MGMT 41150

Chapter 2
Mechanics of Futures Markets

Professor Boquist

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 Forward Contracts
• Forward market is self-regulated.
– Forward contracts are traded OTC.
– Forward contracts are not standardized.
– Forward contracts don’t have explicit margin
requirements.
• Forward contracts are usually closed by
delivering the underlying asset (e.g. corn, cattle,
gold, etc.)

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 Forward Terminology
• Initiation time: t
• Maturity time (delivery time): T
• Spot price of the underlying at initiation: S(t)
• Spot price of the underlying at maturity: S(T)
• Forward price: F(t,T) = K
– Long a forward: agree to buy the underlying
– Short a forward: agree to sell the underlying

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 Forward Price F(t,T)
• Chosen to make the contract’s initial value zero
– No money changes hand when first negotiated
• Not the spot price
– Spot price is the price for delivering the underlying right now
– Forward price is the price for delivering in the future
• Not the value of the forward contract
– The value of the forward contract is the current value of
final payoff and it changes over the life of forward
– Forward price is fixed over the life of the forward

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 Forward Contract Timeline
• A forward contract is an over-the-counter (OTC)
agreement between two counterparties.
At time t: the counterparties enter the contract
– The value of the contract is zero at t, so no money changes
hands
– Net number of outstanding contracts is always zero in the
market: Number of long = Number of short
At time T: deliver underlying, and make payment
– Zero sum game: the winner’s profit is the loser’s loss

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 Example: Currency Forward
• May 8, 2010: a company enters a long forward contract
to:
– Buy £ l,000,000 @ 1.60 $/£ in 90 days
• August 6, 2010: the exchange rate is 1.6500 $/£
According to the contract, the company
PAYS $1,600,000 &
RECEIVES £1,000,000.
The company’s profit is $50,000 since the Pounds can
immediately be sold for $l,650,000

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 Futures Contracts
• Available on a wide range of assets
• Exchange traded
• Specifications need to be defined:
– What can be delivered
– Where it can be delivered
– When it can be delivered
• Settled daily

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 Futures Contract Categories
• Physical futures
– Agricultural: Livestock/Meat, Oats/Corn/Rice, Food/Fiber,
Oilseeds, Wheat
– Electricity, Petroleum
– Metals, Lumber
• Financial futures (>50% of futures market volume):
– Currency futures introduced in 1972, stimulated by the
breakdown of the Bretton Woods system.
– Treasury futures have developed since 1975, motivated by
increases in interest rate volatility.
– Index futures were introduced in 1982, which are used to
speculate or hedge against stock market risk.

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 Futures Contract Exchanges

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 Margin Account for Futures Trade
• A margin is cash or marketable securities
deposited by an investor with his or her broker
• Both the long and short investor establish a
margin account
• 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 Calls
• If the balance in the margin account falls below
the maintenance margin level, then the trader
will get a margin call, and has to deposit money
to bring the margin account up to the initial
margin level
• These daily margin cash flows are referred to as
variation margin

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 Margin Account Example

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 Example of a Futures Trade
• An investor takes a long position in a gold
contract with a futures price of $1,500
– Contract size is 100 oz.
– Initial Margin is $8,000
– Maintenance margin is 75% of initial margin
($6,000)

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 Example of a Futures Trade
• If gold prices follow the following path, what
happens with the margin account?

Day Trade Price Settle Price Gain/Loss Margin balance Margin Call
1 1,500 X X 8,000
2 X 1,470
3 X 1,410
4 X 1,520
5 1,525 X

• Note: trader closes the position on the 5th day

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 Futures Terminology
• Open interest: the total number of contracts
outstanding
– Equal to number of long positions or number of
short positions
• Settlement price: the price just before the final
bell each day
– Used for the daily settlement process
• Volume of trading: the number of trades in one
day

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 Important Features of Futures
• They are settled daily
• Closing out a futures position involves entering into an
offsetting trade
• Most contracts are closed out before maturity
• 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.
• A few contracts (for example, those on stock indices and
Eurodollars) are settled in cash

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 Price Manipulation: Hunt Brothers
• Manipulation:
– Hunt brothers accumulated gigantic futures positions and
demanded delivery on those contracts as they came due
– They concurrently bought a huge quantity of physical silver
and held it off the market
– Silver price jumped from $6/ounce to $48/ounce
• CFTC imposed liquidation-only trading: traders are
only allowed to trade to close a futures position
• Known as “Silver Thursday”
• Hunt brothers went bankrupt afterwards

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 Forwards vs. Futures

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

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 Types of Orders
• Market order
– Trade immediately at the best available price
• Limit order
– Trade can be executed only at specified limit price or
a more favorable price
• Stop-loss order
– Trade is executed immediately once a specified price
(or worse) is reached. For example, a market sell
order is placed once the price is at or below the stop-
loss price (which is less than the current price)
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 Types of Orders (Cont’d)
• Stop-limit order
– Trader specifies stop price and limit price: a limit
order is submitted as soon as the price hits the stop
price (for example, if current price is 30, the stop
price could be 35 with a limit price of 37)
• Market-if-touched order
– Trade is executed at the best available price after a
trade occurs at the specified price (or better). For
example, a sell MIT order would be at a price above
the current market price.

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