Chapter 2MECHANICS OF FUTURE MARKETS

Futures and Forward ContractsFutures and forward contracts are agreements to buy or sell an asset at a future time for a certain price. Futures contracts are traded on an exchange and the contract terms are standardized by that exchange. Forward contracts are traded in the over-the-counter market.

Futures ContractsAvailable on a wide range of assetsSpecifications need to be definedSettled daily

Specifications of Futures Contract

Specifications of the futures contract is vital 5 issues has to be clarified before proceeding with the future contracts:◦ The Asset◦ Contract size◦ Delivery months and delivery arrangements◦ Price Quotes

Specifications: The AssetWhen the asset is a commodity, there may be quite a variation in the quality of what is available in the marketplace.When the asset is specified, it is therefore important that the exchange stipulate the grade or grades of the commodity that are acceptable.The financial assets in futures contracts are generally well defined and unambiguous.

Specifications: Contract Size

The contract size specifies the amount of the asset that has to be delivered under one contract.If the contract size is too large, many investors who wish to hedge relatively small exposures or who wish to take relatively small speculative positions will be unable to use the exchange. On the other hand, if the contract size is too small, trading may be expensive as there is a cost associated with each contract traded.

Specifications: Delivery Months and Delivery Arrangements

The place where delivery will be made must be specified by the exchange. This is particularly important for commodities that involve significant transportation costs.

In the case of the perishable goods, delivery is made to exchange-licensed warehouses It is always short party that delivers the goods that is specified in the contract

Specifications: Delivery Months and Delivery Arrangements

A futures contract is referred to by its delivery month. The exchange must specify the precise period during the month when delivery can be made. For many futures contracts, the delivery period is the whole month.

For some goods delivery can only take place in specific months that will be specified by the exchange. Generally these goods are agriculture products.

Specifications: Price Quotes

The exchange defines how prices will be quoted.

For example, in the U.S. ; crude oil futures prices are quoted in dollars and cents Treasury bond and Treasury note futures prices are quoted in dollars

and thirty-seconds of a dollar.

MarginsA margin is cash or marketable securities deposited by an investor with his or her brokerThe balance in the margin account is adjusted to reflect daily settlementMargins minimize the possibility of a loss through a default on a contract

Some Terminology at MarginsMargins are used due to risk potential that exist in trading commodities in the futures marketsMargin Account is the amount that broker will require the investor to deposit funds. The amount that must be deposited at the time the contract is entered into is known as the initial margin. Maintenance margin is the lower limit that an investor can have in the margin account. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level the next day.

Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5◦ contract size is 100 oz.

◦ futures price is US$900

◦ margin requirement is US$2,000/contract (US$4,000 in total)

◦ maintenance margin is US$1,500/contract (US$3,000 in total)

Days Trade Price($) Settlement Price ($)

Daily Gain Cumulative Gain

Margin Account Balance

Margin Call

1 900 - - - 4000 -

2 897.00 (600) (600) 3,400 -

3 896.70 (60) (660) 3,340

4 895.40 (260) (920) 3,080

5 893.30 (420) (1340) 2,660 1,340

6 895.20 380 (960) 4380* -

Closing Futures PositionIt might be quite shocking to learn that most of the future contracts are not actually exercised.If exercising the contract is costly for the investor, they choose to close out position by making counter trade.Generally this procedure is outlined in the contract by stop-loss provision but we will not cover that procedure in this course.

Closing Futures Position ExampleClosing a position involves entering into an opposite trade (counter-trade) to the original one that opened the position. For example: An investor who buys five July corn futures contracts on May 6 can close out the

position on June 20 by selling (i.e., shorting) five July corn futures contracts. An investor who sells (i.e., shorts) five July contracts on May 6 can close out the position on June 20 by buying five July contracts.

DeliveryIf a futures contract is not closed out before maturity, it is 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 and Eurodollars) are settled in cash When there is cash settlement contracts are traded until a predetermined time. All are then declared to be closed out.

Some More TerminologyOpen interest: the total number of contracts outstanding. This equals to number of long positions or number of short positionsSettlement price: the price just before the final bell each day. This is used for the daily settlement processVolume of trading: the number of trades in 1 day

Possible Midterm QuestionsWhen 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?

Futures and Spot Price ConvergenceThere are always a spread between futures price and spot price of the particular contract.

As time closes to the delivery period it is most likely that spot and futures price converge together.

There are two possibilities on the spreado SPOT PRICE>FUTURES PRICEo SPOT PRICE IS <FUTURES PRICE

There is only one criteria about the convergence issue we just emphasized a while ago. That is at the day of delivery spot price is either equal (=) or there is still really small price differences between two prices.

Futures Price and Spot Price Convergence

Forward ContractsA forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain priceThere is no daily settlement (but collateral may have to be posted). At the end of the life of the contract one party buys the asset for the agreed price from the other party.

Profit from a Long Forward or Futures Position

Profit

Price of Underlying at Maturity

Profit from a Short Forward or Futures Position

Profit

Price of Underlying at Maturity

Forward Contracts vs Futures Contracts

Exchange Rate Quotations for Forwards and FuturesFutures exchange rates are quoted as the number of USD per unit of the foreign currencyForward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.