CHAPTER 1

Futures Markets Introduction

In this chapter, we introduce futures markets and their key
players. This chapter is organized into the following
sections:
1. Forward Contracts Versus Futures Contracts
2. Institutions Facilitating Futures Trading
3. Structure of Futures Exchanges
4. Clearinghouses Role in Futures Markets
5. Types of Futures Contracts
6. The Social Function of Futures Markets
7. Futures Markets Regulatory Framework and Taxation

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Forward Contracts
A forward contract is an agreement between two parties
(counterparties) for the delivery of a physical asset (e.g., oil
or gold) at a certain time in the future for a certain price
that is fixed at the inception of the contract.
Forward contracts can be customized to accommodate any
commodity, in any quantity, for delivery at any point in the
future, at any place.

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Future Contracts
Futures contracts are highly uniform and well-specified
commitments for a carefully described good (quantity and
quality of the good) to be delivered at a certain time and
place (acceptable delivery date) and in a certain manner
(method for closing the contract) and the permissible price
fluctuations are specified (minimum and maximum daily
price changes).

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Forward Versus Futures

COMPARISON

FORWARD

FUTURES

Trade on organized exchanges

No

Yes

Use standardized contract terms

No

Yes

Use associate clearinghouses to

guarantee contract fulfillment

No

Yes

Require margin payments and daily

settlements

No

Yes

Close easily

No

Yes

Regulated by identifiable agencies

No

Yes

Any quantity

Yes

No

Any product

Yes

No

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Futures Contract Standardized Terms

1. Quantity
2. Quality
3. Expiration months
4. Delivery terms
5. Delivery differentials
6. Delivery dates
7. Minimum price fluctuation
8. Daily price limits
9. Trading days and hours

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Institutions Facilitating Futures Contract

Trading
There are two types of organizations that facilitate futures
trading:
Exchange
Exchanges are non-profit or for-profit organizations that
offer standardized futures contracts for physical
commodities, foreign currency and financial products.
Clearinghouse
A clearinghouse is agency associated with an exchange,
which settles trades and regulates delivery. Clearinghouses
guarantee the fulfillment of futures contract obligations by
all parties involved.

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The Organized Exchange

Not-for-Profit Organization Structure
Members hold exchange memberships or seats that allow
them to:
1. Trade on the exchange
2. Have a voice in the exchanges operation

For-Profit Organization Structure

Members receive shares or stocks.
Demutualize
Conversion of an exchange from not-for-profit to for-profit.

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Organized Exchange: Trading Systems

Futures contracts trade by two systems:
Open Outcry
Open outcry is a trading room where traders literally cry
out their bids to locate another trader who is willing to
trade with them.
Electronic Trading Platforms
Contracts are traded through electronic computer
networks. Electronic trading represents over 50% of futures
contracts trading.

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Organized Exchange: Trading Players

Speculator
A trader who enters the futures market in pursuit of profit,
accepting risk in the endeavor.
Hedger
A Trader who enters the futures market to reduce some
pre-existing risk exposure.
Broker
An Individual or firm acting as an intermediary by
conveying customers trade instructions. Account
executives or floor brokers are examples of brokers.

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Major Futures Exchange

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10

Clearinghouses
1. Guarantee that the traders will honor their obligations
(solves issues of trust).
2. Each trader has obligations only to the clearinghouse,
not to other traders.
3. Each exchange uses a futures clearinghouse.
4. Clearinghouses may be part of a futures exchange
(division), or a separate entity.
5. Due to 2000 CFMA, clearing arrangements vary across
industries.
6. Clearinghouses are perfectly hedged by maintaining
no futures market position of their own.

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The Function of Clearinghouses

in Futures Markets
Obligations without a clearinghouse

Buyer

Seller

Obligations with a clearinghouse

Buyer

Clearinghouse

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Seller

12

Major Futures Clearing Organizations

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13

Margin and Daily Settlement

Margin
A good-faith deposit (or performance bond) made by a
prospective trader with a broker. Margin can be posted in
cash, bank letter of credit or short-term U.S. Treasury
instruments.
Daily Settlement
Process by which traders are required to realize any losses
in cash immediately (marked-to-the-market). The losses
are usually deducted from the margin deposit.

