Presentation on

FUTURES CONTRACT meaning,

types, mechanism, SEBI guidelines

Introduction to Derivatives

Derivatives are the financial instruments which derive their value from the value of the underlying & easily marketable asset. According to Wikipedia, a derivative is a an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying).

cont..

The underlying asset can be agriculture products, metals, interest rates, equities, currencies, stock index, or anything that carries a market price.

Derivatives

Commodity Derivatives

Financial Derivatives

Forwards Futures Options Convertibles

Swap Exotics

Futures Market

Futures Market were designed to solve the problems that exist in forward markets.
They are the organized market for the trading of futures contracts.

Futures Contract

A futures contract is a standardised contract b/w 2 parties in which one party agrees to buy from / sell to the other party at a specified future time, a specified asset at a price agreed at the time of the contract and payable on maturity date.

The agreed price is known as the strike price.

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The futures contact being traded on an organised exchange impart liquidity to a transaction. The clearinghouse, being the counter party to both sides of a transaction, provides a mechanism that guarantees the honouring of the contract and ensuring very low level of default. They are subject to a daily settlement procedure. In essence, futures contract is like a liquid forward contract, which is traded on an exchange.

Examples of Futures Contracts

Agreement to:

Buy 100 oz. of gold @ US$1400/oz. in December Sell 62,500 @ 1.4500 US$/ in March Sell 1,000 bbl. of oil @ US$90/bbl. in April

FUTURES TERMINOLOGY Spot price Futures price Contract cycle Expiry date Contract size Initial margin Marking-to-market Maintenance margin Variance margin

Characteristics of Futures Contracts

Standardized contract b/w 2 parties

Seller has legally binding obligation to make delivery on specified date. Buyer/holder has legally binding obligation to take delivery on specified date. Traded on an Organized Exchange Settlement through Clearing House

All trading is done on a margin basis

Daily settlement Less Default risk

It is a contract, not an agreement

Futures Contract Standardized Terms

1. 2. 3. 4. 5. 6. 7. 8. 9.

Quantity Quality Expiration months Delivery terms Delivery differentials Delivery dates Minimum price fluctuation Daily price limits Trading days and hours

Advantages of Using Futures Contracts

Potential for very high returns Margin buying allows use of leverage

Leverage: the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return Dont have to sell crops at harvest time when prices are often low

Allows producers to hedge prices

Commodities can provide an inflation hedge

a. ARBITRAGEURS : These players neither hedge nor speculate. They try to take advantage of the price differences in the spot and forward markets.
b. HEDGERS : They participate in the forward market with a view to protect or cover an existing exposure in the spot market. c. SPECULATORS : A person who makes risky investments, anticipating a major change in the future price of the asset with a view to make profits from the expected movement in the underlying element. He makes an investment that involves a risk of loss but also a chance of profit. d. BROKERS : An Individual or firm acting as an intermediary by conveying customers trade instructions. Ex. Account executives or floor brokers.

Positions in Futures contract

Futures (unlike option contracts) commit both parties to the contract to take a specified action :

The party who has a short position in the futures or forward contract has committed to sell the good at the specified price in the future. Having a long position means you are committed to buy the good at the specified price in the future.

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No money changes hands between the long and short parties at the initial time the contracts are made. Only at the maturity of the forward or futures contract will the long party pay money to the short party and the short party will provide the good to the long party.

Financial Futures
Financial futures can be understood as a notional commitment to buy or sell a standard quantity of a financial instrument at a specified price on a specified future date. These are not different from commodity futures except of the underlying asset.

Types of Futures Contract

Interest rate futures Foreign currencies futures Stock index futures Bond index futures Cost of living index futures / Inflation futures

1. Interest rate futures

In this type of futures contract, the underlying asset is an interest bearing security. For ex., Treasury bills, notes, bonds, debentures. Almost entire range of maturities bearing securities are traded here. This market is further categorized as : (a) Short-term interest bearing instruments (b) Long-term interest bearing instruments

Ex. Notional gilt-contracts, short-term deposit futures , treasury bill

futures, euro-dollar futures, treasury bond futures & treasury note futures.

2. Foreign currencies futures/Currency Futures/Exchange rate futures

It is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date.

These trade in foreign currencies & directly correspond to spot market/inter-bank foreign exchange market.
Major currencies these are made in are US-dollar, Pound Sterling, Yen, French France, Canadian dollar, etc. Future currency contracts are used for hedging by exporters, importers, bankers, financial institutions & large companies.

3. Stock index futures

In a stock index future, the counterparties agree to trade the underlying index at a certain time for a certain price. Because it is impossible to physically deliver the index, stock index futures are settled in cash.
It is based on stock market indicies i.e., future price of the indexed group of stocks. It involves future delivery of a sum of money based on the value of a stock index (in most cases, 500 times the index). By shorting these contracts, stock portfolio managers can protect themselves from the downside price risk of the broader market. As an investment instrument it combines features of securities trading based on stock indices with the features of commodity futures trading.

