Topic 2

Mechanics of Futures
Markets

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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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Specification of Future Contract
The asset (what kind of asset to be traded,
eg. commodity, precious metal etc…)
Contract size (e.g. 30 million tonnes of crude
palm oil per contract)
Delivery arrangements (place is determined
by exchange to trade asset)
Delivery months (maturity of contract)
Price quotes (delivery/futures prices of asset)
Price limits and position limits
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Convergence of Futures to Spot (Figure 2.1)

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (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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Some Terminology of Margin
Margin account
Initial margin (amount of money you must
deposit at the beginning.)
Variation margin (daily flow of funds between
traders to reflect gains and losses.)
Maintenance margin (minimum amount that
traders must have in margin account.)

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Margin Cash Flows
A retail trader has to bring the balance in the margin
account up to the initial margin when it falls below the
maintenance margin level
A member of the exchange clearing house only has
an initial margin and is required to maintain the
balance in its account at that level every day.
These daily margin cash flows are referred to as
variation margin
A member of the exchange is also required to
contribute to a default fund
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Example of a Futures Trade
A retail trader takes a long position in 2
December gold futures contracts on June
5
contract size is 100 oz.
futures price is US$1,750
initial margin requirement is
US$6,000/contract (US$12,000 in total)
maintenance margin is US$4,500/contract
(US$9,000 in total)
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A Possible Outcome (Table 2.1)
Da Trade Settle Daily Cumul. Margin Margin
y Price Price Gain Gain Balance Call
($) ($) ($) ($) ($) ($)
1 1,750.0 12,000
0
1 1,741.0 −1,800 − 1,800 10,200
0
2 1,738.3 −540 −2,340 9,660
0
….. ….. ….. ….. ……
6 1,736.2 −780 −2,760 9,240
0
7 1,729.9 −1,260 −4,020 7,980 4,020
0
8 1,730.8
Options, 180 Derivatives,
Futures, and Other −3,840 12,180
11th Edition,
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Margin Cash Flows When Futures
Price Increases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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Margin Cash Flows When Futures Price
Decreases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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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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Crude Oil Trading on May 21,
2020 (Table 2.2)
Open High Low Prior Last Change Volume
Settl Trade
e
Jul 2020 33.53 34.6 33.26 33.49 33.96 +0.47 356,081
6
Aug 33.93 35.0 33.78 33.94 34.40 +0.46 118,534
2020 5
Dec 35.18 36.0 35.06 35.23 35.76 +0.53 78,825
2020 8
Dec 37.87 38.4 37.78 37.91 38.15 +0.24 22,542
2021 9
Dec 40.30 40.7 39.92 40.27 40.24 −0.03 3,732
2022 4
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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

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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 (can be executed only at this price
or at more favorable to the trader.)
Stop-loss (can be executed only at the
best available price once a bid or offer is
made at that particular price or a less
favorable)
Stop-limit (combination of limit and stop-
loss)
Other types of orders: market-if touched,
discretionary, time© John of day,
C. Hull 2021 open and fill or
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Regulation of Futures
In the US, the regulation of futures
markets is primarily the responsibility of
the Commodity Futures and Trading
Commission (CFTC)
Regulators try to protect the public
interest and prevent questionable trading
practices

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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 attempt to achieve

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Example:
Consider a company with December year end. In September
2021 buys a March 2022 gold futures contract and closes out
the position at the end of February 2022. Given that:
1. Future price of gold is $1230 per ounce.
2. Spot price of gold at the end of 2021 is $1240 per ounce.
3. Spot price of gold when contract closes out is $1243 per
ounce.
Each contract for delivery is 200 ounce.

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Continue…
If the contract does not qualify as a hedge,
thus:
a.) the gain for account purpose: 200 x (1,240-
1,230) = $2,000 in 2021.
b.) and, 200 x (1,243-1,240) = $600 in 2022.
If the company is hedging the purchase of 200
ounce of gold in February 2022, the entire gain
of $2,600 [$2,000+$600] is realised in 2022 for
accounting recording purpose.

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Forward Contracts vs Futures Contracts
(Table 2.3)

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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 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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OTC Derivatives Transactions:
Bilateral Clearing vs Central Clearing

CC
CCP
CC
CP

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