7/18/2014

Mechanics of Futures Markets

Agenda:
Specification of a Futures Contract,
Convergence of Futures prices to spot price,
Daily Settlement and Margins,
Newspaper Quotes,
Types of Traders and Orders,
Regulations, Accounting and Tax

Futures Products in India

Equity Index Futures
Single Stock Futures
Interest Rate Futures (not very active in India)
Commodity Futures (Most flourishing)
Currency Futures (Volume is very low)

Growth of Currency Futures at

NSE

Source: www.nseindia.com

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Specification of a Futures Contract

Specifications need to be defined:

What
How much
Where, &
When

Sometimes alternatives are specified

The Contract Size:

Specification of a Futures Contract

Specifications need to be defined:

What
How much
Where, &
When

Sometimes alternatives are specified

The Contract Size: Neither too large nor too small.

Specification of a Futures Contract

Specifications need to be defined:

What
How much
Where, &
When

Sometimes alternatives are specified

The Contract Size: Neither too large nor too small.

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Closing Out Positions

Closing out a position means entering into the opposite

trade to the original one.

Delivery
If 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.
chooses

A few contracts (for example, those on stock indices

and Eurodollars) are settled in cash

Delivery Arrangements:
Place must be specified
Adjustment of price according to location
Notice of Intention to deliver
Delivery Month

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Price Quotes

10

Price Limits and Position Limits

Limit Down:
Limit Up:
Limit Move:

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Convergence of Futures to Spot

Futures
Price

S t Price
Spot
Pi
Futures
Price

Spot Price

Time

(a)

Time

(b)

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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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Margin Account:

14

Margin Account: the broker requires the investor to

deposit funds in this account.

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Margin Account
Initial Margin:

16

Margin Account
Initial Margin: Amt. deposited at the time of entering
into a contract

17

Margin Account
Initial Margin
Maintenance Margin:

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Margin Account
Initial Margin
Maintenance Margin: To ensure that the balance in the
margin account never becomes negative.

19

Margin Account
Initial Margin
Maintenance Margin:
Margin Call:

20

Margin Account
Initial Margin
Maintenance Margin:
Margin Call:
Variation Margin:

21

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Margin Account
Initial Margin
Maintenance Margin:
Margin Call:
Variation Margin: Extra funds deposited

22

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$600
margin requirement is US$2,000/contract
$
(US$4,000 in total)
maintenance margin is US$1,500/contract
(US$3,000 in total)

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A Possible Outcome

Day

Futures
Price
(US$)

Daily
Gain
(Loss)
(US$)

Cumulative
Gain
(Loss)
(US$)

600 00
600.00

Margin
Account Margin
Balance
Call
(US$)
(US$)
4 000
4,000

5-Jun 597.00
.
.
.
.
.
.

(600)
.
.
.

(600)
.
.
.

3,400
.
.
.

0
.
.
.

13-Jun 593.30
.
.
.
.
.
.

(420)
.
.
.

(1,340)
.
.
.

2,660 + 1,340 = 4,000

.
.
.
.
.
< 3,000

19-Jun 587.00
.
.
.
.
.
.

(1,140)
.
.
.

(2,600)
.
.
.

2,740 + 1,260 = 4,000

.
.
.
.
.
.

26-Jun 592.30

260

(1,540)

5,060

0
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Other Key Points About Futures

They are settled daily
Closing out a futures position involves entering into
an offsetting trade
Most contracts are closed out before maturity

25

Collateralization in OTC Markets

It is becoming increasingly common for contracts to be

collateralized in OTC markets
They are then similar to futures contracts in that they are
settled regularly (e.g. every day or every week)

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Prices
Open
High
Low
Close

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Settlement Price

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Open interest

30

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Open interest
the total number of contracts outstanding
equal to number of long positions or number of short
positions

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Open interest
Day
Mon
Tue

Wed

Thu
Fri

Time
(+/)Buy/Sell Positionduringtheday NetPositionattheendofday
11:05
+5000
+5000
+5000
11:35
3000
2000
13:25
4000
2000
15:05
5 05
5000
5000
7000
000
7000
000
12:05
+4000
3000
13:15
+1500
1500
14:40
+1500
0
15:25
2000
2000
2000
10:25
+5000
3000
10:45
+5000
8000
+8000
14:55
3000
5000
+5000
EndofWeekNumber
+5000

DailyVolume
5000

12000
000

9000
10000
3000
32
39000

Volume of trading
the number of trades in 1 day

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Normal Market: Futures Prices Increase with

Maturity

Futures Price
e ($ per oz)

650
640
630
620
610

Contract Maturity Month

600
Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

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Futures Price (cents per lb)

Inverted Market: Futures Prices Decrease

with Maturity

210
205
200
195
190
185
180
175
170
Jan-07

Contract Maturity Month

Mar-07

May-07

Jul-07

Sep-07

Nov-07

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Types of Traders
Commission Brokers
Locals

36

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Types of Orders
Scalpers:

Day Traders:

Position Traders:

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Questions
When 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?

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Regulation of Futures
Regulation is designed to protect the public interest

Regulators
g
try
y to p
prevent q
questionable trading
g
practices by either individuals on the floor of the
exchange or outside groups

39

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Accounting & Tax

Ideally hedging profits (losses) should be recognized
at the same time as the losses (profits) on the item
being hedged
Ideally profits and losses from speculation should be
recognized on a mark-to-market basis
Roughly speaking, this is what the accounting and tax
treatment of futures in the U.S. and many other
countries attempts to achieve

40

Forward Contracts vs Futures

Contracts
FORWARDS

FUTURES

Private contract between 2 parties

Exchange traded

Non-standard contract

Standard contract

Usually 1 specified delivery date

Settled at end of contract
Delivery or final cash
settlement usually occurs
Some credit risk

Range of delivery dates

Settled daily
Contract usually closed out
prior to maturity
Virtually no credit risk
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Foreign Exchange Quotes

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