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Mechanics of Futures Market

Mechanics of Futures Markets


1. 2. 3. 4. 5. 6. 7. Specifications of a Futures Contract Convergence of Futures Price to Spot Price Safeguards in the Futures Market Closing a Futures Position Open Interest Pay-off from a Futures Contract Transaction on a Futures Exchange

Mechanics of Futures Market

Specifications of a Futures Contract


A futures contract is a standardised contract. Defined (specified) in terms of: Underlying asset Contract size Delivery arrangements Delivery month Price quotes Daily Price Movement Limits

Mechanics of Futures Market

Underlying Asset
In case of Commodity Futures, the Exchange stipulates the grade(s) of the commodity. E.g.: Lumber Futures - standard length of 8by 20. Juice Futures in terms of Brix value A range of grades may be delivered with adjustment in price based on the grade delivered. In case of Financial assets - Futures contracts are well defined & unambiguous. E.g.: Enough to say Futures on BSE Sensex or Futures on Infosys.
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Contract Size
Contract size specifies the amount of the asset that has to be delivered under a Futures contract. If the Contract size is set too high, it will keep away many investors, while if set too small, it will make trading expensive as transaction cost are linked to no. of contracts traded. E.g.: Futures on S&P CNX Nifty have a contract size of 200 & multiples thereof.

Mechanics of Futures Market

Delivery Arrangements
Place where the delivery will be made, is specified by the exchange, especially in case of Commodity Futures. Delivery may be made at alternative site with due adjustments in the delivery prices.

Mechanics of Futures Market

Delivery Month
Futures contract is referred to by its Delivery month. The exchange specifies the precise period during the month when delivery is to be made. Vary from contract to contract At any given time, contracts trade for the closest delivery month & a number of subsequent delivery months. NSE futures 1, 2, 3 month futures. Exchange also specifies the last day on which trading can take place for a given contract

Mechanics of Futures Market

Price Quotes
The exchange defines how price will be quoted In a way that is convenient and easy to understand. E.g.: Crude Oil NYMEX - $/per barrel Minimum price movement that can occur in trading is also set by the exchange tick size E.g.: Crude Oil ($0.01 or 1 cent per barrel)

Mechanics of Futures Market

Daily Price Movement Limits


Maximum movement in prices during a day (in either direction) so as to prevent large price movements due to speculative trading. Exchange may change the limits to counter excessive speculation.

Mechanics of Futures Market

Convergence of Futures to Spot Price


As the delivery month approaches, the Futures price converges to the Spot price of the underlying asset. At the delivery date, the Futures price equals ( or is very close to ) the Spot price. If the prices differ substantially, arbitrageur shall take appropriate position to drive away any benefits. Eventually the two prices will converge.

Mechanics of Futures Market

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Convergence of Futures to Spot Price

Futures Price

Spot Price

Price

Spot Price Price

Futures Price

Time

Time

Mechanics of Futures Market

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Safeguards in the Futures Market


Clearing House Margin Requirements Daily Settlement (Mark-to-Market)

Clearing House
To ensure smooth functioning, each Futures Market has a Clearing House (CH) associated. CH guarantees ALL trades on the Exchange. This is achieved by CH adopting the position of a Buyer for every Seller & that of a Seller for every Buyer. Each trader has obligations only to the CH & hopes that CH will execute its side of the trade as well. CH substitutes its own credibility for the promise of each trader. CH, however, does not take ACTIVE position but interposes itself between all parties to every transactions.

Mechanics of Futures Market

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Clearing House (Contd.) Obligations without Clearing House


Funds

Buyer
Goods

Seller

Obligations with Clearing House


Funds Funds

Buyer
Goods

Clearing House

Seller
Goods

Mechanics of Futures Market

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Clearing House (Contd.)


Without CH, both parties would deal with each other-direct obligation to each other. With CH, each party has obligation to the CH which ensures that both parties perform. Because of the CH, the two parties need not trust or know each other. They need to be concerned about the reliability of the CH. Hence, CH is a large, well-capitalised Institution. US Futures trading history, CH have never faulted. Default Risk of CH is very small.

Mechanics of Futures Market

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Operation of Margins
When investors contract, there are various risks one party may backout or may not have the financial resources to honour his commitments. The exchange organises trades as as to avoid such defaults thru a system of Margins. Futures trading is guided by the need to eliminate the payments crises- Default Risk or Credit Risk Besides the role of the Clearing House, the system of Margins protects from a payments problem. Different types of margins are maintained: Initial Margin (IM) Maintenance Margin (MM) Variation Margin (VM)
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Operation of Margins (Contd.)


Initial Margin (IM):Good faith deposit paid by the trader at the time of entering the contract to ensure performance. IM may vary from contract to contract & from trader to trader.Typically set at 5% of the contract value. Trader retains title to the deposit. Usually equal to Maximum Daily Price fluctuation limit. IM is returned upon proper completion of all the obligations. At the end of each day, the margin account is adjusted to reflect gain/loss. This is called Mark to market
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Operation of Margins (Contd.)


