Chapter 3.1 Mechanics of Futures Markets

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Mechanics of Futures

Markets

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Futures Contract

is a standardized contract,

traded on a futures exchange,

to buy or sell a certain underlying instrument

at a certain date in the future,

at a pre-set price.

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Futures Contracts Available on a wide range of assets

Exchange traded

pecifications need to be defined!

"hat can be delivered,

"here it can be delivered, #

"hen it can be deliveredettled daily

$



%he future date is called the delivery date or

final settlement date.

%he pre-set price is called the futures price.

%he price of the underlying asset on the

delivery date is called the settlement price.

%he settlement price, normally, converges

towards the futures price on the delivery date.

&



Convergence of Futures to Spot(Figure

2.1, page 27)

'

Time Time

(a) (b)

Futures

Price

Futures

PriceSpot Price

Spot Price



A futures contract gives the holder the right and the

obligation to buy or sell

(oth parties of a )futures contract) must exercise the

contract *buy or sell+ on the settlement date.%o exit the commitment,

a. the holder of a futures position has to sell his long

position or

b. buy bac his short position, effectively closing out thefutures position and its contract obligations.



Margins A margin is cash or maretable securities

deposited by an investor with his or her

broer

%he balance in the margin account is

adusted to reflect daily settlement

/argins minimize the possibility of a lossthrough a default on a contract

0



Some Terminologpen interest! the total number of contracts

outstanding

eual to number of long positions or number of shortpositions

ettlement price! the price ust before the final

bell each day

used for the daily settlement process

3olume of trading! the number of trades in one

day

4



!e "oints #$out Futures%hey are settled daily

5losing out a futures position involves

entering into an offsetting trade/ost contracts are closed out beforematurity

6



Cru%e &il Tra%ing on Ma 2',21

17

Open High Low Settle Change Volume Open Int

Jul 2010 70.06 71.70

69.21 71.51 2.76 6,15 !!,902

"ug2010

71.25 72.77

70.#2 72.5# 2.## ,7#6 115,05

$e%2010

7#.00 75.#

7.17 75.2 2.19 5,055 196,0

$e%2011

77.01 7!.59

76.51 7!.5 2.00 #,175 100,67#

$e%2012

7!.50 !0.21

7!.50 !0.1! 1.!6 1,25! 70,126



eliver8f a futures contract is not closed out before

maturity, it is usually settled by delivering the

assets underlying the contract. "hen there arealternatives 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 stocindices and Eurodollars+ are settled in cash

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Tpes of &r%ersLimit

Stop&lo''

Stop&limit

(a)*et&i+ tou%he

$i'%)etiona)-

ime o+ a-

Open

/ill o) *ill

12



For*ar% Contracts vs Futures Contracts

1$

Contract usually closed out

Private contract between 2 parties Exchange traded

on!standard contract Standard contract

"sually # speci$ied delivery date %ange o$ delivery dates

Settled at end o$ contract Settled daily

&elivery or $inal cashsettlement usually occurs prior to maturity

FORWARDS FUTURES

Some credit ris' irtually no credit ris'



+ong Short -e%ges A long futures hedge is appropriate when

you now you will purchase an asset in

the future and want to loc in the price

A short futures hedge is appropriate

when you now you will sell an asset in

the future and want to loc in the price

1&



asis /isk (asis is usually defined as the spot

price minus the futures price

(asis ris arises because of theuncertainty about the basis when

the hedge is closed out

1'



Choice of Contract 5hoose a delivery month that is as close as

possible to, but later than, the end of the life

of the hedge

"hen there is no futures contract on the

asset being hedged, choose the contract

whose futures price is most highly correlatedwith the asset price. %his is nown as cross

hedging.

1



Stack an% /oll (page '0'')

"e can roll futures contracts forward to

hedge future exposures

8nitially we enter into futures contracts to

hedge exposures up to a time horizon

9ust before maturity we close them out an

replace them with new contract reflect thenew exposure

etc

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Chapter 3.1 Mechanics of Futures Markets

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