Mechanics of Futures Markets

Transaction on a Futures Exchange

1 3 2
Buyer Buyer’s 1
Futures 2
Seller’s Seller
5 Broker Broker
Exchange 5

6 4 6

Buyer’s 7 7 Seller’s
Broker’s Futures Broker’s
Clearing Firm Clearing House Clearing Firm

1: Buyer places a BUY order with his Broker who in turn places it with the Futures Exchange.
2: Seller places a SELL order with his Broker who in turn places it with the Futures Exchange.
3: Futures Exchange matches the trade through a computerised system.
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 Clearing House.

Mechanics of Futures Markets 2

 Futures Exchanges in India

Futures Exchange Futures Contracts

National Stock • Equity Index Futures
Exchange • Single Stock Futures
(NSE) • Currency Futures
• Interest Rate Futures
www.nseindia.com • VIX Futures
Bombay Stock • Equity Index Futures
Exchange • Single Stock Futures
(BSE) • Currency Futures
www.bseindia.com • Interest Rate Futures
Metropolitan Stock • Equity Index Futures
Exchange of India • Single Stock Futures
(MSEI) • Currency Futures
www.msei.in • Interest Rate Futures
Mechanics of Futures Markets 3
 Futures Exchanges in India

Futures Exchange Futures Contracts

National Commodity • Cereals& Pulses: Bajara, Barley,
& Derivatives Chana, Mazie, Wheat
Exchanges Ltd • Oil & Oil seeds: Castor seeds, Cotton
(NCDEX) seeds, Soyabean, Refined Soy Oil,
Mustard Seed, Crude Palm Oil.
www.ncdex.com • Fibres: Kapas, Cotton
• Soft: Sugar, Gur
• Guar Complex: Guar Seed & Gum
• Spices: Pepper, Turmeric, Jeera, Chilli,
Coriander
• Plantation Products: Rubber
• Others: Potato
• Metals: Steel, Copper
• Precious Metals: Gold, Silver
• Energy: Crude Oil, Brent Crude Oil.

Mechanics of Futures Markets 4

 Futures Exchanges in India

Futures Exchange Futures Contracts

National Multi • Oils & Oil seeds: Castor seed, Copra,
Commodity Soyabean Oil, Mustard Seed, Guar
Exchange of India Seed.
Limited (NMCE) • Pulses: Chana
• Spices: Pepper, Cardamom
www.nmce.com • Others: Rubber, Sacking, Coffee Rep
Bulk, Isabgul seed
Multi-Commodity • Bullion: Gold, Silver
Exchange of India • Base Metals: Aluminum, Copper,
Limited (MCX) Lead, Nickel, Zinc
• Energy: Crude Oil, Brent Crude Oil,
www.mcxindia.com Natural Gas
• Agro-Commodities: Cardamom,
Cotton, Crude Palm Oil, Kapas,
Mentha Oil

Mechanics of Futures Markets 5

 Specifications of a Futures Contract
• Futures Exchange specifies in detail the nature of a
Futures contract, subject to regulatory approval.
• Futures contract are specified in terms of:
✓ Underlying asset
✓ Contract size
✓ Delivery arrangements
✓ Delivery month
✓ Price quotes
✓ Price & Position Limits

Mechanics of Futures Markets 6

 Underlying Asset
• In case of Commodity Futures, the Exchange stipulates the
underlying assets and grade(s) that are acceptable.
✓ Silver(MCX): Grade 999, Fine 999 (as per IS2112:1981)
✓ Aluminum (MCX) : Min purity 99.7%
✓ Copper (MCX): Grade 1 electrolytic copper (as per B115 specification)
• For some commodities, a range of grades may be delivered with
adjustment in price based on the grade delivered.
❑ Standard Grade: No. 2 Yellow for Corn Futures (CME)
❑ Acceptable Grade: No. 1 Yellow with 1.5 cents per bushel more or No. 3
Yellow with 1.5 cents per bushel less than No. 2 Yellow.
• In case of Financial assets - Futures contracts are well defined &
unambiguous.
✓ Enough to say ‘Futures on BSE Sensex’ or ‘Futures on Infosys’

