Futures

Futures --
Futures contract are obligations on the
part of both buyers and sellers but these
are standardised agreements to buy or
sell the underlying on a specified future
date.

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 --Futures --
These contracts are traded on organised
exchanges. The main purpose of the exchange
is to determine standardised specifications for
traded contracts and enforce trading rules. The
terms and conditions governing the future
contracts are standardised by the exchange
where it is traded.

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 --Futures --
Thus, the futures contract is an agreement for
future delivery of a specified quantity of an
asset at a specified price. The standardised
item in any futures contract are:
* Quantity of the underlying assets
* Quality of the underlying asset
* the date and month of delivery
* the units of price quotation
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Features of Futures Contracts--
The principal features of the futures contract
are as follows:
• Organised Exchanges
Futures are traded on organised exchanges with a
designated physical location where trading takes
place.
• Standardisation
In a futures contract, quantity of the asset and
maturity date are standardised by the exchange on
which the contract is traded. Contracts are traded in
whole numbers.
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--Features of Futures Contracts--
• Clearing House
On the trading floor, a futures contract is agreed
upon between two parties, say A and B. When it is
recorded by the exchange, the contract between A
and B is immediately replaced by two contracts:
One contract between A and the clearing house
and other contract between B and the clearing
house.
It protects itself by imposing margin requirements
on traders and a system known as marking to
market.
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--Features of Futures Contracts--
e.g.:
Day 1: A buys, B sells.
* A buys and clearing house sells.
* B sells and clearing house buys.
Day 2: A sells, C buys.
* A sells and clearing house buys.
* C buys and clearing house sells.
i.e. C buys and clearing house sells.
& B sells and clearing house buys.

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--Features of Futures Contracts--
• Margins
Only members of an exchange can trade in
futures contract on the exchange. Other
people use the member’s service as brokers
to trade on their behalf. The exchange
requires that a performance bond in the form
of a margin must be deposited with the
clearing house by a member who enters into
a futures commitment.
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Features of Futures Contracts--
• Marking to market
It means that at the end of a trading session,
all outstanding contracts are re-priced at the
settlement price of that session. Margin
accounts of those who made losses are
debited and of those who gained are
credited.

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Features of Futures Contracts--

• Actual delivery is rare

In futures market, actual delivery is rare.
Most of the contracts are offset before
maturity by entering into a matching contract
in the opposite direction.

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The Futures Trading Process--

* Futures contracts are traded on a regulated

exchange.

* All traders represent exchange members.

Those who trade for their own account are
called floor traders. Those who trade on
behalf of others are floor brokers. Those who
do both are called dual traders.
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The Futures Trading Process--

* The variables to be negotiated in any deal

are price and the number of contracts.

* A buyer of futures acquires a long position

while the sellers acquire a short position.
Clearly, when two traders agree on a deal, it
is entered as a short and long both vis-à-vis
the clearing house.
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--The Futures Trading Process--

* When a position is opened, the trader (both

the long and the short) must post an initial
margin. As prices change, the contract is
marked to market with gains credited to the
margin account and losses debited to the
margin account.

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--The Futures Trading Process--

* If as a result of losses, the amount in the

margin account falls below a certain level
(known as maintenance margin) , the trader
receives a margin call and must make-up
the amount to the level of the required
margin in a specified time. If the trader fails
to do so, his or her position is liquidated
immediately.

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--The Futures Trading Process

* For every contract, the exchange specifies

a “last trading day”. Those who have not
liquidated their contracts at the end of this
day are obliged to make or accept delivery
as the case may be. For physical delivery,
the exchange specifies the mechanism of
delivery.

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e.g.:
On May 7, Mr. John took a long position in one June
SFr contract at an opening price of $0.6350. The
initial margin was $1500 and the maintenance margin
was $ 1200. The settlement prices for May 8,9,10
were $ 0.6280, $ 0.6355, $ 0.6335. On May 11, the
transaction is reversed.
Compute the cash flows assuming the opening
balance $ 1500 and no cash deposits or withdrawals
other than gains and losses from his futures position.

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Solution:
We have,
Date of contract : May 7
Position : Long
Opening Price : $ 0.6350
Initial margin : $ 1500
Maintenance Margin : $ 1200
Standard size of the contract : $ 1,25,000

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Now, we have
Date Contract Settlement Price Cash flow Deposits/ Margin
price price change (in $) Withdrawa (in $)
ls (in $)

May 7 0.6350 1500

May 8 0.6280 - 0.0070 - 875 575 1200

May 9 0.6355 + 0.0075 + 937.50 ------- 2137.50

May 10 0.6335 - 0.0020 - 250 ---------- 1887.50

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e.g.: On a certain day in February, a speculator
observes the following prices in the foreign exchange
and currency futures market:
$/£ Spot : 1.6465
March Futures : 1.6425
September Futures : 1.6250
December Futures : 1.6130
The speculator thinks that the markets are
overestimating the weaknesses of sterling against the
dollar.
a) How can he act on this to make a profit?
b) Under what circumstances do his action lead to a
loss?
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Solution:
a)
As the speculator feels that the sterling will not
depreciate as much as the market is expecting, his
view is that sterling is underpriced. Thus, he will buy
£ futures for December.
Let us assume that his estimate comes true and the
value at the time of delivery is 1.6230 (say).
Now,
Value of Dec. Futures=62500 × 1.6130 = $ 100812.50
Value on maturity = 62500 × 1.6230 = $ 101437.50
Gain = $ 625.00

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--Solution:
b) However, this exposes him to the risk of losing if
the sterling depreciates more than what the market
expects.
If he wants to minimise the risk, he may buy
December Futures and sell September Futures so
that the changes in the value of sterling is offset to
some extent.

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e.g.:
In April, 2008, the following prices were observed:
$/DM $/¥
Spot 0.6343 0.0080
Futures:
June 0.6380 0.0081
September 0.6460 0.0082
December 0.6504 0.0083
March’09 0.6510 0.0084

What do these prices imply regarding market’s long-

term view of DM’s prospects against the yen? A
speculator thinks otherwise. He thinks that the DM is
going to move in the opposite direction against the
yen. How can he profit from his forecast?
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Solution:
We have,
Quotes $/DM $/¥ ¥/DM (Implied)
Spot 0.6343 0.0080 79.2875
Futures:
June 0.6380 0.0081 78.7654
September 0.6460 0.0082 78.7805
December 0.6504 0.0083 78.3614
March’09 0.6510 0.0084 77.5000
The long-term view of the market is that both DM
and ¥ will appreciate against the dollar and the
implied quotes indicate that market is expecting ¥ to
appreciate against DM.
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Speculator’s View
DM and ¥ move in the opposite direction. As
the market expects that ¥ will appreciate, the
speculative view is that ¥ will depreciate
against DM. As per his viewpoint, ¥ is
overpriced and DM is underpriced. Hence, he
will buy DM futures and sell ¥ futures.
Let us assume that future spot rate on the date
of delivery be 0.6520 and 0.0082 for DM and ¥
futures respectively.

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DM
Buying value of DM-futures = 125000 × 0.6510
= $ 81375.00
Selling value (Spot market) = 125000 × 0.6520
= $ 81500.00
Gain = $ 125.00
Yen
Selling value of ¥ - futures = 125000 × 0.0084
= $ 1050.00
Buying value (Spot market) = 125000 × 0.0082
= $ 1025.00
Gain = $ 25.00
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i.e. there will be a gain under both the
contracts.
If he wishes to minimise the risk, he may prefer
to sell or buy both the futures depending on his
view so that the loss and gain may offset each
other to some extent.

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