Price fluctuation limit.

IM is returned upon proper completion of all the

obligations.

At the end of each day, the margin account is adjusted toreflect gain/loss. This is called Mark to market


Maintenance Margin (MM) :(% of the Initial Margin) isthe Minimum amount of margin below which marginaccount should NOT fall.

MM is used to calculate the third margin VariationMargin.

If the margin account falls below the MM, trader isrequired to replenish ( top-up) the margin, bringingthe margin amount back to the Initial Margin. Thisadditional amount paid by the trader is called VM.

Any amount in excess of the IM can be withdrawn bythe investor.

Initial margin covers 1 days price fluctuations, anyadditional losses is covered by the VM.

Failure to pay VM leads to the futures position beingclosed out.

Operation of Margins (Contd.)


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Operation of Margins - An Example

X buys 2 Gold Futures @ Rs 400 per ounce.

Contract size = 100 ounces.

Initial Margin (IM) = Rs 2000 per contract

= 2000 x 2 = Rs 4000

Maintenance = Rs 1500 per contract

Margin (MM) = 1500 x 2 = Rs 3000


Operation of Margins

Futures Daily Cumulative Margin Margin CallDay Price Gain/(Loss) Gain/(loss) Account

Balance

0 400.00 4000.001 397.00 (600.00) (600.00) 3400.002 396.10 (180.00) (780.00) 3220.003 398.20 420.00 (360.00) 3640.004 397.10 (220.00) (580.00) 3420.005 396.70 (80.00) (660.00) 3340.006 395.40 (260.00) (920.00) 3080.007 393.30 (420.00) (1340.00) 2660.00 1340.008 393.60 60.00 (1280.00) 4060.009 391.80 (360.00) (1640.00) 3700.00

10 392.70 180.00 (1460.00) 3880.0011 387.00 (1140.00) (2600.00) 2740.00 1260.0012 387.00 0.00 (2600.00) 4000.0013 388.10 220.00 (2380.00) 4220.0014 388.70 120.00 (2260.00) 4340.0015 391.00 460.00 (1800.00) 4800.0016 392.30 260.00 (1540.00) 5060.00

3080-420+x=4000

3880-1140+x=4000


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Closing a Futures Position

1. Delivery: Delivery of the goods under the contract will

automatically close the position. Physical Settlement: Physical delivery of the asset at a

certain location at a specified time as per theexchange rules.

Cash Settlement: Traders make payment at expiry ofcontract to settle any gain or loss.


Closing a Futures Position

2. Offset: Most Futures contracts are settled by Offsets- byentering into a exactly reverse trade which shall cancel theoriginal trade.

The trader, in order to close the contract, should enter intoan exactly reverse contract in terms of the underlyingassets , No. of contracts & expiry date

If it does not, then the trader shall undertakes a newobligation instead of cancelling the old obligation.


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Offset Trades An ExampleMay 1 Party As Initial

Position:Bought 1 SeptemberWheat Futures Contract

@ Rs 2200/-.

Party B :

Sold 1 September WheatFutures Contract @ Rs 2200/-.

May 15 Party As ReversingTrade:

Sold 1 SeptemberWheat Futures Contract@ Rs 2300/-.

Party C:

Bought 1 September WheatFutures Contract @ Rs 2300/-.

After this Party As net position is zero and is out of theFutures market.Party B & C have obligations towards theClearing House.


Closing a Futures Position (Contd.)

3. Exchange for Physicals: Two traders simultaneouslyexchange for cash, commodity & Futures contract basedon that commodity.

EFP vs. Offset:

Under both, the traders have completed their obligations &are now out of the market.

Differs from Offsets:

Traders actually exchange the physical goods.

Futures is not closed by a transaction through theExchange.

Traders privately negotiate the terms, hence also calledex-pit


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Exchange for Physicals An Example

Before the EFP

Party A Long 1 Wheat Futures Wants to acquire ActualWheat

Party BShort 1 Wheat FuturesOwns Wheat & wishes to sell

EFP Transaction

Party A Agrees with B to purchase

wheat & cancels Futures Receives wheat & pays B Reports EFP to the

Exchange Exchange adjusts to show

A is out of the Market.

Party B Agrees with A to sell wheat

& cancels Futures Delivers wheat & receives

payment from A

Reports EFP to theExchange

Exchange adjusts to showB is out of the Market.


Open Interest

Open Interest refers to the number of futures contractsoutstanding.

It is the total no. of open positions waiting to be liquidatedbefore the contracts maturity.

Todays newspaper carry yesterdays trading data and daybefore yesterdays Open Interest data.

Three rules regarding open interest

Any trade (long or short) initiated afresh raises OI

Any trade (long or short) that squares up existingposition lowers OI

Every trade needs a buyer & a seller


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Open Interest : An Example

Trader 1 Trader 2 Trader 3 Trader 4 Trader 5 OpenInterest

Long Short 20

Long Short 20

Long Short 40

Long Short 20

Short Long 0


Pay-off from a Futures Contract

Consider a trader who has entered into a 3-monthLong position to buy 100 kg. of Silver @ Rs 2000/-per kg.

At the end of 3-months, if the price is Rs 2500/- perkg, then the trader has made a profit of Rs. 500/-per kg.

At the end of 3-months, if the price is Rs 1900/- perkg, then the trader has made a loss of Rs. 100/-per kg.

In general, the pay-off from a long position in theForward/Futures Contract is:

Spot Price on Maturity (ST) lessDelivery Price(K)


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Pay-off from a Futures Contract

Pay-off : Long Position

Pay-off from a short position in the Forward/Futures

Contract is:Delivery Price (K) lessSpot Price on Maturity (ST)

These pay-offs represents total profit/loss from thecontract, as it costs nothing to enter into aForward/Futures contract

ST

K

Profit

ST

K

Profit

Pay-off : Short Position


Transaction on a Futures Exchange

Buyer BuyersBroker

SellersBroker

SellerFuturesExchange

FuturesClearinghouse

BuyersBrokers

Clearing Firm

SellersBrokers

Clearing Firm

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1: Buyer places a BUY order with his Broker who in turn places it with the Futures Exchange.2: Seller places a SELL order with his Broker who in turn placesit with the Futures Exchange.3: Futures Exchange matches the trade through a computerised system.4: Information about the trade is reported to the Clearing House5: Buyer and Seller deposit margin with their respective brokers6: Buyers and Sellers Brokers deposit the margins with their respective clearing firms7: Clearing firms deposit the margins with the ClearingHouse

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2_Mechanics of Futures Markets

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