By Gopal Bhatta March 2009 2 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.2 Futures Contracts Available on a wide range of underlyings Exchange traded Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered Settled daily 3 Futures Contract A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts,future contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. As two parties to the contract do not necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored. 4 Background of Mechanics of Futures Markets Future contracts are now traded actively all over the world. The largest Future exchanges in US CBOT- www.cbot.com Chicago Mercantile Exchange- www.cme.com IN EUROPE London International Financial Futures and Options Exchange- www.liffe.com Eurex- www.eurexchange.com Euronext- www.euronext.com Others Tokyo International Financial Futures Exchange- www.tiffe.com
5 The Specification of a Futures Contract While developing a new contract, the exchange must specify in some detail: The asset The contract size (exactly how much of the asset will be delivered under one contract) Where delivery will be made When delivery will be made
6 The Asset When the asset is a commodity, there may be a quite variation in the quality of what is available in a market place. The New York Cotton Exchange has specified the asset in its orange juice futures contract as: US grade A, with Brix value of not less than 57 degrees, having a Brix value to acid ratio of not less than13 to 1 nor more than 19 to 1, with factors of colors and flavor each scoring 37 points or higher and 19 for defects, with a minimum score 94. The financial assets in futures contract are generally well defined and unambiguous. 7 The Contract Size The contract size specifies the amount of asset that has to be delivered under one contract. If contract size is too large, investors who wish to take small speculative position will be unable to use the exchange. If contract size is too small, trading may be expensive, as there is a cost associated with each contract. 8 The Contract Size Some examples: Corn: 5000 bushel (CBT, cents/bushel) Soybean Meal: 100 tons (CBT, $/ton) Soybean oil: 60,000 lbs (CBT, cents/lbs) Cattle-Feeder: 50,000 lbs (CME, cents/lbs) Gold: 100 troy oz, (CMX, $/troy oz) Japanese yen: 12.5 million yen (CME, $ per yen) British pound: 62,500 pound (CME, $/pound) DJIA: $10 times average (CBOT) S&P 500 index ($250 times average) 9 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.9 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 10 Delivery Arrangements The where delivery will be made must be specified by the exchange. An example : CMEs random length lumber contract. The delivery location is specified as: On track and shall either be unitized in double door boxcars or, at no additional cost to buyer, each unit shall be individually paper-wrapped and loaded on flatcars. par deliver of hem-fir in California, Idaho, Montana, Nevada, Oregon, and Washington, and in the province of British Columbia. 11 Delivery Months A futures contract is referred to by its delivery month. The exchange must specify the precise period during the month when delivery can be made. For many futures contracts, the delivery period is the whole month. The exchange also specifies the last day on which trading can take place for a given contract. 12 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.12 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 1 day 13 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.13 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 14 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.14 Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 oz. futures price is US$400 margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total) 15 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.15 A Possible Outcome Table 2.1, Page 27
Daily Cumulative Margin Futures Gain Gain Account Margin Price (Loss) (Loss) Balance Call Day (US$) (US$) (US$) (US$) (US$) 400.00 4,000 5-Jun 397.00 (600) (600) 3,400 0 . . . . . . . . . . . . . . . . . . 13-Jun 393.30 (420) (1,340) 2,660 1,340 . . . . . . . . . . . . . . . . . 19-Jun 387.00 (1,140) (2,600) 2,740 1,260 . . . . . . . . . . . . . . . . . . 26-Jun 392.30 260 (1,540) 5,060 0 + = 4,000 3,000 + = 4,000 < 16 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.16 Other 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 17 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.17 Convergence of Futures to Spot (Figure 2.1, page 25)
Time Time (a) (b) Futures Price Futures Price Spot Price Spot Price 18 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.18 Regulation of Futures Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups 19 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.19 Accounting & Tax It is logical to recognize hedging profits (losses) at the same time as the losses (profits) on the item being hedged It is logical to recognize profits and losses from speculation 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 attempts to achieve 20 Introduction to Forward Contract A forward contract gives the owner the right and obligation to buy a specified asset on a specified date at a specified price. The seller of the contract has the right and obligation to sell the asset on the date for that specified price. At delivery, ownership of good is transferred and payment is made. The agreement is made today to exchange cash for a good or service at a later date. In a spot transaction, one party pays for a good or service, and immediately receives that good or service. 21 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.21 Forward Contracts A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price There is no daily settlement (unless a collateralization agreement requires it). At the end of the life of the contract one party buys the asset for the agreed price from the other party
22 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.22 Profit from a Long Forward or Futures Position Profit Price of Underlying at Maturity 23 Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.23 Profit from a Short Forward or Futures Position Profit Price of Underlying at Maturity 24 Futures vs. Forwards Futures are standardized, Forwards custom made contracts. Futures are more liquid than forwards. Counter party risk is higher in forwards than in futures. Most futures contract are eventually offset where as most forward contract terminate with delivery of the specific good. While profits or losses on forward contracts are realized only on the delivery day, the change in the value of futures contract results in a cash flow every day. Less default risk with futures contract.
