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

Chapter 1 1
 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.

Chapter 1 2
 EXAMPLE: St. Bernard Puppy
Counterparties: Buyers and Seller

Asset/Commodity: St. Bernard Pup

Delivery/Payment Time: 6 weeks

Priced Fixed: $400

Buyer: Dog Fancier has a

long position

Seller: Breeder has a short

position

Trading Volume: Occurs when one

trader buys &
another sells

Open Interest: Number of open

contracts obligated
for delivery

If the dog owner had completed similar contracts for six

different dogs, the open interest would be 6.

Chapter 1 3
 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).

Chapter 1 4
 Forward Versus Futures

COMPARISON FORWARD FUTURES

Trade on organized exchanges No Yes

Use standardized contract terms No Yes

Use associate clearinghouses to

No Yes
guarantee contract fulfillment

Require margin payments and daily

No Yes
settlements

Close easily No Yes

Regulated by identifiable agencies No Yes

Any quantity Yes No

Any product Yes No

Chapter 1 5
 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

Chapter 1 6
 CBOT Wheat Futures Contract

Quantity: 5,000 bushels per contract.

Quality: No. 2 Soft Red, No. 2 Hard Red Winter
No. 2 Dark Northern Spring, or No. 1
Northern Spring.
Expiration: July, September, December, March, &
May.
Delivery Terms: Wheat must be delivered at a “regular”
or approved warehouse (e.g.,
warehouses located Chicago Switching
District).
Delivery: Any business days in the delivery month.
Payment: Seller received payment and delivers a
warehouse receipt to the buyer.
Price Fluctuation: 1/4 cent per bushel.
Daily Price Limit: Trading price on a given day cannot
differ from the preceding day's closing
price by more than 30
cents/bushel ($1,500/contract).
Trading Days: Wheat trades from 9:30 a.m. to 1:15
p.m. Chicago time.
Chapter 1 7
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.

Chapter 1 8
 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 exchange’s operation

For-Profit Organization Structure

Members receive shares or stocks.

Demutualize

Conversion of an exchange from not-for-profit to for-profit.

Chapter 1 9
 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.

Chapter 1 10
 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.

Chapter 1 11
 Major Futures Exchange

Table 1.6
Major Futures Exchanges in the World for 2003

EXCHANGE 2003 Volume Top 20 %

(Futures Only) Volume
Eurex (Germany) 668,650,028 24.55
Chicago Mercantile Exchange (USA) 530,989,007 19.49
Chicago Board of Trade (USA) 373,,669,290 13.72
Euronext-Liffe (Netherlands) 273,121,004 10.03
Mexican Derivatives Exchange (Mexico) 173,820,944 6.38
Bolsa de Mercadorias e Futuros (Brazil) 113,895,061 4.18
New York Mercantile Exchange (USA) 111,789,658 4.10
Tokyo Commodity Exchange (Japan) 87,252,219 3.20
London Metals Exchange (UK). 68,570,154 2.52
Korea Stock Exchange (South Korea) 62,204,783 2.28
Sydney Futures Exchange (Australia) 41,831,862 1.54
National Stock Exchange of India (India) 36,141,561 1.33
SIMEX (Singapore) 35,356,776 1.30
International Petroleum Exchange (UK) 33,258,385 1.22
OM Stockholm (Sweden) 22,667,198 .83
Tokyo Grain Exchange (Japan) 21,084,727 .77
New York Board of Trade (USA) 18,822,048 .69
Bourse de Montreal (Canada) 17,682,999 .65
MEFF Renta Variable (Spain) 17,109,363 .63
Tokyo Stock Exchange (Japan) 15,965,175 .59

Total Top 20 2003 Futures Volume 2,723,882,242 100%

Source: Futures Industry Association.

Chapter 1 12
 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.

