Mechanics of

Futures Markets
Chapter 2
1
FORWARDS AND FUTURES

The CONTRACTS
The MARKETS
PRICING FORWARDS and
FUTURES

Speculation
Arbitrage
Hedging
CASH OR SPOT MARKET:
THE MARKET FOR IMMEDIATE
DELIVERY AND PAYMENT
GAS STATION, GROCERY STORE,
DEPARTMENT STORE
SELLER BUYER
Delivers Commodity Accept
Commodity
Receives payment Pays

The SELLER is said to be SHORT
The BUYER is said to be LONG

2
A FORWARD MARKET
THE MARKET FOR DEFERRED
DELIVERY AND DEFERRED
PAYMENT.
SHORT =commit to sell
LONG = commit to buy

THE TWO PARTIES MAKE
A CONTRACT THAT
DETERMINES THE
DELIVERY AND PAYMENT PLACE AND
TIME IN THE FUTURE.
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A FORWARD

IS A CONTRACT IN WHICH ONE
PARTY (the long) COMMITS TO BUY
AND THE OTHER PARTY (the short)
COMMITS TO SELL A SPECIFIED
AMOUNT OF AN AGREED UPON
COMMODITY FOR A
PREDETERMINED PRICE ON A
SPECIFIC DATE IN THE FUTURE.

Forwards are traded OTC
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5

FORWARDS ARE TRADED
ON THE OTC:
Credit risk
Operational risk
Liquidity risk

6
1.Credit Risk:

Does the other party have the means
to pay?

2. Operational Risk:

Will the other party deliver the
commodity?
Will the other party take delivery?
Will the other party pay?

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3.Liquidity Risk.
Liquidity = the speed with which
investors can buy or sell securities
(commodities) in the market. In case
either party wishes to get out of its
side of the contract, what are the
obstacles?
How to find another counterparty?
It may not be easy to do that. Even
if you find someone who is willing
to take your side of the contract,
the other party may not agree.
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The exchanges understood that
there will exist no efficient
futures markets unless the above
problems are resolved. So they
created a non profit corporation:
CLEARINGHOUSE
In order to manage the futures
trading
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CLEARING
MEMBERS
NONCLEARING
MEMEBRS
THE EXCHANGE CORPORATION
THE CLEARINGHOUSE
Futures Commission
Merchants
CLIENTES
THE CLEARINGHOUSE PLACE IN
THE MARKET
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The clearinghouse
is a non profit corporation.
It gives every trading party
an absolute guarantee of the
completion of its side
of the contract
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A FUTURES
is
A STANDARDIZED FORWARD

TRADED
ON AN

ORGANIZED EXCHANGE

Under the
CLEARINGHOUSE RULES
and
REGULATIONS

12
The Clearinghouse
guarantee:
To:
The LONG: will be able to take
delivery and pay the
agreed upon price.
The SHORT will be able to
deliver and receive
the agreed upon
price.
A. BUYER = LONG

100, June crude oil futures

B. SELLER = SHORT

100, June crude oil futures

FOR: $90/ bbl



13
A BUY {CLEARINGHOUSE} B SELL
A BUY CH SELL B

CLEARINGHOUSE GUARANTEE to BOTH:

To LONG (SHORT)
If you maintain your futures position open
until delivery time in June, and wish to take
delivery (deliver) of the 100,000 barrels of oil
for $9,000,000 as per your contract, you will
encounter NO PROBLEM.

1. THERE IS NO CREDIT or PERFORMANCE
PROBLEM.

2. LIQUIDITY PROBLEMS DISAPPEAR!

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15
A FUTURES
is
A STANDARDIZED FORWARD TRADED
ON AN ORGANIZED EXCHANGE.

STANDARDIZATION

THE COMMODITY
TYPE AND QUALITY
THE QUANTITY
PRICE QUOTES
DELIVERY DATES
DELIVERY PROCEDURES
CBOT Corn Futures
16

Trading Unit 5,000 bushels
Tick Size cent per bushel ($12.50 per contract)
Daily Price Limit 12 cents per bushel ($600 per contract)
above or below the previous days
settlement price (expandable to 18
cents per bushel). No limit in the spot
month.
Contract Months December, March, May, July,
September
Trading Hours 9:30 a.m. to 1:15 p.m. (Chicago time),
Monday through Friday. Trading in
expiring contracts closes at noon on
the last trading day.
Last Trading Day Seventh business day preceding the
last business day of the delivery
month.
Deliverable Grades No. 2 Yellow at par and substitution at
differentials established by the
exchange.


NIKKEI 225 Stock Index Futures
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Trading Unit 1,000 times Nikkei stock average
Tick Size 10 per Nikkei stock average
(minimum value 10,000)
Daily Price Limit Plus or minus 3 percent of the
previous days closing price
Contract Months March, June, September, December
cycle (five contract months traded at
all times)
Trading Hours 9:00 a.m. to 11:00 a.m. and 12:30 p.m.
to 3:00 p.m. (Osaka time)
Last Trading Day The business day before the second
Friday of each contract month
Delivery Cash settled


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THE CLEARINGHOUSE

sets

MARGINS

DAILY SETTLEMENT PRICES

and regulates the

DAILY MARKEING TO MARKET

process.


MARGINS
A margin is cash or marketable
securities deposited 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 loss through a default on a
contract
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MARGINS
A MARGIN is an amount of money
that must be deposited in a margin
account in order to open any
futures position. It is a good will
deposit. The clearinghouse
maintains a system of margin
requirements from all traders,
brokers and futures commercial
merchants.
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MARGINS. There are two types of margins:

The initial margin: This is the amount that
every trader must deposit with the broker in
order to open an account; short or long.
The maintenance (variable) margin: This is a
minimum level of the traders equity in the
margin account. If the traders equity falls
below this level, the trader will receive a
margin call requiring the trader to deposit
more money and bring the account to its
initial level. Otherwise, the account will be
closed.
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Most of the time, Initial margins are
between 2% to 10% of the position
value. Maintenance (variable) margin
is usually around 70 - 80% of the
initial margin.
Example: a position of 10 CBT treasury bonds
futures ($100,000 face value each) at a price of
$75,000 each. The initial margin deposit of 5% of
$750,000 is: $37,500. If the variable margin is
70% Margin call if the amount in the margin
account falls to $26,250.
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Daily margin changes in the margin
account:
MARKING TO MARKET
Every day, upon the market close, all
profits and losses for that day must be
SETTLED in cash. The capital in the
margin accounts is used in order to
settle the accounts, using the
SETTLEMENT PRICES

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A SETTLEMENT PRICE IS
the average price of trades during the
last several minutes of the trading day.
Every day, when the markets close,
SETTLEMENT PRICES
for the futures of all products and for all
months of delivery are set. They are then
compared with the previous day
settlement prices and the difference must
be settled overnight.
A Possible Outcome


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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
<
Some Terminology
Open interest: the total number of
contracts outstanding = the number
of long positions or the number of
short positions

Volume of trading: the number of
trades in a specific contract in a day.
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A futures markets statistic:
97-98% of all the futures for all
delivery months and for all
underlying assets
do not get to delivery!!


What is the implication of this
statistics?
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CONCLUSIONS:

Most traders close their positions
before they get to delivery.

Most traders do not open futures
positions for business.

Most futures are traded for
financial purpose
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