Mechanics of Futures Markets 7

 Contract Size
• Contract size specifies the amount of the asset that
has to be delivered under one Futures contract.
✓ Wheat (MCX) : 10 Tons
✓ Copper (MCX): 1 MT
✓ Infosys: 125 shares
• If the contract size is set too large high, it will keep
away many investors.
• If the contract size is too small, it will make trading
expensive as transaction cost are linked to no. of
contracts traded.
• Contract size depends upon the intended user
Smaller - Agricultural commodities; Larger - Financial
products.
Mechanics of Futures Markets 8
 Delivery Arrangements
• Place where the delivery will be made is specified by
the Futures exchange.
• In case of Commodity Futures, delivery is to exchange-
licensed warehouses.
• Delivery may also be made at alternative locations,
with price adjustments.
• Prices tend to be higher for delivery locations that are
relatively far from the main sources of commodity
trade.

Mechanics of Futures Markets 9

 Delivery Month
• Futures contracts are referred to by their Delivery
month.
✓July Nifty, August Nifty or July ACC.
• At any given time, contracts trade for the closest
delivery month & a number of subsequent delivery
months.
✓NSE futures – 1, 2, 3 month futures.
• Exchange specifies the last day on which trading can
take place for a given contract.
✓NSE Currency Futures: Last working day (excluding
Sat.) of the expiry month
✓NSE Equity/Index Futures: Last Thursday of the
expiry month.
• Varies
Mechanics from
of Futures Markets contract to contract 10
 Price Quotes

• The exchange also defines how the Futures prices will

be quoted.
• In a way that is convenient and easy to understand
✓ Wheat (MCX) : Rs. per 100 kgs
✓ Crude Oil (NYMEX) : USD per barrel

• Minimum price movement that can occur in trading is

also set by the exchange – ‘tick size’
✓ Wheat (MCX) : 10 paise
✓ Crude Oil (NYMEX) : 1 cent

Mechanics of Futures Markets 11

 Price & Position Limits
• Daily price movement limits are set by the futures
exchange - maximum movement in prices during a day
(in either direction) so as to prevent large price
movements due to speculative trading.
• If prices hit the upper or lower limits in a day, trading is
suspended for duration as specified by the Exchange.
• Limits vary with contracts.
• Exchange may change the limits to counter excessive
speculation.
• Position limits are also imposed on traders - maximum
contracts they can trade in a day – so as to prevent
any one trader from exercising excessive influence
over prices.
Mechanics of Futures Markets 12
 Equity Futures on NSE
Parameter Index Futures Futures on Individual Securities
Underlying • Nifty 50 209 securities
• Nifty IT
• Nifty Bank
• Nifty Midcap 50
• Nifty Infrastructure
• Nifty PSE
• Nifty CPSE
• India VIX
• DJIA
• S&P 500
• FTSE 100
Instrument FUTIDX FUTSTK

Trading Cycle 3 month trading cycle - the near month (one), the next month (two) and the
far month (three)
Expiry Day Last Thursday of the expiry month. If the last Thursday is a trading holiday,
then the expiry day is the previous trading day.
Permitted Lot Size Underlying specific Underlying specific
Price Steps Rs.0.05 Rs.0.05

Mechanics of Futures Markets 13

 Currency Futures on NSE
Symbol USDINR EURINR GBPINR JPYINR
1 - 1 unit denotes 1 - 1 unit denotes
1 - 1 unit denotes 1 - 1 unit denotes 1000 POUND 100000 JAPANESE
Unit of trading 1000 USD. 1000 EURO. STERLING. YEN.
The exchange rate
The exchange rate in The exchange rate The exchange rate in in Indian Rupees
Underlying / Order Indian Rupees for US in Indian Rupees Indian Rupees for for 100 Japanese
Quotation Dollars for Euro. Pound Sterling. Yen.
Tick size 0.25 paise or INR 0.0025
Trading hours Monday to Friday 9:00 a.m. to 5:00 p.m.
Contract trading
cycle 12 month trading cycle.
Last trading day Two working days prior to the last business day of the expiry month at 12 noon.
Final settlement Last working day (excluding Saturdays) of the expiry month.
day The last working day will be the same as that for Interbank Settlements in Mumbai.
Initial margin SPAN Based Margin