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TYPES OF MARGIN
There are 3 types of margin:
1. Initial Margin
Deposit that a trader must make before trading any
futures.
2. Maintenance Margin
When margin reaches a minimum maintenance level,
the trader is required to bring the margin back to its
initial level. The maintenance margin is generally about
75% of the initial margin.
3. Variation Margin
Additional margin required to bring an account up to
the required level.

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Futures Market Obligations

Table 1.2 shows a typical trading situation.

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Futures Market Obligations

Based on Table 1.2, a trader purchases an oat Contract at
171 cents/ bushel at the close of day 0. The initial margin is
$1,400.
DAY 1
Contract closed @ 168 cents/bushel.
Loss: 3 cents/bushel or $150 .
Required maintenance margin: $1,100.
Initial Margin
(-) Daily Settlement
New Margin Balance

$1,400
150
$1,250

DAY 2
Loss: 4 cents/bushel or $200
Margin Balance
(-) Daily Settlement
New Margin Balance

$1,250
200
$1,050

Traders margin is below the maintenance margin. Margin

call occurs.
Variation Margin needed:
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$350
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Account Equity & Margin Requirements

Figure 1.3 illustrates the account equity and margin
requirements at different price levels.
Insert figure 1.3 here

Notice that the trader would have received two margin calls.

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Margin Cash Flows

Trader A

Clearing
member

Clearinghouse

Non-clearing
member

Trader B

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Closing a Futures Position

There are 3 ways to close a futures position:
1. Delivery or cash settlement
2. Offset or reversing trade
3. Exchange-for-physicals (EFP) or ex-pit transaction

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Closing a Futures Position: Delivery or

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

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Completion of Futures Contracts

Notice that very few contracts are delivered or settled

in cash.
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Delivery Differential
Sometimes the quantity and quality do not exactly match
the quantity and quality specified in the contract. In these
cases, shorts are given the option of delivering nonstandard commodities at non-standard delivery points.
However, they may have to pay a surcharge or delivery
differential relative to standard terms of the futures
contracts.
There are 2 types of delivery differential:
1. Quality Differentials
2. Location Differential

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Delivery Differential
Example: CBOT Corn Contract
Quality differential
Grade differential based on the standard par delivery grade.
Premium grade:
Premium grade price differential :
Price:

No. 1 Yellow
1.5cents/bushel
$3.015/bushel

Par grade:
Par grade price:

No. 2 Yellow
$3/bushel

Lower grade:
Lower grade Price differential :
Price:

No. 3 Yellow
1.5 cents/bushel or
$2.985/bushel

Location differential
Based relative to the standard delivery point or points specified in
the futures contracts.
Premium Location:

2 cents/bushel for
delivery at terminals
between Lockport
& Seneca, Illinois

Par Location:

Terminals between
Chicago & Burns
Harbor, Indiana
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Closing a Futures Position: Offset or

Reversing Trade
If you previously sold a futures contract, you can close out
your position by purchasing an identical futures contract.
The exchange will cancel out your two positions. Table 1.4
illustrates a reversing trade.

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Closing a Futures Position: Exchange-forPhysicals (EFP)

Two traders agree to a simultaneous exchange of a
cash commodity and futures contracts based on that
cash commodity. Table 1.5 illustrates a EFP transaction.

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Types of Futures Contracts

In this section, we will examine the following types of
futures contracts:
Physical Commodity
Foreign Currency
Interest-Earning Asset
Index (Stock Index)
Individual Stocks

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Future Contracts: Physical Commodity

Contracts on physical commodities include:
1. Agricultural contracts
2. Metallurgical contracts
3. Energy contracts

These commodities, excluding electricity, are physically

settled and are highly storable.
Trading varies from commodity to commodity.

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Future Contracts: Physical Commodity

AGRICULTURAL

METALLURGICAL

ENERGY

Grains - corn, oats,

rice, wheat

Gold

Heating oil

Silver

Crude oil

Aluminum

Natural gas

Platinum

Unleaded gasoline

Livestock - live
hogs, cattle
Forest - lumber and
plywood

Coal, propane

Textiles - cotton

Electricity

Foodstuffs - rice
cocoa, coffee,
orange juice, sugar

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Futures Contracts: Foreign Currency and

Interest-Earning Asset
Foreign Currency

Interest-Earning Assets

Australian dollar

Treasury bills

Brazilian Real

Notes

Russian Ruble

Bonds

New Zealand dollar

Eurodollar deposits

Swedish Krona

Interest rate swaps

South African Rand

Fed funds

Norwegian Krone

Municipal bonds

British pound
Canadian dollar
Japanese yen
Swiss franc
Mexican peso
Euro

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Futures Contracts: Index Based

