PRESENTATION SUPERIOR

UNIVERSITY
RAIWIND ROAD
LAHORE

CHAPTER 20
FUTURE MARKETS
BY: HURMAT FAIZA

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 TABLE OF CONTENTS
• Understanding future markets
a) Future markets b) Future contracts
• Structure of future markets
a) Future exchanges b) Clearing houses
• Mechanics of trading
a) Basic procedures b) Margin
• Using future contracts
a) Hedgers b) Speculators
• Financial futures
a) Interest rate futures b) Stock index futures c)
single stock futures
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 Futures exchange

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 2 major futures market trading
institutes

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 NCEL
• National Commodities Exchange
Limited (NCEL) is Pakistan's first
futures commodity market having
its registered Head office in
Karachi.
• It is the only company in Pakistan
to provide a centralized and
regulated place for commodity
futures trading and is regulated by
Securities and Exchange
Commission of Pakistan (SECP).
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Karachi Stock Exchange
• KSE began with a 50 shares index.
• As the market grew a representative index was
needed. On November 1, 91 the KSE-100 was
introduced and remains to this day the most
generally accepted measure of the Exchange.
• Karachi Stock Exchange 100 Index (KSE-100
Index) is a benchmark used to compare prices
overtime, companies with the highest market
capitalization are selected.

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 Definition
A futures exchange or derivatives
exchange is a central financial exchange
where people can trade standardized
futures contracts; that is, a contract to buy
specific quantities of a commodity or
financial instrument at a specified price
with delivery set at a specified time in the
future.

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 Nature of contracts

Exchange-traded contracts are standardized

by the exchanges where they trade. The
contract details what asset is to be bought
or sold, and how, when, where and in what
quantity it is to be delivered. The terms
also specify the currency in which the
contract will trade, minimum tick value,
and the last trading day and expiry or
delivery month
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 CHARACTERISTICS
• Organized futures exchange standardizes
nonstandard forward contracts.
• This standardization consists of:
a) contract size
b) delivery dates
c) conditions of items to be delivered.

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 Important point to negotiate
Futures traders are left only to negotiate
only the following
a) Price of contracts
b) Number of contracts.

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 Primary function enlightened
• Primary functions of futures are
1) Price Discovery
2) Price risk management

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 Detail
• An important economic function performed
by futures markets is Price discovery.
• As Price of a futures contract shows
current expectations about values at some
future date.
• Transactors can establish current prices
against later transactions.
• Serve by allowing hedgers to shift price
risk to speculators.
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 Shift of risk
• The risk of Price fluctuations is shifted
from participants unwilling to take risk to
those who are.

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 Futures Contracts
• A futures contract is
a) Standardized
b) Transferable agreement
c) Provides deferred delivery of either
i) A specified grade & quantity of designed
commodity within a specified geographic area
or
ii) A financial instrument

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 Main features
• A future contract locks in a price for
delivery on a future date.
• Futures price at which the exchange will
occur at contract maturity is determined
today.

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 IMPORTANT INFO
• Futures contracts are not securities and
are not securities & exchange commission
regulated
• The CFTC commodity Futures Trading
exchange commission, a federal
regulatory authority is responsible for
regulating trading in all domestic markets.

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 Structure Of Futures markets

1. Futures Exchanges

2. Clearing house

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 Futures exchange
• Here futures contracts are traded on
designated futures exchanges (non-profit,
voluntary associations).
• Provides an organized marketplace
• Financed by both membership dues &
fees charged for services rendered.

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 Membership criteria
• Owned by individuals
• Limited number of membership
• Can be traded at market determined
prices.

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 Trading Criteria
Members can trade for
• their own accounts
• As agents for others
Example: Floor trades trade for their own
accounts, floor brokers often act as agents
for others.

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 Agents of futures markets
• Future brokerage firms are called Future
commission merchants acting as agents,
for which they earn commission.

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 Operations of FCM
• FCM can be either be any of following
a) Full service
b) Discount firms,
c) stand alone firms,
d) part of financial system offering securities
Example: Regional brokerage firms.
• A customer can establish an account with an
FCM.
• Who then works through a floor broker

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 Clearing House
• A corporation separate from each
exchange
• but associated with, each exchange,
• playing an important role in every future
transaction.

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 Detail
• Here all futures trades are cleared each
day.
• Buyers & sellers settle with a clearing
house
• Stands ready to fulfill a contract if either a
buyer or seller defaults
• Helps facilitate orderly market in futures.

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 FM impersonality
• It makes future markets impersonal
REASON:
• Any buyer and seller can always close out
a position & be assured of payment.
• Ensures all payments are made as
specified.

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• Deals with clearing members & not with
individual investors.
• Relies entirely on clearing members
carrying individual customer accounts
when it comes to margin requirements &
payments.

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• Clearing house participants can easily
reverse a position before maturity as it
keeps track of all the participants’
obligations.
• Example: An investor short of gold
contract can easily cancel this position by
buying the same gold.

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 Mechanics of trading
• Basic Procedures

• Margin

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 Basic Procedures
• Futures contract is a commitment to buy or
sell at a specified future settlement date.
• A contract is not really being sold or
bought, i.e., Treasury bills, stocks or CDs.
• Reason: No money is exchanged at time
when the contract is negotiated

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 Buying & Selling trends
• Modes of buying & selling of futures
a) A short term position (seller): Committing
a trader to deliver an item at contract
maturity at Price agreed upon today.
b) A long position (buyer): committing a
trader to purchase an item at contract
maturity at a price agreed upon today.

