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Mechanics of Futures

Markets

Futures Contract
is a standardized contract,
traded on a futures exchange,
to buy or sell a certain underlying instrument
at a certain date in the future,
at a pre-set price.

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

The future date is called the delivery date or


final settlement date.
The pre-set price is called the futures price.
The price of the underlying asset on the
delivery date is called the settlement price.
The settlement price, normally, converges
towards the futures price on the delivery date.

Convergence of Futures to Spot (Figure


2.1, page 27)

Futures
Price

Spot Price
Futures
Price

Spot Price

Time

(a)

Time

(b)

A futures contract gives the holder the right and the


obligation to buy or sell
Both parties of a "futures contract" must exercise the
contract (buy or sell) on the settlement date.
To exit the commitment,
a. the holder of a futures position has to sell his long
position or
b. buy back his short position, effectively closing out the
futures position and its contract obligations.

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

Some 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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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

Crude Oil Trading on May 26,


2010
Open

High

Low

Settl
e

Chang
e

Volume

Open Int

Jul 2010

70.06

71.7
0

69.21

71.51

2.76

6,315

388,902

Aug
2010

71.25

72.7
7

70.42

72.54

2.44

3,746

115,305

Dec
2010

74.00

75.3
4

73.17

75.23

2.19

5,055

196,033

Dec
2011

77.01

78.5
9

76.51

78.53

2.00

4,175

100,674

Dec
2012

78.50

80.2
1

78.50

80.18

1.86

1,258

70,126
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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.
A few contracts (for example, those on stock
indices and Eurodollars) are settled in cash

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Types of Orders
Limit
Stop-loss
Stop-limit
Market-if touched

Discretionary
Time of day
Open
Fill or kill

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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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Long & Short Hedges


A long futures hedge is appropriate when
you know you will purchase an asset in
the future and want to lock in the price
A short futures hedge is appropriate
when you know you will sell an asset in
the future and want to lock in the price

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Basis Risk
Basis is usually defined as the spot
price minus the futures price
Basis risk arises because of the
uncertainty about the basis when
the hedge is closed out

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Choice of Contract
Choose a delivery month that is as close as
possible to, but later than, the end of the life
of the hedge
When there is no futures contract on the
asset being hedged, choose the contract
whose futures price is most highly correlated
with the asset price. This is known as cross
hedging.
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Stack and Roll (page 65-66)


We can roll futures contracts forward to
hedge future exposures
Initially we enter into futures contracts to
hedge exposures up to a time horizon
Just before maturity we close them out an
replace them with new contract reflect the
new exposure
etc
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