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Mechanics of Futures Markets
1. 2. 3. 4. 5. 6. 7. Specifications of a Futures Contract Convergence of Futures Price to Spot Price Safeguards in the Futures Market Closing a Futures Position Open Interest Pay-off from a Futures Contract Transaction on a Futures Exchange
Mechanics of Futures Market
Mechanics of Futures Market 4 2 . Defined (specified) in terms of: Underlying asset Contract size Delivery arrangements Delivery month Price quotes Daily Price Movement Limits Mechanics of Futures Market 3 Underlying Asset • In case of Commodity Futures.standard length of 8”by 20”. E.Futures contracts are well defined & unambiguous.g. Juice Futures – in terms of Brix value • A range of grades may be delivered with adjustment in price based on the grade delivered.: Lumber Futures . the Exchange stipulates the grade(s) of the commodity.Specifications of a Futures Contract • • A futures contract is a standardised contract. E. • In case of Financial assets .: Enough to say “Futures on BSE Sensex” or “Futures on Infosys”.g.
• If the Contract size is set too high. it will keep away many investors. it will make trading expensive as transaction cost are linked to no. of contracts traded. while if set too small.Contract Size • Contract size specifies the amount of the asset that has to be delivered under a Futures contract.: Futures on S&P CNX Nifty have a contract size of 200 & multiples thereof. Mechanics of Futures Market 5 Delivery Arrangements • Place where the delivery will be made. Mechanics of Futures Market 6 3 .g. especially in case of Commodity Futures. is specified by the exchange. E. • Delivery may be made at alternative site with due adjustments in the delivery prices.
contracts trade for the closest delivery month & a number of subsequent delivery months. • Exchange also specifies the last day on which trading can take place for a given contract Mechanics of Futures Market 7 Price Quotes • The exchange defines how price will be quoted • In a way that is convenient and easy to understand. E.: Crude Oil – NYMEX . • NSE futures – 1.Delivery Month • Futures contract is referred to by its Delivery month. • Vary from contract to contract • At any given time.$/per barrel • Minimum price movement that can occur in trading is also set by the exchange – “tick size” E. 2.: Crude Oil ($0. 3 month futures. • The exchange specifies the precise period during the month when delivery is to be made.01 or 1 cent per barrel) Mechanics of Futures Market 8 4 .g.g.
the Futures price equals ( or is very close to ) the Spot price. • Eventually the two prices will converge. the Futures price converges to the Spot price of the underlying asset. • If the prices differ substantially. • At the delivery date. • Exchange may change the limits to counter excessive speculation. arbitrageur shall take appropriate position to drive away any benefits. Mechanics of Futures Market 10 5 .Daily Price Movement Limits • Maximum movement in prices during a day (in either direction) so as to prevent large price movements due to speculative trading. Mechanics of Futures Market 9 Convergence of Futures to Spot Price • As the delivery month approaches.
Convergence of Futures to Spot Price Futures Price Spot Price Price Spot Price Price Futures Price Time Time Mechanics of Futures Market 11 Safeguards in the Futures Market • Clearing House • Margin Requirements • Daily Settlement (Mark-to-Market) 6 .
• Each trader has obligations only to the CH & hopes that CH will execute its side of the trade as well. • CH “guarantees” ALL trades on the Exchange. Mechanics of Futures Market 13 Clearing House (Contd. does not take ACTIVE position but ”interposes” itself between all parties to every transactions. • CH substitutes its own credibility for the promise of each trader.Clearing House • To ensure smooth functioning. • CH.) Obligations without Clearing House Funds Buyer Goods Seller Obligations with Clearing House Funds Funds Buyer Goods Clearing House Seller Goods Mechanics of Futures Market 14 7 . each Futures Market has a Clearing House (CH) associated. however. • This is achieved by CH “adopting” the position of a Buyer for every Seller & that of a “Seller” for every “Buyer”.