Maintenance Margin (MM) :(% of the Initial Margin) is the Minimum amount of margin below which margin account should NOT fall. MM is used to calculate the third margin Variation Margin. If the margin account falls below the MM, trader is required to replenish ( top-up) the margin, bringing the margin amount back to the Initial Margin. This additional amount paid by the trader is called VM. Any amount in excess of the IM can be withdrawn by the investor. Initial margin covers 1 days price fluctuations, any additional losses is covered by the VM. Failure to pay VM leads to the futures position being closed out.
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Operation of Margins - An Example


X buys 2 Gold Futures @ Rs 400 per ounce. Contract size = 100 ounces. Initial Margin (IM) = Rs 2000 per contract = 2000 x 2 = Rs 4000 Maintenance = Rs 1500 per contract

Margin (MM) = 1500 x 2 = Rs 3000

Mechanics of Futures Market

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Operation of Margins
Day 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Futures Price 400.00 397.00 396.10 398.20 397.10 396.70 395.40 393.30 393.60 391.80 392.70 387.00 387.00 388.10 388.70 391.00 392.30 Daily Gain/(Loss) Cumulative Gain/(loss) Margin Account Balance 4000.00 3400.00 3220.00 3640.00 3420.00 3340.00 3080.00 2660.00 4060.00 3700.00 3880.00 2740.00 4000.00 4220.00 4340.00 4800.00 5060.00 Margin Call

(600.00) (180.00) 420.00 (220.00) (80.00) (260.00) (420.00) 60.00 (360.00) 180.00 (1140.00) 0.00 220.00 120.00 460.00 260.00

(600.00) (780.00) (360.00) (580.00) (660.00) (920.00) (1340.00) (1280.00) (1640.00) (1460.00) (2600.00) (2600.00) (2380.00) (2260.00) (1800.00) (1540.00)

3080-420+x=4000

1340.00

1260.00 3880-1140+x=4000

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Closing a Futures Position


1. Delivery: Delivery of the goods under the contract will automatically close the position. Physical Settlement: Physical delivery of the asset at a certain location at a specified time as per the exchange rules. Cash Settlement: Traders make payment at expiry of contract to settle any gain or loss.

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Closing a Futures Position


2. Offset: Most Futures contracts are settled by Offsets- by entering into a exactly reverse trade which shall cancel the original trade. The trader, in order to close the contract, should enter into an exactly reverse contract in terms of the underlying assets , No. of contracts & expiry date If it does not, then the trader shall undertakes a new obligation instead of cancelling the old obligation.

Mechanics of Futures Market

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Offset Trades An Example


May 1 Party As Initial Position: Bought 1 September Wheat Futures Contract @ Rs 2200/-. Party As Reversing Trade: Sold 1 September Wheat Futures Contract @ Rs 2300/-. Party B : Sold 1 September Wheat Futures Contract @ Rs 2200/. Party C: Bought 1 September Wheat Futures Contract @ Rs 2300/.

May 15

After this Party As net position is zero and is out of the Futures market.Party B & C have obligations towards the Clearing House.
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Closing a Futures Position (Contd.)


3. Exchange for Physicals: Two traders simultaneously exchange for cash, commodity & Futures contract based on that commodity. EFP vs. Offset: Under both, the traders have completed their obligations & are now out of the market. Differs from Offsets: Traders actually exchange the physical goods. Futures is not closed by a transaction through the Exchange. Traders privately negotiate the terms, hence also called ex-pit
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Exchange for Physicals An Example


Before the EFP Party A Long 1 Wheat Futures Wants to acquire Actual Wheat Party A Agrees with B to purchase wheat & cancels Futures Receives wheat & pays B Reports EFP to the Exchange Exchange adjusts to show A is out of the Market. Party B Short 1 Wheat Futures Owns Wheat & wishes to sell

EFP Transaction Party B Agrees with A to sell wheat & cancels Futures Delivers wheat & receives payment from A Reports EFP to the Exchange Exchange adjusts to show B is out of the Market. 25

Mechanics of Futures Market

Open Interest
Open Interest refers to the number of futures contracts outstanding. It is the total no. of open positions waiting to be liquidated before the contracts maturity. Todays newspaper carry yesterdays trading data and day before yesterdays Open Interest data. Three rules regarding open interest Any trade (long or short) initiated afresh raises OI Any trade (long or short) that squares up existing position lowers OI Every trade needs a buyer & a seller

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Open Interest : An Example


Trader 1 Trader 2 Trader 3 Trader 4 Trader 5 Long Short Long Short Long Long Short Short Long Short Open Interest 20 20 40 20 0

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Pay-off from a Futures Contract


Consider a trader who has entered into a 3-month Long position to buy 100 kg. of Silver @ Rs 2000/per kg. At the end of 3-months, if the price is Rs 2500/- per kg, then the trader has made a profit of Rs. 500/per kg. At the end of 3-months, if the price is Rs 1900/- per kg, then the trader has made a loss of Rs. 100/per kg. In general, the pay-off from a long position in the Forward/Futures Contract is: Spot Price on Maturity (ST) less Delivery Price(K)
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Pay-off from a Futures Contract


Pay-off from a short position in the Forward/Futures Contract is: Delivery Price (K) less Spot Price on Maturity (ST) These pay-offs represents total profit/loss from the contract, as it costs nothing to enter into a Forward/Futures contract
K Profit Profit ST
Pay-off : Long Position
Mechanics of Futures Market

K ST
Pay-off : Short Position
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Transaction on a Futures Exchange


Buyer
1 5

Buyers Broker
6 Buyers Brokers Clearing Firm

Futures Exchange
4

Sellers Broker
6

Seller
5

Futures Clearinghouse

Sellers Brokers Clearing Firm

1: Buyer places a BUY order with his Broker who in turn places it with the Futures Exchange. 2: Seller places a SELL order with his Broker who in turn placesit with the Futures Exchange. 3: Futures Exchange matches the trade through a computerised system. 4: Information about the trade is reported to the Clearing House 5: Buyer and Seller deposit margin with their respective brokers 6: Buyers and Sellers Brokers deposit the margins with their respective clearing firms 7: Clearing firms deposit the margins with the ClearingHouse
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