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 Selling short in futures trading
• It means that only that a contract not
previously purchased is sold.
• For every futures contract has
a) Someone selling it (establishing a short
term position)
b) Someone buying it (establishing long
term position).

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 Nature
• Like Option, futures trading is a zero sum
game.
• Gains & losses on all positions net to zero.

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 Main difference b/w options &
futures
1. Options: Involves right to make or take
delivery
2. Futures: Involves an obligation to take or
make a delivery.
3. Delivery: It is the settlement of contract,
occurring in months as designated by
various exchanges for each of the items
traded
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 Settling of futures
• Futures contracts can be settled byeither
a) Delivery,
or
b) Offset

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 Offset
1. A typical method of settling a contract.
2. 95% of contracts are closed by offset before
the contract expires.
3. Holders liquidate a position by arranging an
offsetting transaction.
4. Buyers sell their positions & sellers buy in their
positions at time prior to delivery.
5. When an investor offsets a position, it shows
the adjustment of their trading account, to show
gains or losses & their position is closed.

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 Price fluctuation limits
• These are established by each exchange
on various type of contracts.
• Typically a minimum price change is
specified.
• Example: Case (corn) = 0.25 cents/bushel
• OR $12.50 per contract.
• A daily price limit is in affect for contracts
except stock-index futures.
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 Example
• For corn it is 10 cents per bushel ($500)
per contract, above & below previous
day’s settlement price.
• Open interest: Shows contracts that are
not offset by opposite transactions or
delivery.
• It measures number of un liquidated
contracts at any point in time on
cumulative basis.
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 Measurement of open interest
• It is measured by either of following.
a) Open long positions: When investor long
on a contract
or
b) Open short positions: Here the open
interest is reduced when a contract is
liquidated.

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 Margin
• Refers to the down payment in a transaction in which the
money is borrowed from broker to finance the total cost.
• Futures Margin: Is not a down payment.
• Reason: The ownership of underlying item is not being
transferred at time of transaction.
• FM is a performance bond guaranteeing fulfillment of
obligation.
• In futures the margin is the norm.
• All participants must deposit minimum specified amounts
in their futures margin accounts to guarantee contract
obligations.

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 2 forms of future margin
1. Initial margin & its requirements

2. Maintenance margin & its requirements

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 Initial margin
• It is margin required for future contracts
• Is smaller in relation to the value of
contract itself
• Represents equity of transactor.
• Generalized approximation for futures
contracts = 6% of value of contract.
• Since equity is small the risk is magnified.

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 Maintenance margin
or
Variation Margin
• Below this the investor’s equity cannot drop.
• A margin call occurs when price goes against
investor when account balance goes below
maintenance level.
• Then the investor is required to deposit
additional cash to restore account back to initial
margin level or to close out the account.
• If account balance is above the maintenance
margin but below the initial then no action is
required.
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 Using Futures contracts
1. Hedgers

2. Speculators

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 Hedgers
• Hedgers are the parties at risk with a
commodity or an asset
• They are exposed to price changes
• They buy or sell futures contracts in order
to offset the risk.
• Take a position opposite to that already
held at price set today.
• This investment is a form of insurance.
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1. Hedger is willing to forego some profit
potential in exchange for having
someone else assume part of the risk.
2. Hedged position has a smaller chances
of small return but also has smaller
chances of higher return.
3. It reduces variances in outcome.

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 Hedging with futures
1. Key to hedge: Futures position is taken
opposite to position in cash market
2. Cash market determines hedge in future.
3. A financial instrument held shows a long
position as these items could be sold in
cash market.
4. An investor who sells futures positions
creates a short position.
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2 basic positions of future contracts
• Short sell hedge

• Long Buy hedge

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 Short (Sell) hedge
• Involves a cash market inventory holder selling
the futures short.
• Protect the value of the investors’ portfolios.
• Securities are held
• Long on cash positions
• Need to protect themselves against fall in prices
• Eliminates risk taken in cash market (long)
position.

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 Long (Buy) Hedge
• Here the investor holds no cash inventory
• Is currently in cash market
• Expects to be in future
• Wants to lock in current prices & yields
until cash is available to make investment
• Reduces the risk of short positions.

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 Basis Risk
Cash Price- Future Price
• Difference between futures price of an item
& spot price of item.
• It must be 0 at maturity date of contract.
• In interim fluctuates in unprecedented way
• Is not constant during a hedge period
• Buyer benefits from weakening basis( sash
price weakens relative to futures)
• Seller benefits from strengthening ( cash P
strengthens to futures).
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 Speculators
• Buy or sell contracts in attempt to earn a
return.
• Willing to assume risk of price fluctuations,
• Hoping to gain profit
• Have no prior market position
• Trade for their own accounts & for others
& often take very short term positions to
exploit any short lived market anomalies.
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 Significance
• Contribute to liquidity of market
• Reduce variability of prices over time.
• Potential advantages of speculating in
future markets include:
A) Leverage: Magnifying gains
B) Ease of transacting: easy to rake short
position in T bonds futures contract
C) Transaction costs: Smaller in future
markets.
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 Financial futures
• Contracts on the equity indexes
• Fixed income securities
• Currencies
• Give investors greater opportunity to fine
tune risk return characteristics of their
portfolios.

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 3 Boards of financial futures

1. Currency Futures
2. Interest rate futures
3. Equity Futures

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 Interest rate futures
• Bond prices are highly volatile
• Investors are exposed to adverse price
movements
• Investors transfer the risk

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 Stock Index Futures
• Offer investors opportunity to act on their
investment opinions concerning the future
direction of market
• Investors concerned with short term
prospects remaining bullish for longer run
can protect themselves in interim by
selling stock index futures.

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