Mechanics of Futures Markets 14

 Currency Futures on NSE
Symbol USDINR EURINR GBPINR JPYINR
Initial margin SPAN Based Margin
Daily settlement : T + 1
Settlement Final settlement : T + 2
Mode of
settlement Cash settled in Indian Rupees
Daily settlement
price
(DSP) Calculated on the basis of the last half an hour weighted average price.
Exchange rate Exchange rate
published by published by
RBI in its Press RBI in its Press
Release Release
captioned RBI captioned RBI
Final settlement reference reference
price RBI reference Rate for US$ Rate for US$
(FSP) RBI reference rate rate and Euro and Euro
Mechanics of Futures Markets 15
 Players in the Futures Market

• Hedgers are investors who have a pre-existing

commitment to buy or sell and use the futures market
to eliminate or reduce the price risk from that
commitment.
• Speculators are those who take directional bets either
on price or on the difference of two prices. Unlike
Hedgers, they do not have any pre-existing risk which
they intend to offset by trading in the futures market.
• Arbitrageurs are those who exploit risk-less profit
opportunities arising from difference in prices of two
equivalent securities.

Mechanics of Futures Markets 16

 Convergence of Futures Price to Spot Price

• As the delivery month approaches, the Futures price

converges to the Spot price (on that date) of the
underlying asset.
• On the delivery date, the Futures price equals (or is
very close to) the Spot price (on that date).
• If the two prices differ substantially, arbitrageur can
take appropriate position to drive away any benefits.
• Eventually the two prices will converge.
• Such arbitrage trades would ensure that the Futures
price is close to the Spot price (on that date).

Mechanics of Futures Markets 18

 Convergence of Futures to Spot Price

Futures Price Spot Price

Spot Price Futures Price

Price

Price
Time Time

Contango Backwardation
(Futures > Spot) (Spot > Futures)

Mechanics of Futures Markets 19

 Clearing House
• To ensure smooth functioning, each Futures Exchange has a
Clearing House (CH) associated with it.
• CH “guarantees” ALL trades on the Exchange.
• This is achieved by CH “adopting” the position of a Buyer for
every Seller & “Seller” for every “Buyer”.
• Each trader has obligations only to the CH & hopes that CH
will execute its side of the trade as well.
• CH substitutes its own credibility for the promise of each
trader.
• CH, however, does not take ACTIVE position but “interposes”
itself between all parties to every transactions (Novation).
NSE : National Securities Clearing Corporation Ltd (NSCCL)
BSE : Indian Securities Clearing Corporation Ltd (ISCCL)
MSEI: MCX-SX Clearing Corporation Limited (MCCL)
Mechanics of Futures Markets 20
 Clearing House (Contd.)
Obligations without Clearing House
Funds
Buyer Seller
Goods
• Without CH, both parties would deal with each other-direct
obligation to each other.
Obligations with Clearing House
Funds Funds
Clearing
Buyer Seller
Goods
House Goods
• With CH, each party has obligation to the CH which ensures
that both parties perform, the two parties need not trust or
know each other.
• They need to be concerned about the reliability of the CH.
Hence, CH is a large, well-capitalised Institution.
Mechanics of Futures Markets 21
 Operation of Margins

• When 2 investors contract, one party may back out or

may not have the financial resources to honour his
commitments.
• Futures Exchange organises trades so as to avoid
defaults, through a system of margins.
• Different types of margins are maintained:
✓Initial Margin (IM)
✓Maintenance Margin (MM)
✓Variation Margin (VM)

Mechanics of Futures Markets 22

 Operation of Margins
• Initial Margin (IM):Good faith deposit paid by the trader at
the time of entering the contract to ensure performance.
• IM may vary from contract to contract & from trader to
trader.
• Typically set at 5% of the contract value.
• Trader retains title to the deposit.
• Usually equal to Maximum Daily Price fluctuation limit.
• IM is returned upon proper completion of all the
obligations.
• At the end of each day, the initial margin account is
adjusted to reflect investor’s gain/loss. → daily settlement
or Mark– to – market
Mechanics of Futures Markets 23
 Operation of Margins
• Maintenance Margin (MM) :(% of the Initial Margin) is the
minimum amount of margin below which amount in Initial
Margin account should NOT fall.
• MM is used to calculate the third margin – Variation
Margin (VM).
• If the Initial Margin account falls below the MM, trader is
required to replenish ( or top-up) the Initial Margin
account.
• This additional amount paid by the trader is called
Variation Margin.
• Any amount in excess of the IM can be withdrawn by the
investor.
• Failure to pay VM leads to the futures position being
closed out.

