Futures

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Objective
What are derivatives?

Forwards, futures, options

How to trade them?

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How margin account works for futures

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Alternativewaystobuyastock
Processhasthreecomponents

Fixingtheprice
Buyermakingpaymenttotheseller
Thesellertransferringownershipofthesharetotheseller

Alternativeways

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Outrightpurchase
Fullyleveragedpurchase
Prepaidforwardcontract
Forwardcontract
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The Nature of Derivatives

A derivative is an instrument whose value depends
on the values of other more basic underlying
variables
Example
Options
Swaps
Forward Contracts
Futures Contracts

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Derivatives Markets
Exchange Traded

standard products
trading floor or computer trading
virtually no credit risk

Over-the-Counter

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non-standard products
telephone market
some credit risk

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Forward Contracts
A forward contract is an agreement to buy or sell an asset
at a certain time in the future for a certain price (the
delivery price)

It can be contrasted with a spot contract which is an agreement to

buy or sell immediately

The contract is an over-the-counter (OTC) agreement

between 2 companies
The delivery price is usually chosen so that the initial
value of the contract is zero
No money changes hands when contract is first
negotiated and it is settled at maturity

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The Forward Price

The forward price for a contract is the delivery
price that would be applicable to the contract if
were negotiated today (i.e., it is the delivery
price that would make the contract worth
exactly zero)

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The forward price may be different for contracts of

different maturities

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Example
On August 20, 2006 a trader enters into an
agreement to buy 1 million in three months at an
exchange rate of 1.6196
This obligates the trader to pay $1,619,600 for 1
million on November 20, 2006
What are the possible outcomes?

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Profit from a
Long Forward Position
Profit

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Price of Underlying
at Maturity, ST

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Profit from a
Short Forward Position
Profit

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Price of Underlying
at Maturity, ST

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Futures
Futures - similar to forward but feature formalized and
standardized characteristics

Agreement to buy or sell an asset for a certain price at a certain time

Whereas a forward contract is traded OTC a futures contract is

traded on an exchange
Key difference in futures

Exchange traded
Specifications need to be defined:

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What can be delivered,

Where it can be delivered,
When it can be delivered

Settled daily
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Key Terms for Futures

Contracts

Futures price - agreed-upon price at maturity

Long position - agree to purchase
Short position - agree to sell
Profits on positions at maturity
Long = spot minus original futures price
Short = original futures price minus spot

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Types of Contracts

Agricultural commodities
Metals and minerals (including energy contracts)
Foreign currencies
Financial futures
Interest rate futures
Stock index futures

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Examples of Futures Contracts

Agreement to:
buy 100 oz. of gold @ US$1,250/oz. in
December (COMEX)
sell 62,500 @ 1.5000 US$/ in March
(CME)
sell 1,000 bbl. of oil @ US$110/bbl. in April
(NYMEX)

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Trading Mechanics
Clearinghouse - acts as a party to all buyers and sellers.
Obligated to deliver or supply delivery

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Trading Mechanics
Closing out positions

Reversing the trade

Take or make delivery

Delivery - Actual commodity of a certain grade with a delivery

location or for some contracts cash settlement

Most trades are reversed and do not involve actual

delivery

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Margin and Trading

Arrangements
Initial Margin - funds deposited to provide capital
to absorb losses
Marking to Market - each day the profits or losses
from the new futures price are reflected in the
account.
Maintenance or variation margin - an established
value below which a traders margin may not fall.

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Margin call - when the maintenance margin is reached,

broker will ask for additional margin funds
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Example of a Futures Trade

On June 5, An investor takes a long position in 2
December gold futures contracts on COMEX
division of the New York Mercantile Exchange
(NYMEX)

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contract size is 100 oz.

futures price is US$1250 /ounce
margin requirement is US$6000/contract (US$12,000 in total)
maintenance margin is US$4,500/contract (US$9,000 in total)

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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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If a contract is not closed out before maturity, it 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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Convergence of Futures to Spot

Futures
Price
Spot Price

Spot Price
Futures
Price

Time
(a)
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Time
(b)
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