Chapter 2 Mechanics of Futures Markets. Options, Futures, and Other Derivatives, 8th Edition, Copyright John C. Hull

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1 Chapter 2 Mechanics of Futures Markets Copyright John C. Hull

2 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 (mark-to-market) 2

3 Convergence of Futures to Spot (Figure 2.1, page 26) Spot Price Futures Price Futures Price Spot Price (a) Time (b) Time 3

4 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 4

5 Example of a Futures Trade (page 27-29) An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 oz. futures price is US$1250 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) 5

6 A Possible Outcome (Table 2.1, page 28) Day Trade Price ($) Settle Price ($) Daily Gain ($) Cumul. Gain ($) Margin Balance ($) 1 1, , , ,800 1,800 10, , ,340 9, , ,760 9,240 Margin Call ($) 7 1, ,260 4,020 7,980 4, , ,840 12, , ,620 15,180 6

7 Margin Cash Flows When Futures Price Increases Clearing House Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader 7

8 Margin Cash Flows When Futures Price Decreases Clearing House Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader 8

9 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 9

10 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 10

11 Crude Oil Trading on May 26, 2010 Open High Low Settle Change Volume Open Int Jul , ,902 Aug , ,305 Dec , ,033 Dec , ,674 Dec ,258 70,126 11

12 Collateralization in OTC Markets It is becoming increasingly common for transactions to be collateralized in OTC markets Consider transactions between companies A and B These might be be governed by an ISDA Master agreement with a credit support annex (CSA) The CSA might require A to post collateral with B equal to the value to B of its outstanding transactions with B when this value is positive. 12

13 Collateralization in OTC Markets continued If A defaults, B is entitled to take possession of the collateral The transactions are not settled daily and interest is paid on cash collateral See Business Snapshot 2.2 for how collateralization affected Long Term Capital Management when there was a flight to quality in

14 Clearing Houses and OTC Markets Traditionally transactions have been cleared bilaterally in OTC markets Following the crisis, it has been a requirement for most standardized OTC derivatives transactions to be cleared centrally through clearing houses. 14

15 Bilateral Clearing vs Central Clearing House 15

16 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. 16

17 Questions When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest? 17

18 Types of Orders Limit Stop-loss Stop-limit Market if touched Discretionary Time of day Open (GTC) Fill or kill Copyright John C. Hull

19 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 19

20 Forward Contracts vs Futures Contracts (Table 2.3, page 41) FORWARDS Private contract between 2 parties Non-standard contract Usually 1 specified delivery date Settled at end of contract Delivery or final cash settlement usually occurs Some credit risk FUTURES Exchange traded Standard contract Range of delivery dates Settled daily Contract usually closed out prior to maturity Virtually no credit risk 20

21 Daily Settlement Revisited For the sake of simplicity assume that δ is the risk-free interest rate for one day. Consider the days 1,2,,n, where n is the maturity day of the futures contract. Assume that the risk-free interest rate is constant up to time n. This means a risk-free investment of US$1 yields US$(1+δ) t after t days (t=1,2,,n). 21

22 Daily Settlement Revisited Daily settlement means that a long position in a futures contract leads to the cash flow F1 F 0 after the first day. After the second day the cash flow is F2 F 1, etc., up to time n. The broker pays interest on the margin account! 22

23 Daily Settlement Revisited The first cash flow leads to at time to maturity. The second cash flow yields at time n, etc. ( ) n 1 F F ( ) ( ) n 2 F F ( ) Hence, at time to maturity the futures contract does not provide exactly the cash flow F n F 0. 23

24 Daily Settlement Revisited How can the futures contract instead be used to produce n F n F Sn S (1 0 = 0 + ) at time to maturity? Note that the latter is just the cash flow of the corresponding forward contract at time n! The adequate strategy is referred to as tailing adjustment. 24

25 Tailing Adjustment Tailing adjustment means to hold (1+δ) -(n-t-1) instead of 1 futures contract at time t=0,,n-1. With tailing adjustment the first cash flow yields n 1 ( n 1) F F ( 1+ ) (1 + = F F ( ) 1 0 ) 1 0 at time to maturity, etc. Now, after n days the cumulated cash flow is indeed F n F n 1 + F n 1... F = F F = S S ( n 0 n ) n. 25

26 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. 26

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