Mechanics of Futures Markets

After completing this reading, you should be able to:

  • Define and describe the key features of a futures contract, including the asset, the contract price and size, delivery, and limits.
  • Explain the convergence of futures and spot prices.
  • Describe the rationale for margin requirements and explain how they work.
  • Describe the role of a clearinghouse in futures and over-the-counter market transactions.
  • Describe the role of central counterparties (CCPs) and distinguish between bilateral and centralized clearing.
  • Describe the role of collateralization in the over-the-counter market and compare it to the margining system.
  • Identify the differences between a normal and inverted futures market.
  • Explain the different market quotes.
  • Describe the mechanics of the delivery process and contrast it with cash settlement.
  • Evaluate the impact of different trading order types.
  • Compare and contrast forward and futures contracts.

The Key Features of a Futures Contract

A futures contract is a standardized, exchange-tradable obligation to buy or sell a certain amount of an underlying good at a specified price, on a specified date.

Key Features:

  • Exchange-tradable: Unlike forwards which trade on OTC markets, futures contracts are traded on an organized exchange with a designated physical location.
  • Standardization: With respect to forward contracts, specific details about quality to be delivered, price, and delivery date are subjects of negotiation between the buyer and the seller. In futures contracts, however, the choice of expiry dates is limited, and trades have fixed sizes. This standardization paves the way for an active secondary market where trades can be executed. However, perhaps the most pronounced benefit is increased liquidity.
  • Marking to market: Since the clearinghouse must monitor the credit risk between the buyer and the seller, it performs daily marking to market. This is the settlement of the gains and losses on the contract on a daily basis. It avoids the accumulation of large losses over time, something that can lead to a default by one of the parties.
  • Margins: Daily settlements may not provide a buffer strong enough to avoid future losses. For this reason, each party is required to post collateral that can be seized in the event of default. The initial margin must be posted when initiating the contract. If the equity in the account falls below the maintenance margin, the relevant party receives a margin call– a requirement to provide additional funds to restore the margin account to the initial level.
  • Clearinghouse: The clearinghouse is an interposed party between the buyer and the seller which ensures the performance of the contract. In essence, futures contracts have no credit risk. Each exchange has a clearinghouse. The clearinghouse splits each trade and acts as the opposite side of each position. It’s the buyer to every seller and seller to every buyer. In other words, there is no direct contact between the short and long parties. It’s the clearinghouse that makes margin calls whenever the need arises. In OTC markets, clearinghouses play a similar role.
  • Position limits: The number of contracts that a speculator can hold is capped at a certain value by the exchange. The aim is to prevent speculators from having an undue influence in the market.

A long exposure in a futures contract means the holder of the position is obliged to buy the underlying instrument at the contract price at expiry. The holder will make a profit if the price of the instrument goes up. Conversely, they will make a loss if the price goes down. The long futures position can be entered by a speculator who expects the price to rise.

A short exposure in a futures contract means the holder of the position is obliged to sell the underlying instrument at the contract price at expiry. The holder will make a profit if the price of the instrument goes down. Conversely, they will make a loss if the price of the underlying rises dramatically.

How Futures Margin Requirements work

Consider an investor who enters in a long \(gold\) futures contract at \($300\). Each contract is worth \(100 \quad troy \quad ounces\) (with a market value of \($30,000\)). The initial margin required is \($5,000\) while the maintenance margin is \($3,000\).

Day 0: margin account balance = \($5,000\)

Day 1: The price moves to \($290\). Hence, the investor makes a loss of \($1,000\left( =$10×100 \right) \). The ending balance of margin account is now \($4,000\). Since this is above the maintenance of \($3,000\), no funds need to be added to the account, i.e., no margin call.

Day 2: The price moves further down to \($278\). The investor thus makes a further loss of \($1,200\left( =$12×100 \right)\) . This leaves the margin account with just \($2,800\left( =$4,000-$1,200 \right) \). That’s below the maintenance margin, and therefore the investor will receive a margin call requiring them to deposit some \($2,200\) into the margin account to bring it up to the initial margin required. This amount (required to bring the account back to the initial margin) is called the variation margin.

Note: If the price rises on any given day, the long investor will make a profit, and the short will make a loss. Margin calls will always be made to the party that has made a loss, provided the maintenance margin is breached.

Convergence of Futures and Spot Prices

The spot price is the current market price at which an instrument or commodity is bought or sold for immediate payment and delivery. The futures price, on the other hand, is the price of an instrument/commodity today for delivery at some point in the future, called the maturity date. The difference between the two is called the basis.

$$ Basis=spot\quad price-futures\quad price $$

As the maturity date nears, the basis converges toward zero, i.e., the spot price tends towards the futures price. On the actual maturity date, the two rates must be equal as long as no arbitrage opportunities exist. At maturity, the futures price becomes the current market price, which is actually the definition of the spot price.

frm-convergence-futures-spot-price

Collateralization in OTC Markets

OTC markets have more credit risk compared to organized exchanges because the other party in an OTC contract could default on its payments. One of the approaches used to mitigate this risk is collateralization.

In the context of OTC trading, collateral is the set of assets – securities or cash – given as security by both parties in a contract to hedge against credit risk. In case of default, the collateral posted by the defaulting party is used to compensate the other party for the financial loss suffered.