well-capitalised Institution. • US Futures trading history. Default Risk of CH is very small. each party has obligation to the CH which ensures that both parties perform. CH have never faulted.) • Without CH. Futures trading is guided by the need to eliminate the payments crises. • Because of the CH. Mechanics of Futures Market 15 Operation of Margins • When investors contract.Default Risk or Credit Risk Besides the role of the Clearing House. both parties would deal with each other-direct obligation to each other. • With CH. The exchange organises trades as as to avoid such defaults thru a system of Margins. Different types of margins are maintained: • Initial Margin (IM) • Maintenance Margin (MM) • Variation Margin (VM) Mechanics of Futures Market 16 • • • • 8 . Hence. there are various risks – one party may backout or may not have the financial resources to honour his commitments. • They need to be concerned about the reliability of the CH. the two parties need not trust or know each other. CH is a large.Clearing House (Contd. the system of Margins protects from a payments problem.
This is called “Mark– to– market” Mechanics of Futures Market 17 Operation of Margins (Contd. • Initial margin covers 1 days price fluctuations. • Failure to pay VM leads to the futures position being closed out.Operation of Margins (Contd.Typically set at 5% of the contract value. trader is required to replenish (“ top-up”) the margin. • Trader retains title to the deposit. • IM is returned upon proper completion of all the obligations.) • Initial Margin (IM):Good faith deposit paid by the trader at the time of entering the contract to ensure performance. • At the end of each day. • Any amount in excess of the IM can be withdrawn by the investor. the margin account is adjusted to reflect gain/loss. Mechanics of Futures Market 18 9 . • If the margin account falls below the MM. • IM may vary from contract to contract & from trader to trader. • Usually equal to Maximum Daily Price fluctuation limit. • MM is used to calculate the third margin – Variation Margin. This additional amount paid by the trader is called VM. bringing the margin amount back to the Initial Margin.) • Maintenance Margin (MM) :(% of the Initial Margin) is the Minimum amount of margin below which margin account should NOT fall. any additional losses is covered by the VM.
00 3640.20 397.00 1260.Operation of Margins .30 393.00 Margin Call (600.70 387.00) (580.00 (600.00 3700.00 3880-1140+x=4000 Mechanics of Futures Market 20 10 .00 220. • Contract size = 100 ounces.00) (1280.00 3080.00) (920.60 391.70 391.00 5060.00) (1800.00) (1340.70 395.00 (1140.80 392.00 3340.00 3220.00) (80.00) (1540.00) (2600.00) 3080-420+x=4000 1340.00 460.00) 60.30 Daily Gain/(Loss) Cumulative Gain/(loss) Margin Account Balance 4000.00) (360.00 392.00 (360.00 4060.00 4000.00) (260.00 4220.00) (780.00 4800.00 120.00) (660.00 3420.10 396.10 388.00 2740.00 (220.00) (2260.00 396.00) 0.00 260.00 4340.00) (420.00) 180.00) (2600.00) 420.00 3880.10 398.An Example • X buys “2” Gold Futures @ Rs 400 per ounce.00) (2380.00) (1640.00 388.00) (1460. • Initial Margin (IM) = Rs 2000 per contract = 2000 x 2 = Rs 4000 • Maintenance = Rs 1500 per contract Margin (MM) = 1500 x 2 = Rs 3000 Mechanics of Futures Market 19 Operation of Margins Day 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Futures Price 400.00 2660.40 393.00 3400.00 397.00) (180.00 387.
of contracts & expiry date • If it does not. • Physical Settlement: Physical delivery of the asset at a certain location at a specified time as per the exchange rules. in order to close the contract. Mechanics of Futures Market 22 11 . • The trader. • Cash Settlement: Traders make payment at expiry of contract to settle any gain or loss.by entering into a exactly reverse trade which shall cancel the original trade. Mechanics of Futures Market 21 Closing a Futures Position 2. Delivery: Delivery of the goods under the contract will automatically close the position. should enter into an exactly reverse contract in terms of the underlying assets .Closing a Futures Position 1. No. then the trader shall undertakes a new obligation instead of cancelling the old obligation. Offset: Most Futures contracts are settled by “Offsets”.