25 Forward Contracts vs Futures Contracts (Table 2.3, page 39) Forward Futures Private contract between two parties Traded on an exchange Not standardized Standardized Usually one specified delivery date Range of delivery dates Settled at end of contract Settled daily Delivery or final settlement usual Usually closed out prior to maturity Some credit risk Virtually no credit risk Fundamentals of Futures and Options Markets, 6 th Edition, Copyright John C. Hull 2007 2.25 26 Forwards:General Concepts Two parties: Buyer: agrees to buy something in future, Long position Seller: Obligation to sell something in future, Short position Delivery date The terms of the contract are agreed upon today, and delivery and payment take place in the future, what is called delivery date, or settlement date or Maturity date. The buyer agreed to take delivery and seller agreed to make delivery. 27 Forwards:General Concepts (2) Money rarely changes hands when a forward contract is originated. However, one or both of the parties may demand good faith money to serve as collateral that backs up the obligations stated in the contract. Payment from the buyer of the forward contract to the seller is generally made only upon the delivery of the good. 28 Forwards:General Concepts (3) Most business transactions are actually forward transactions. A firm might order 10,000 widgets from another firm. The price is agreed upon today. No cash flows occur today. The widgets will be delivered one month hence. Payment is not made until after the widgets have been received. For all practical purposes, this is a forward contract. 29 Forwards:General Concepts (4) The failure of a party to do what has been agreed to, as stated in the contract, is known as default. On the day that a forward contract is originated, both parties face possible default risk: the future uncertainty concerning the other parties ability and/or willingness to fulfill the terms of the contract. Penalties for failing to fulfill the terms of forward contracts vary, however, in business default is serious matter that will likely to lead to legal action. 30 Forwards:General Concepts (5) Forward price is the specified price in forward contract to be paid in future specified date. It differ from spot price which is today's price for delivery. A fair forward price will result in a forward contract that has no value when it is originated. The equilibrium forward price is a fair price in the sense that the demand for forward contracts equals the supply of forward contracts at that forward price. The value of a forward contract at that fair forward price is zero.
31 Forwards:General Concepts (6) Forward contracts, like all derivatives, are zero sum games. Whatever one party gains, the other party must lose. The profit and losses associated with forward contracts are typically realized at delivery. Before delivery, as forward prices for delivery on the settlement date of the original contract fluctuate, each party could experience unrealized gains and losses. 32 Forwards:General Concepts (7) Let us define the following: origination date of the forward contract = time 0 Delivery date of the forward contract = time t forward price on origination date of the forward contract = F(0,T) the spot price on the deliver date = S(T) The actual profit or loss for the party that is long the forward contract is then S(T) F(0,T) per unit of the good under contract. The actual profit or loss for the party that is short the forward contract is the same amount, but the opposite sign: F(0,T) - S(T). Many forward contracts are cash settled. No delivery takes place on the settlement date. 33 Forwards:General Concepts (8) It was stated that when a forward contract is originated, it has no value. At subsequent times, it will almost surely have positive value for one party and negative value for the other party. When a forward contract becomes an asset (has positive value) for one party, that party will become concerned about the default risk or performance or credit risk of counter party. At a point in time only one party, the one for which the forward contract is an asset, will worry about current default risk. 34
35 Convergence of Futures Price to Spot Price As the delivery period for a futures contract is approached, the futures price converges to the spot price of the underlying asset When the delivery period is reached, the futures price equals or is very close to- the spot price. If futures price is above or below the spot price, there exist an arbitrage opportunity. 36 The Clearing House Each futures exchange has an associated clearing house that becomes the sellers buyer and the buyers seller as soon as a trade is concluded. When investors (long and short trader) reach in their agreements though their brokers in exchange, the clearing house will immediately step in and break the transaction apart. The clearing house is in potentially risky position if nothing regarding the margin requirements are done. 37 Initial Margin In order to buy and sell futures contract, an investor must open a futures account with a brokerage firm. Whenever a futures contract is signed, both buyer and seller are required to post initial margin, i.e.make security deposits that are intended to guarantee that will in fact be able to fulfill their obligations. the amount of this margin is roughly 5-15% of the total purchase price this deposit can be made in the form of either cash or cash equivalents, or a bank line of credit, and it forms the equity in the account on the first day. Initial margin does not provide complete protection. 38 Marking to Market The process of adjusting the equity in an investors account in order to reflect the change in the settlement price of the futures contract is known as Marking to market. As a part of marking to market clearing house every day replaces each existing futures contract with a new one that has as the purchase price the settlement price as reported in the financial press. The equity in buyers or sellers account is initial margin deposit plus the sum of all daily gains less losses on open positions in futures. As the amount of gains (or losses) changes every day, the amount of equity changes every day. 39 Marking to Market (2) An Example; A July wheat contract future for 5000 bushels at $5 per bushel cost $20,000. Initial margin is $1000. B is buyer and S is seller. In day 2, the settlement price of July wheat is $4.10. B gains $500 and S lost $500 on day 2. S has the equity of $500 and B has equity of $1500 in day 2. In day 3, the settlement price of July wheat had fallen to $3.95. B account dropped to $750 and Ss equity has risen to $1,250. 40 Maintenance Margin The investor must keep the accounts equity equal to or greater than a certain percentage of the amount deposited as initial margin (roughly > or =65% of initial margin). If this requirement is not made, the investor will receive a margin call from his or her broker. The call is a request for an additional deposit of cash known as variation margin to bring the equity up to the initial margin level. If the investor does not respond , then the broker will close out the investors position by entering a reversing trade in the in the investors account.
41 Closing Out positions The vast majority of futures contracts do not lead to delivery. The reason is that most traders choose to close out their positions prior to the delivery period specified in the contract. Closing out a position means entering in to the opposite type of trade from the original one. Once the reversing trade has been made, the trader will be able to withdraw money from his equity account. Delivery is so unusual that traders sometime forget how the delivery process works. 42