Apart from cash, other acceptable collateral securities include:

  • Negotiable securities such as government bonds and AAA-rated corporate bonds
  • Performance bonds – documents issued by a bank or insurance company committing to cover the debts of a third party in case of failure, usually up to a maximum amount.

To avoid complications, collateral securities that are near maturity or those with anticipated coupons during the lifetime of the hedged transaction are not used.

Any loss is settled using the collateral at the end of the day. This closely resembles margining in organized exchanges where the futures trader is required to deposit “restoration” funds once the margin account drops below the maintenance level.

In recent years, OTC markets have increasingly embraced the use of clearinghouses in trading:

  • It allows for automatic posting of collateral
  • It reduces credit risk
  • It results in increased transparency in the market

Normal vs Inverted Futures Markets

A normal futures market, also known as a Contango market, means that futures contracts are trading at a premium to the spot price. For example, suppose the price of a barrel of \(crude oil\) today is \($50\) per barrel, but the price for delivery in three months is \($53\): the market would be in Contango. On the other hand, if crude oil is trading at \($50\) per barrel for delivery right now, and the three-month contract is trading at \($45\) per barrel, then that market would be said to be inverted ( backwardation).

A normal futures curve will show a rising slope as the prices of futures contracts rise over time. An inverted futures curve will show a falling slope as the prices of futures contracts fall over time.

frm-part-1-contango-vs-backwardation

Terminating a Futures Contract

Traders with short or long positions in futures contracts can terminate them in one of four ways:

  1. DeliveryA short terminates the position by delivering the goods, and the long pays the contract price. This is called delivery. In each exchange, there are certain conditions that must be met before a delivery can be executed. Such conditions are contained in the “intention to deliver” file. This method is, however, hardly used.
  2. CloseoutThis is a scenario where the futures trader closes out the contract even before the expiry. If a trader has a long position, they will take an equivalent short-term position in the same contract, and both positions will offset each other. Similarly, if a trader has a short position, they will take an equivalent long-term position in the same contract, and both positions will offset each other.
  3. Cash settlementIn this scenario, a trader just leaves his position open, and when the contract expires, his margin account will be marked-to-market for P&L on the final day of the contract.
  4. Exchange-for-physicalsIn this case, a trader finds another trader who has an opposite position in the same futures contract and delivers the underlying assets to them. This happens outside the designated trading floor, but the traders are obliged to inform the clearinghouse of the transaction immediately afterward.

Different Trading Order Types

A trader uses a futures order or options order to tell his broker exactly what to buy or sell, when to do it, and at what price. There are several order types:

  1. Market orderA market order is executed at the best possible price. It instructs the executing broker to buy or sell futures contracts immediately at the market price, the best possible price.
  2. Limit orderLimit orders are orders to buy or sell away from the current market price. A limit buy order is placed below the current market price while a limit sell order is placed above the current market price.
  3. Stop loss orderA stop loss order has three main uses:
    • To cut short (minimize a loss) on a long/short position
    • To safeguard a profit on a long/short position
    • To initiate a new long/short position.

Questions

Question 1

An investor enters into a short position in a \(coffee\) futures contract at \($500\). Each futures contract controls \(100 \quad bags\). The initial margin is \($10,200\), and the maintenance margin is \($9,100\). At the close of trading on the first day, the futures price rises to \($510\). At the close of business on the second day, the price stands at \($515\). Determine the amount of variation margin required at the close of business on the second day.

  1. $0
  2. $500
  3. $1,500
  4. $1,000

The correct answer is C.

A short will make a profit if the price of the instrument goes down. Conversely, they will make a loss if the price of the underlying rises.

Day 0: margin account balance = \($10,200\)

Day 1: The price moves up to \($510\). Hence, the investor makes a loss of \($1,000\left( =$10×100 \right) \). The ending balance of margin account is now \($9,200\). Since this is above the maintenance of \($9,100\) no funds need to be added to the account, i.e., no margin call.

Day 2: The price moves further up to \($515\). The investor thus makes a further loss of \($500\left( =$5×100 \right) \). This leaves the margin account with just \($8,700\left( =$9,200-$500 \right) \). That’s below the maintenance margin, and therefore the investor will receive a margin call requiring them to deposit some \($1,500\) into the margin account to bring it up to the initial margin required

Question 2

The price of a six-month futures contract on an equity index is currently at \(USD \quad 1,215\). The underlying index stocks are valued at \(USD \quad 1,200\). The stocks also pay dividends at a continuously compounded rate of \(3\%\). Given that the continuously compounded risk-free rate is \(5\%\), determine the potential arbitrage profit per contract.

  1. $3
  2. $12
  3. $15
  4. $0

The correct answer is A.

The fair value of the futures contract, \(F\), is given by:

$$ F=S\times \frac { e^{-{ r }^{ \ast }\times T} }{ e^{-r \times T} } $$

Where:

\(S\) = current value of the underlying

\({ r }^{ \ast }\)=continuously compounded rate of dividends

\(r\)=continuously compounded riskfree rate

\(T\)=time to maturity=\(\frac { 6 }{ 12 } \)

$$ F=1200\times \frac { e^{ -0.03\times 0.5} }{ e^{-0.05\times 0.5} } $$

$$ =1,212 $$

Thus, the actual futures price is too high by \($3\left( =1,215–$1,212 \right) \).


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