the traders have completed their obligations & are now out of the market. • Futures is not closed by a transaction through the Exchange.) 3. Offset: • Under both. Party C: Bought 1 September Wheat Futures Contract @ Rs 2300/. • Traders privately negotiate the terms. commodity & Futures contract based on that commodity. Party A’s Reversing Trade: Sold 1 September Wheat Futures Contract @ Rs 2300/-. May 15 After this Party A’s net position is zero and is out of the Futures market.Offset Trades – An Example May 1 Party A’s Initial Position: Bought 1 September Wheat Futures Contract @ Rs 2200/-. Mechanics of Futures Market 23 Closing a Futures Position (Contd.Party B & C have obligations towards the Clearing House. hence also called “ex-pit” Mechanics of Futures Market 24 12 . • Differs from Offsets: • Traders actually exchange the physical goods. EFP vs. Exchange for Physicals: Two traders simultaneously exchange for cash. Party B : Sold 1 September Wheat Futures Contract @ Rs 2200/.
Exchange for Physicals – An Example Before the EFP Party “A” • Long 1 Wheat Futures • Wants to acquire Actual Wheat Party “A” Agrees with “B” to purchase wheat & cancels Futures Receives wheat & pays “B” Reports EFP to the Exchange Exchange adjusts to show “A” is out of the Market. 25 Mechanics of Futures Market Open Interest • “Open Interest” refers to the number of futures contracts outstanding. • It is the total no. of “open” positions waiting to be liquidated before the contract’s maturity. • Three rules regarding open interest • Any trade (long or short) initiated afresh raises OI • Any trade (long or short) that squares up existing position lowers OI • Every trade needs a buyer & a seller Mechanics of Futures Market 26 13 . • Today’s newspaper carry yesterday’s trading data and day before yesterday’s Open Interest data. Party “B” •Short 1 Wheat Futures •Owns Wheat & wishes to sell EFP Transaction • • • • • • • • Party “B” Agrees with “A” to sell wheat & cancels Futures Delivers wheat & receives payment from “A” Reports EFP to the Exchange Exchange adjusts to show “B” is out of the Market.
of Silver @ Rs 2000/per kg. 500/per kg. • In general. then the trader has made a loss of Rs. then the trader has made a profit of Rs. the pay-off from a long position in the Forward/Futures Contract is: Spot Price on Maturity (ST) less Delivery Price(K) Mechanics of Futures Market 28 14 . • At the end of 3-months. 100/per kg.per kg.Open Interest : An Example Trader 1 Trader 2 Trader 3 Trader 4 Trader 5 Long Short Long Short Long Long Short Short Long Short Open Interest 20 20 40 20 0 Mechanics of Futures Market 27 Pay-off from a Futures Contract • Consider a trader who has entered into a 3-month Long position to buy 100 kg. • At the end of 3-months. if the price is Rs 2500/. if the price is Rs 1900/.per kg.
2: Seller places a SELL order with his Broker who in turn placesit with the Futures Exchange. as it costs nothing to enter into a Forward/Futures contract K Profit Profit ST Pay-off : Long Position Mechanics of Futures Market K ST Pay-off : Short Position 29 Transaction on a Futures Exchange Buyer 1 5 Buyer’s Broker 6 Buyer’s Broker’s Clearing Firm 1 Futures Exchange 4 3 2 Seller’s Broker 6 2 Seller 5 7 Futures Clearinghouse 7 Seller’s Broker’s Clearing Firm 1: Buyer places a BUY order with his Broker who in turn places it with the Futures Exchange.Pay-off from a Futures Contract • Pay-off from a short position in the Forward/Futures Contract is: Delivery Price (K) less Spot Price on Maturity (ST) • These pay-offs represents total profit/loss from the contract. 4: Information about the trade is reported to the Clearing House 5: Buyer and Seller deposit margin with their respective brokers 6: Buyer’s and Seller’s Brokers deposit the margins with their respective clearing firms 7: Clearing firms deposit the margins with the ClearingHouse Mechanics of Futures Market 30 15 . 3: Futures Exchange matches the trade through a computerised system.