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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
$
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%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.
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Convergence of Futures to Spot(Figure
2.1, page 27)
'
Time Time
(a) (b)
Futures
Price
Futures
PriceSpot Price
Spot Price
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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.
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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
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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
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!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
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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
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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
$i'%)etiona)-
ime o+ a-
Open
/ill o) *ill
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For*ar% Contracts vs Futures Contracts
1$
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'
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+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&
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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
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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.
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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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