Chapter 1 13
 The Function of Clearinghouses
in Futures Markets

Obligations without a clearinghouse

Buyer Seller

Obligations with a clearinghouse

Clearing-
Buyer Seller
house

Chapter 1 14
 Major Futures Clearing Organizations

Table 1.7
Major Futures Clearing Organizations

Clearinghouse Affiliated Exchanges

The Clearing Corporation (CCorp) US Futures Exchange and the

Chicago Mercantile Exchange
Clearinghouse
Kansas City Board of Trade Clearing
Corporation
Energy Clear Corporation
Merchants Exchange of St. Louis
Chicago Mercantile exchange
With clearing link to CBOT
Kansas City Board of Trade
Exempt Commercial Markets

MGE Clearinghouse Minneapolis Grain Exchange

NYMEX Clearinghouse New York Mercantile Exchange

New York Clearing Corporation New York Board of Trade

The Options Clearing Corporation OneChicago, NQLX, & option

exchanges
The London Clearinghouse
Exempt Commercial Markets and OTC
markets

Sources: The CFTC web site, www.cftc.gov.

Chapter 1 15
 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.

Chapter 1 16
 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.

Chapter 1 17
 Futures Market Obligations

Table 1.2 shows a typical trading situation.

Table 1.2
Futures Market Obligations
The oat contract is traded by the Chicago Board of Trade. Each contract is for
5,000 bushels, and prices are quoted in cents per bushel.
(a) Party 1 Party 2
Buys 1 SEP contract for oats at 171 Sells 1 SEP contract for oats at 171
cents per bushel cents per bushel
(b) Party 1 Clearinghouse
Buys 1 SEP contract for oats at 171 Agrees to delivery to Party 1 a SEP
cents per bushel contract for oats at a price of 171
cents per bushel
(c) Party 2 Clearinghouse
Sells 1 SEP contract for oats at 171 Agrees to receive from Party 2 1 SEP
cents per bushel contract for oats and to pay 171 cents
per bushel

Chapter 1 18
 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 $1,400

(-) Daily Settlement 150
New Margin Balance $1,250

DAY 2
Loss: 4 cents/bushel or $200

Margin Balance $1,250

(-) Daily Settlement 200
New Margin Balance $1,050

Trader’s margin is below the maintenance margin. Margin

call occurs.

Variation Margin needed: $350

Chapter 1 19
 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.

Chapter 1 20
Margin Cash Flows

Trader A

Clearing Clearinghouse
member

Non-clearing
member

Trader B

Chapter 1 21
 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

Chapter 1 22
 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.

Chapter 1 23
Completion of Futures Contracts

Table 1.3
Completion of Futures Contracts
via Delivery or Cash Settlement
October 1, 2002BSeptember 30, 2003
Delivered or Settled in Cash
Commodity Group Volume Contracts Percentage
Grains 28,917,090 98,235 0.33
Oilseeds 30,917,636 51,143 0.17
Livestock 7,190,906 36,107 0.50
Other Agricultural 15,560,473 95,344 0.61
Energy/Wood 94,635,656 839,221 0.89
Metals 18,602,108 209,186 1.12
Financial Instruments 760,292,234 7,115,757 0.94
Currencies 30,032,897 682,095 2.27
All Commodities 986,149,000 9,125,088 0.93
Source: Commodity Futures Trading Commission, Annual Report, 2003.

Notice that very few contracts are delivered or settled

in cash.

Chapter 1 24
 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 non-
standard 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

Chapter 1 25
 Delivery Differential

Example: CBOT Corn Contract

Quality differential
Grade differential based on the standard “par” delivery grade.

Premium grade: No. 1 Yellow

Premium grade price differential : 1.5cents/bushel
Price: $3.015/bushel

Par grade: No. 2 Yellow

Par grade price: $3/bushel

Lower grade: No. 3 Yellow

Lower grade Price differential : 1.5 cents/bushel or
Price: $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

Chapter 1 26
 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.

Table 1.4
The Reversing Trade
Party 1's Initial Position Party 2
May 1 Bought 1 SEP contract for oats Sold 1 SEP contract for oats at 171
at 171 cents per bushel cents per bushel
Party 1's Reversing Trade Party 3
May 10 Sells 1 SEP contract for oats at Buys 1 SEP oats contract at 180
180 cents per bushel cents per bushel

Chapter 1 27
 Closing a Futures Position: Exchange-for-
Physicals (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.