Mechanics of Futures Markets 24

 Operation of Margins - An Example
▪ Suppose Mr X is long on 5 Futures contract on gold at
MCX. Each contract is for 100 grams. The price quoted
is Rs. 15,550/- per 10 grams.
▪ Tick size is Re 1.
▪ Initial margin is 4% while maintenance margin of 90%
of initial margin.

Mechanics of Futures Markets 25

 Operation of Margins

Mechanics of Futures Markets 26

 Operation of Margins

Without Mark-to-Market:

With Mark-to-Market:

Mechanics of Futures Markets 27

 Closing a Futures Position
Delivery: Delivery of the goods under the contract will automatically
close the position.
• Physical Settlement: Physical delivery of the asset at a certain
location at a specified time as per the exchange rules.
▪ Decision regarding location of delivery is with the seller.
▪ If seller decides to deliver the underlying, it would issue a
“Notice of intention to Deliver” to the exchange.
▪ The exchange will then choose the party with the long position
to accept the delivery.
▪ Usually, the notice is passed to the party with the oldest long
position outstanding.
▪ Parties with long positions must accept delivery.
• Cash Settlement: Traders make payment at expiry of contract
to settle any gain or loss.

Mechanics of Futures Markets 28

 Closing a Futures Position
Offset: Most Futures contracts are settled by “Offsets”, by entering
into a exactly reverse trade which shall cancel the original trade.
• The trader, in order to close the contract, should enter into an
exactly reverse contract in terms of:
(a) the underlying assets,
(b) No. of contracts &
(c) expiry date
• If it does not, then the trader shall undertake a new obligation
instead of cancelling the old obligation.

Mechanics of Futures Markets 29

 Offset Trades – An Example
May 1 Party A’s Initial Position: Party B :
Bought 1 September Sold 1 September Wheat
Wheat Futures Contract Futures Contract @ Rs
@ Rs 2,200/-. 2,200/-.

May 15 Party A’s Reversing Party C:

Trade: Bought 1 September Wheat
Sold 1 September Futures Contract @ Rs
Wheat Futures Contract 2,300/-.
@ Rs 2,300/-.

After the two trades, A’s net position is Zero and is out
of the market. B & C still have obligations to the CH.
Mechanics of Futures Markets 30
 Closing a Futures Position (Contd.)
Exchange for Physicals: Buyer and Seller exchange for
cash, the underlying asset outside the exchange
system.
EFP vs. Offset:
• Under both, the traders have completed their
obligations & are now out of the market.
• Differs from Offsets:
• Traders actually exchange the physical goods.
• Futures is not closed by a transaction through the
Exchange.
• Traders privately negotiate the terms, hence also
called “ex-pit”
Mechanics of Futures Markets 31
 Exchange for Physicals – An Example

Before the EFP

Party “A” Party “B”
•Long 1 Wheat Futures •Short 1 Wheat Futures
•Wants to acquire Actual Wheat •Owns Wheat & wishes to sell

EFP Transaction
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.
Mechanics of Futures Markets
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.
32
 Open Interest
• ‘Open Interest’ refers to the number of futures contracts
outstanding (not squared off) at any point in time. It is the total
no. of ‘open’ positions waiting to be liquidated before the
contract’s maturity.
• OI rises with time as more and more investors enter into new
contracts.
• As maturity approaches, investors unwind their positions by
entering into reverse trades. Hence, OI starts to decline.
• Today’s newspaper carry yesterday’s trading data and day
before yesterday’s Open Interest data.
✓ Every trade needs a buyer & a seller
✓ Any trade (long or short) initiated afresh raises OI
✓ Any trade (long or short) that squares up existing position lowers
OI
Mechanics of Futures Markets 33
 Open Interest
Day Trades No. of Contracts Open Daily
Interest Volume
Long Short
1 A B 50 150 150
C D 100
2 E F 100 250 100
3 B H 50 250 50
4 D C 100 150 100

Mechanics of Futures Markets 34

 Newspaper Quotations

Mechanics of Futures Markets 35