FRM Part 1

Financial Markets and

Products

AIM Statement:
www.iplanonline.in Mechanics of Futures
Markets

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 Products
Financial Markets and
FRM Part 1
AIM Statement:
 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 transactions.
 Describe the role of collateralization in the over-the-counter market and
compare it to the margining system.
 Identify and describe the differences between a normal and inverted futures
market.
 Describe the mechanics of the delivery process and contrast it with cash
settlement.

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 Products
Financial Markets and
FRM Part 1
AIM Statement:
 Define and demonstrate an understanding of the impact of different order
types, including: market, limit, stop-loss, stop-limit, market-if-touched,
discretionary, time-of-day, open, and fill-or-kill.
 Compare and contrast forward and futures contracts

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Future Contracts

• Exchange-traded obligations to buy or sell a certain amount of an

underlying good at a specified price and date.
• Most futures positions are not held to take delivery of the underlying good.
• For each contract, there are 2 sides

Long Short

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Future Contracts

• Arbitraging
• Hedging
• Speculation
• Open interest : Total number of Long/Short positions in a contracts. It could be
even lower than the trading volume for that day.
• Trading

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Features specified for a Future Contract

• Quality of underlying asset

• Delivery time
• Delivery location
• Contract size
• Daily Price limits
• Position limits
• Price quotations and tick size

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The convergence of Spot and Future

• Basis = Spot price – Forward price

• Near maturity Basis converges to Zero.
• Convergence through Arbitrage example

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Margin trading : Functioning

• Initial Margin and Leverage

• Maintenance Margin
• Variation Margin
• Numerical example

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Clearing House

• An intermediary in futures transactions

• Investor maintains margin account with the broker
• The broker maintains margin account with the clearing house member
• Clearing house member maintains margin account (Clearing Margin) with the
clearing house.

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Settlement

• The settlement price is similar to the closing price

• An average of the prices of the trades during the last (closing) period, set by the
exchange
• It is used to make margin calculations at the end of each trading day
• Increasing settlement prices over time indicates a normal market. Conversely,
decreasing settlement prices over time indicates an inverted market.

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OTC Market

• Credit Risk and Collateralization

• Use of clearing house

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Delivery Process

One can terminate the future contract in 4 different ways –

1. Delivery - A short can terminate the contract by delivering the goods, a long by
accepting delivery and paying the contract price to the short.
2. In a cash-settlement contract, the futures account is marked to market based on
the settlement price on the last day of trading. There is no delivery in this case.
3. Reversing or closing a trade.
4. Settling a trade through physical exchange in an ex-pit transaction.

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Types of orders

• Market order and discretionary market order

• Limit order
• With time limit ( IOC (Fill or Kill), Good till day, Good till week)
• Without time limit – Good till cancelled (Open Orders)
• Stop Loss orders
• Stop Limit orders
• Market If Touched (MIT) orders

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Questions
Q1. Which of the following is not a characteristic specified in a future contract

A. Delivery time
B. Asset quality
C. Asset quantity
D. Collateral details

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Questions
Q2. A trader holds a long position in a commodity futures contract with the following characteristics:
• The initial margin is $1,000.
• The maintenance margin is $250.
• The contract price is $ 2,500.
• Each contract include 100 units.
If the price drops to $2,495 at the end of the first day and $2,492 at the end of the second day, which of
the following is closest to the variation margin required at the end of the second day?
A. $700
B. $250
C. $800
D. $1,000

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Questions
Q3. All of the following orders may never be executed except -

A. Market order
B. Limit order
C. Stop loss order
D. Immediate or cancel order

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Questions
Q4. Which of the following is false regarding a Forward contract

A. It is traded OTC
B. may include collateral
C. It is fully standardized
D. It can be used for hedging activities

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Questions
Q5. A futures trader is concerned about credit risk on a particular futures contract. Will the process of
collateralization protect him?

A) Collateral is posted, and losses are guaranteed by the exchange, thus he will be protected.
B) Collateral is held by the exchange, and losses are covered via the collateral at conclusion of the
contract term, thus he is protected.
C) There is no collateralization process in the OTC market, thus he is not protected.
D) There is a mark to market feature, and losses are settled in cash daily, thus he will be protected.

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Questions
Q6. Initial margin deposits for futures accounts are:

A) set by the Federal Reserve for U.S. markets.

B) typically 50% of the purchase price.
C) usually larger for the short position.
D) based on price volatility.

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Questions
Q7. All of the following are methods to close out a futures position except :

A) delivery of the underlying commodity.

B) engaging in an offsetting trade in the futures market.
C) through an exchange for physicals with another trader.
D) allowing the contract to expire without taking action.

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Questions
Q8. A similarity of margin accounts for both equities and futures is that for both:

A) interest is charged on the margin loan balance.

B) the initial margin is effectively paid to the seller of the security by the buyer.
C) additional payment is required if margin falls below the maintenance margin.
D) the value of the security is the collateral for the loan.

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Thank you

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