Traders must fulfill their obligation by reversing trade or
cash settlement at the end of trading.
EXAMPLE OF INDEX BASED CONTRACTS
US Exchanges

Foreign Exchanges

Broad-Based stock indexes

Foreign Stock Indexes

S&P 500

British FTSE 100

Dow Jones Industrial Average

French CAC 40

Russell 2000

Dow Jones Euro Stoxx 50

NASDAQ 100

German DAX

Style-Based Indexes

Brazillian Bovespa stock

S&P Barra Growth

Japanese Nikkei 225

S&P Barra Value

Korean KOSPI 200

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Future Contracts on Individual Stocks

Permitted for trade in United States after the passage of
the Commodity Futures Modernization Act of 2000
(CFMA).

Also called single stock futures in the United States and

universal futures in Great Britain.

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Relative Importance of Commodity Types

INSERT FIGURE 1.5 HERE

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Changing Commodity Trading Volume

INSERT FIGURE 1.6 HERE

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Social Function of Futures Markets

Futures markets meet the needs of three groups of users:
1. Those who wish to discover information about future
prices of commodities
2. Those who wish to speculate
3. Those who wish to hedge

There are two main social functions of futures markets:

1. Price discovery
2. Hedging
Speculation is not regarded as a social function by itself, but it
may have socially useful by-products.

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Social Function of Futures Markets

PRICE DISCOVERY
Futures market information helps people make better
estimates of future prices.
Futures market information helps people with their
production or consumption decisions.
Example: silver Mine
HEDGING
Hedging is the prime social rationale for futures trading.
Hedgers have a pre-existing risk exposure that leads them
to use futures transactions as a substitute for a cash
market transaction. By doing so, they are able to reduce or
eliminate their risk.
Example: wheat Farmer

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Regulation of Futures Markets

CEA
Grain Futures Act of 1922, superseded by the Commodity
Exchange Act (CEA) of 1936.
The CEA was last amended by the Commodity Futures
Modernization Act of 2000 (CFMA).
CFMA
Promotes competition and innovation in futures markets.
Provides a predictable and calibrated regulatory structure
tailored to the product, the participant, and the trading
platform (the three Ps).

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The CFMAs Three Tiers of Regulation

First Tier- Agricultural Commodities
Futures on commodities (agricultural commodities) that
Congress judged to be potentially susceptible to
manipulation and that are offered to members of the public.
Second Tier- Exempt Futures Contracts
Futures contracts on metals and energy that are judged to
be less susceptible to manipulation.
Third Tier- Trade Principal to Principal Basis
Contracts on financial products (swaps) that are privatelynegotiated between large, sophisticated contract
counterparties.

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Futures Markets Levels of Regulation

(Market Regulators)
1. Brokers
2. Exchanges and clearinghouses
3. National Futures Association (NFA), industry selfregulatory body
4. Commodity Futures Trading Commission (CFTC),
federal governmental agency

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Market Regulators: Brokers

The Broker is responsible for:
1. Knowing the customer's position and intentions.
2. Ensuring that the customer does not disrupt the market or
place the system in jeopardy.
3. Keeping the customer's trading activity in line with
industry regulations and legal restrictions.

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Market Regulators: Exchange &

Clearinghouses
Futures exchanges and clearinghouses formulate and
enforce rules to:
1. Prohibit fraud
2. Prohibit dishonorable conduct
3. Prevent defaulting on contract obligations

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Abusive Trading Practices

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Market Regulators: National Futures

Association (NFA)
The NFA seeks to prevent fraudulent and manipulative acts
by:
1. Screening and test applicants for registration.
2. Requiring members who handle customer funds to
maintain adequate capital.
3. Requiring members to keep accurate trading records.

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Market Regulators: Commodity Futures Trading

Commission (CFTC)
CFTC protects market participants from manipulation,
abusive trading practices, and fraud by enforcing
regulatory oversight of:
1. Futures exchanges
2. Futures clearinghouses
3. NFA

The heart of the CFTCs market surveillance is its largetrader electronic reporting system. This reporting system
helps identify potential concentrations of market power
within a market and to enforce speculative position limits.

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