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These are traded by MFs, investment trusts, insurance companies, speculators, arbitragers & hedgers. The most popular electronically traded stock index futures traded are : --- E-mini S&P 500 contract --- The Nasdaq 100 on the Chicago Mercantile Exchange --- The Dow Jones Industrial Average on the Chicago Board of Trade ---The New York Stock Exchange Composite Index on the New York Board of Trade (NYBOT) --- The Value Line Composite Index on the Kansas City Board of Trade (KCBT)

4. Bond index futures

It is an agreement to buy or sell a bond at a certain date at a certain price. For ex., Investor A may make a contract with Investor B in which A agrees to buy a certain number of B's bonds at 90% of their par value on January 15. This contract must be honoured whether the price of the bonds goes to 80% or 125% of par. These are based on particular bond indicies,i.e., indicies of bond prices (like stock index futures). Prices of debt instruments are inversely related to bond index. Ex. Municiplal Bond Index futures based on CBOT.

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Bond futures contracts can help reduce volatility in certain markets, but they contain the risks inherent to all speculative investing.
These contracts may be sold on the secondary market, but the person holding the contract at its end must take delivery of the underlying asset.

5. Cost of living index futures / Inflation futures

These futures contracts are based on a specified cost of living index. For ex., consumer price index, wholesale price index, etc. These can be used to hedge against unanticipated inflation which cannot be avoided. Inflation futures can be useful to investors like provident funds, pension funds, mutual funds, large cos. & Governments.

Functions of Futures Market

Hedging A Risk Management Tool Price Discovery Financing function Liquidity function Price stabilization function Disseminating information

An investor (prospective trader) who enters into a futures contract is required to deposit some funds with his broker which serves as a good-faith deposit (or performance bond). The basic objective is to provide a financial safeguard for ensuring that investors will perform their contract obligations.

Margin can be deposited in different forms like cash, banks letter of credit & Treasury securities.
Margin deposited by the traders are subject to daily settlement(marked-to-the-market). DS is a process by which traders are required to realize any losses in cash immediately.

 Initial

Margin

Maintenance
Variation

Margin

Margin

IM is the deposit that a trader must make before trading any futures.
It is the original amount that must be deposited into account to establish futures position. It varies from stock to stock & is determined on the basis of degree of volatility of price movements in the past of underlying asset.

MM is the minimum amount which must be remained in a margin account.

This is normally 75% of the initial margin

When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level, for which the broker will make a call .

VM refers to additional amount required to bring balance of margin account to the initial margin level. It is the difference between initial margin & balance in margin account.

If investor does not pay initial margin immediately, the broker may proceed to unilaterally close out the account by entering into an offsetting futures position.

Marking-to-market (Daily Settlement)

In the futures market, all the transactions are settled on daily basis. The system of daily settlement in the futures market is called marking-to-market. The traders realize their gains or losses on the daily basis. The basic purpose is that the futures contract should be daily marked or settled & not at the end of its life.

Mechanics of Trading Futures Contracts

Futures Commission Merchants (FCM)

Exchanges
Floor Brokers Clearinghouse The Order Flow Liquidation or settling a futures position The performance bond (Margins) Various Types of Futures Orders

Futures Commission Merchants (FCM)

The FCM is a central institution in the futures industry, that performs functions similar to a brokerage house in the securities industry.

Futures traders first have to open an account at an FCM Futures traders with FCM accounts give their trading orders to an account executive employed at the FCM The FCM executives give customer orders to floor brokers to execute the orders on the floor of an exchange The FCM collects margin balance from the customers (traders), maintains customer money balance, and records and reports all trading activity of its customers FCMs are regulated by Commodity Futures Trading Commission (CFTC) under the Commodity Exchange Act (CEA).

Exchanges

In order to execute customer orders, FCMs transmit such orders to an exchange.

Exchanges are membership organizations whose members are either individuals or business organizations Membership is limited to a specified number of seats Members receive the right to trade on the floor of the exchange, without having to pay FCM commissions
Exchanges perform three functions: Provide and maintain a physical marketplace the floor Police and enforce financial and ethical standards Promote the business interests of members

Floor Brokers

Floor brokers take the responsibility for executing the orders to trade futures contracts that are accepted by FCMs.

Includes self-employed individual members of the exchange who act as agents for FCMs and other exchange members May trade customer accounts as well as their own accounts Dual trading Floor brokers are subject to CFTC regulations

The Clearing House

Every futures exchange has a clearing house associated with it which clears all transactions of that exchange. The clearing house regulates, monitors, and protects the clearing members. Exchange members provide daily reports of all futures trades to the clearing house, which matches shorts against longs and provide a daily reconciliation. The main task of clearing house is to keep track of all the transactions that take place during a day, so that it can calculate the net position of each its members. Collects security deposits (margins) from the members and customers.

