Ch02HullFundamentals7thEd.ppt

8/11/2019 Ch02HullFundamentals7thEd.ppt

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2.1

Mechanics of FuturesMarkets

Chapter 2


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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 Settled daily


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2.3

Margins

A margin is cash or marketable securitiesdeposited by an investor with his or her

broker The balance in the margin account is

adjusted to reflect daily settlement

Margins minimize the possibility of a lossthrough a default on a contract


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2.4

Example of a Futures Trade

An investor takes a long position in 2December gold futures contracts on June 5,before close of trading, say morning of:

contract size is 100 oz. futures price is US$400

Initial marginrequirement is US$2,000/contractor US$4,000 in total

Maintenance marginis US$1,500/contract orUS$3,000 in total. Usually: MM=.75xIM


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2.5

Possible Outcome:Futures price drops steadily, on 13 Junethere is a margin call for $1,340, which must be paid by end of next trading day.

Margin call occurs when MABIM, investor can withdraw MAB-IM from margin account.

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. . . . . .

. . . . .. . . . . .

19-Jun 387.00 (1,140) (2,600) 2,740 1,260. . . . . .. . . . . .. . . . . .

26-Jun 392.30 260 (1,540) 5,060 0

+

= 4,000

3,000

+

= 4,000


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2.6

Other Key Points About Futures

They are settled daily

Closing out a futures positioninvolves entering into an offsettingor closing trade

Most contracts are closed outbefore maturity


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2.7

Collateralization in OTC Markets

It is becoming increasingly common forcontracts to be collateralized in OTC

markets They are then similar to futures contracts

in that they are settled regularly (e.g. everyday or every week)


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2.8

Delivery

If a futures contract is not closed out beforematurity, it is usually settled by delivering theassets underlying the contract. When there are

alternatives about what is delivered, where it isdelivered, and when it is delivered, the party withthe short position chooses.

A few contracts (for example, those on stockindices and Eurodollars) are settled in cash


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2.9

Some Terminology

Open interest: the total number of contractsoutstanding

equal to number of long positions or

number of short positions

Settlement price: the price just before thefinal bell each day

used for the daily settlement process Volume of trading: the number of trades in 1

day


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2.10

Question: When a new trade is completed what

are the possible effects on the open interest?

Note that a transaction occurs when a long position is mated witha short position, i.e. one entity buys and the other entity sells.

Open interest can rise by 1: This occurs when both long and short

positions are opening transactions.

Open interest can remain constant: This occurs when oneposition is an opening transaction and the other position is aclosing transaction.

Open interest can drop by 1: This occurs when both long andshort positions are closing transactions.


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Question: Can the volume of trading in a day be

greater than the open interest?

Yes, if there are a large number of scalpers or daytraders, who open and then close positions in a singleday, i.e. opening and closing trades occur on the sameday.


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2.12

Convergence of Futures to Spot

Time Time

(a) (b)

FuturesPrice

FuturesPrice

Spot Price

Spot Price


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2.13

Regulation of Futures

Regulation is designed toprotect the public interest

Regulators try to preventquestionable trading practicesby either individuals on the floorof the exchange or outsidegroups


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2.14

Accounting & Tax

It is logical to recognize hedging profits(losses) at the same time as the losses(profits) on the item being hedged

It is logical to recognize profits and lossesfrom speculation on a mark to market basis

Roughly speaking, this is what theaccounting and tax treatment of futures inthe U.S. and many other countries attemptsto achieve


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Example: Hedger (taxed when profits realized) versus Speculator

(taxed on a marked-to-market basis). Same tax rate for both =

40%. Financial year is calendar year. Contract size is 1,000

barrels.

Sept07 opening transaction: long @ $68.30/barrel

Dec07 no transaction: $69.10/barrel

Mar08 closing transaction: short @ $70.50/barrel

Speculators taxes: for 07 are 40% (69.10-68.30)1000= $320;for 08 are 40%(70.50-69.10)1000 = $560

Hedgers taxes: for 07 are 0; for 08 are 40%(70.50-68.30)1000= $880


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2.16

Forward Contracts

A forward contract is an OTCagreement to buy or sell an asset at acertain time in the future for a certain

price There is no daily settlement (unless a

collateralization agreement requires it).At the end of the life of the contract oneparty buys the asset for the agreedprice from the other party


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2.17

Profit from a Long Forward or

Futures Position

Profit

Price of Underlying

at Maturity


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Forward Contracts vs Futures

Contracts (Table 2.3, page 39)

Forward Futures

Private contract between two parties Traded on an exchange

Not standardized Standardized

Usually one specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final settlement usual Usually closed out prior to maturity

Some credit risk Virtually no credit risk

2.19


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2.20

Foreign Exchange Quotes

Futures exchange rates are quoted as thenumber of USD per unit of the foreign currency

Forward exchange rates are quoted in the sameway as spot exchange rates. This means thatGBP, EUR, AUD, and NZD are USD per unit offoreign currency. Other currencies (e.g., CADand JPY) are quoted as units of the foreigncurrency per USD.

Ch02HullFundamentals7thEd.ppt

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