Table 1.5
An Exchange-for-Physicals Transaction
Before the EFP
Trader A Trader B
Long 1 wheat futures Short 1 wheat futures
Wants to acquire actual wheat Owns wheat and wishes to sell
EFP Transaction
Trader A Trader B
Agrees with Trader B to purchase Agrees with Trader A to sell wheat and
wheat and cancel futures cancel futures
Receives wheat; pays Trader B Delivers wheat; receives payment from
Trader A
Reports EFP to exchange; exchange a- Reports EFP to exchange; exchange
djusts books to show that Trader A is adjusts books to show that Trader B is
out of the market out of the market

Chapter 1 28
 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

Chapter 1 29
 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.

Chapter 1 30
 Future Contracts: Physical Commodity

AGRICULTURAL METALLURGICAL ENERGY

Grains - corn, oats, Gold Heating oil
rice, wheat
Silver Crude oil
Livestock - live
hogs, cattle Aluminum Natural gas

Forest - lumber and Platinum Unleaded gasoline

plywood
Coal, propane
Textiles - cotton
Electricity
Foodstuffs - rice
cocoa, coffee,
orange juice, sugar

Chapter 1 31
 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

Chapter 1 32
 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

Chapter 1 33
 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.

Chapter 1 34
 Relative Importance of Commodity Types

INSERT FIGURE 1.5 HERE

Chapter 1 35
 Changing Commodity Trading Volume

INSERT FIGURE 1.6 HERE

Chapter 1 36
 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.

Chapter 1 37
 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

Chapter 1 38
 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 P’s).

Chapter 1 39
 The CFMA’s 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 privately-

negotiated between large, sophisticated contract
counterparties.

Chapter 1 40
 Futures Markets Levels of Regulation
(Market Regulators)

1. Brokers

2. Exchanges and clearinghouses

3. National Futures Association (NFA), industry self-

regulatory body

4. Commodity Futures Trading Commission (CFTC),

federal governmental agency

Chapter 1 41
 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.

Chapter 1 42
 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

Chapter 1 43
 Abusive Trading Practices

Table 1.8
Abusive Trading Practices
Pre-arranged trading Agreeing to some aspect of a transaction before it is
openly executed on the exchange floor.
Accommodation trading Entering transactions to assist another floor partici-
pant in accomplishing improper trading objectives.
Trading before custom- Trading for one's personal account or an account in
ers orders, front running which one has an interest, while having in hand any
executable customer order in that contract.
Bucketing Failing to introduce an order to the marketplace,
traditionally occurring when a broker noncompeti-
tively takes the other side of a customer order to the
detriment of the customer or other members.
Wash trading Entering transactions to provide the appearance of
trading activity without resulting in a change in
market position.
Curb trading Trading after the official close of trading.

Source: Government Accounting Office, “Automation Can Enhance Detection of

Trade Abuses but Introduces New Risks,” September 1989.

Chapter 1 44
 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.

Chapter 1 45
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 CFTC’s market surveillance is its large-

trader electronic reporting system. This reporting system
helps identify potential concentrations of market power
within a market and to enforce speculative position limits.

Chapter 1 46
 Insert figure 1.7 here

Figure 1.7 shows the place of the CFTC in the regulatory structure
of the futures industry in the United States.

Insert Figure 1.7 here

Chapter 1 47
 Recent Regulatory Initiatives

FASB ACCOUNTING RULES

In 1998, The FASB adopted new rules for disclosure of risk
positions in firms’ derivatives positions.
CFMA 2000
Allows futures trading on individual stocks and narrow-based
stock indexes.
Clarifies the legal status of privately-negotiated swap
transactions.
Provides a predictable and calibrated regulatory structure
tailored to the product, the participant, and the trading
platform.
Allows exchanges to bring new contracts to market without
prior regulatory approval.
Establishes a set of standards, that permit futures exchanges
and clearinghouses to use different methods to achieve
federal requirements.
Gives the CFTC clear authority to stop certain illegal, foreign
exchange transactions aimed at defrauding small investors.
Gives the CFTC separate oversight authority with respect to
clearinghouse organizations.

Chapter 1 48
 Recent Regulatory Initiatives

TAXATION OF FUTURES TRADING

1981 LAW
Futures positions must be marked-to-market at the end of the
year.

ACT of 1986
Stipulates that short-term and long-term capital gains will be
taxed at one rate.

Chapter 1 49