Major Futures Clearing Organizations

Table 1.7 Major Futures Clearing Organizations
Clearinghouse The Clearing Corporation (CCorp) Chicago Mercantile Exchange Clearinghouse Kansas City Board of Trade Clearing Corporation Energy Clear Corporation MGE Clearinghouse NYMEX Clearinghouse New York Clearing Corporation The Options Clearing Corporation The London Clearinghouse Exempt Commercial Markets and OTC markets Sources: The CFTC web site, www.cftc.gov. Affiliated Exchanges US Futures Exchange and the Merchants Exchange of St. Louis Chicago Mercantile exchange With clearing link to CBOT Kansas City Board of Trade Exempt Commercial Markets Minneapolis Grain Exchange New York Mercantile Exchange New York Board of Trade OneChicago, NQLX, & option exchanges

The Order Flows: Floor Trading

Buyer/Seller: Place long/short orders to FCM

FCM: Receives orders, sends to Floor Broker

Floor Broker: Receives orders and takes to the floor Trading Pits: Orders executed by open Outcry Floor Broker: Confirms transaction to the FCM FCM: Confirms transaction to the buyer/seller Buyer/Seller: Has Long/Short position on the contract

Liquidating or Closing / Settling a Futures Position

Offsetting/Reversing Trade

The most common way of liquidating an open futures position. The initial buyer (long) liquidates his position by selling (short) an identical futures contract (same commodity and same delivery month). The initial seller (short) liquidates his position by buying (long) an identical futures contract (same commodity and same delivery month). The clearinghouse plays a vital role in facilitating settlement by offset. Offsetting entails only the usual brokerage costs. A form of physical delivery that may occur prior to contract maturity An EFP transaction involves the sale of a commodity off the exchange by the holder of the short contracts to the holder of long contracts, if they can identify each other and strike a deal.

Exchange of futures for Physicals (EFP)

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Table 1.4 The Reversing Trade
Party 1's Initial Position May 1 Bought 1 SEP contract for oats at 171 cents per bushel Party 1's Reversing Trade May 10 Sells 1 SEP contract for oats at 180 cents per bushel Party 2 Sold 1 SEP contract for oats at 171 cents per bushel Party 3 Buys 1 SEP oats contract at 180 cents per bushel

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Two traders agree to a simultaneous exchange of a cash commodity and futures contracts based on that cash commodity.
Table 1.5 An Exchange-for-Physicals Transaction
Before the EFP

Trader A Long 1 wheat futures Wants to acquire actual wheat

Trader B Short 1 wheat futures Owns wheat and wishes to sell EFP Transaction Trader A Trader B Agrees with Trader B to purchase Agrees with Trader A to sell wheat and wheat and cancel futures cancel futures Receives wheat; pays Trader B Delivers wheat; receives payment from Trader A Reports EFP to exchange; exchange a- Reports EFP to exchange; exchange djusts books to show that Trader A is adjusts books to show that Trader B is out of the market out of the market

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Physical Delivery
Most commodity futures contracts are written for completion of the futures contract through the physical delivery of a particular good.

Cash Settlement/delivery
Most financial futures contracts allow completion through cash settlement. In cash settlement, traders make payments at the expiration of the contract to settle any gains or losses, instead of making physical delivery.

Initial Margin or Performance Bond

Futures contracts require a performance bond (previously called margin). The requirements are not set as a percentage of contract value. Instead they are a function of the price volatility of the commodity.

An initial performance bond is a deposit to cover losses the trader may incur on a futures contract as it is marked-to-market. A maintenance performance bond is a minimum amount of money (a lesser amount than the initial performance bond) that must be maintained on deposit in a traders account. A call / variation performance bond is a demand for an additional deposit to bring a traders account up to the initial performance bond level.

Traders post the funds for performance bond with their FCMs.

Differences between Futures and Options Futures

1. 2.

Options
1. 2. 3.

3.

4.

5.

Parties have rights and obligations There is an initial margin payment There are also other margins There is daily settlement through marked to market Compulsory settlement

4.

5.

Option buyer has no obligation No margin is payable There is a payment of premium There is an exercise at a fixed period or within a fixed period There is no settlement, if the buyer does not exercise the option

Differences between Forward and Futures

Forward
1.

Futures
1. 2. 3. 4. 5.

2.
3. 4. 5. 6.

OTC Product Customized Terms Settlement at any time Delivery based contract Illiquid contract No Guaranteed Settlement No margin requirement No public knowledge

6.

7. 8.

7. 8.

Exchange traded Standardized terms Daily settlement Reversal of transactions Liquid contract Settlement guaranteed by Exchange Margin requirement Public knowledge

Measures specified by SEBI to protect the rights of investor in Derivatives Market

The measures specified by SEBI include: Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives. Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member.

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In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilized towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges. The Exchanges are required to set up arbitration and investor grievances Redressal mechanism operative from all the four areas / regions of the country.