2.

0 Mechanics of Futures Market

2.1 Specifications of Futures Contract
 When developing a contract, the exchange must specify in detail the exact nature of
the agreement between two parties.
1. Asset
 If the asset is a commodity, it is necessary to specify the grade of the
commodities that are acceptable.
 Financial assets are usually well-defined and unambiguous, except Treasuries
(Treasury bonds, Treasury notes) with vary maturity.
2. Contract Size
 Specify the amount of the asset that has to be delivered under one contract.
o Too large – Investors who wish to hedge small exposures are unable to
use the exchange.
o Too small – Trading may be expensive as there are trading costs
associated with each contract traded.
3. Delivery Arrangement
 The place where delivery will be made.
 Particularly important for commodities that involve significant transaction
costs.
 Price received by short position tends to be higher when the delivery location
is far from the main source of commodity.
4. Delivery Months
 The precise period during the month to which the delivery can be made
(usually the whole month).
5. Price Quotes
 Defines how price will be quoted (dollars and cents, …)
6. Price Limits
 Specify the price movement limits.
 Limit Down: The price move down from the previous day’s closing price by
an amount equal to the daily price limit.
 Limit Up: The price move up from the previous day’s closing price by an
amount equal to the daily price limit.
  Limit Move: The price move in either direction equal to the daily price limit.
 Trading ceases once the contract is limit up/down.
o In some instances the exchange will have the authority to step in and
change the limits.
 Purpose: Prevent large price movements from occurring due to speculative excesses.

 Limitations: May become an artificial barrier to trading when price of

underlying commodities are advancing/declining rapidly.
7. Position Limits
 Maximum number of contracts a speculator may hold.
 Prevent speculators from exercising undue influence on the market.

2.2 Convergence of Futures Price to Spot Price

 As delivery period approaches, futures price converge to the spot price and eventually
equals to the spot price at maturity.
 Suppose the futures price is above the spot price:
 Short futures contract (Lock the price now to sell higher in the future);
 Long the asset (Buy now at a lower price to sell for a higher price in the
future);
 Make delivery
 Make profit equals F 0 ( T )−ST .
 Suppose the future price is below the spot price:
 Long futures contract (Lock the price now to but at a lower price in the
future);
 Wait for delivery to be made.
 Profit equals ST −F 0(T ).
 Once the arbitrage opportunity is exploited, the futures price will tend to decline/rise,
resulting futures price very close to spot price at maturity.
2.3 Margin
 Fees required by exchange when coordinating trades between two parties to ensure
both parties honour their contract.
 The margin mechanism:
1. Once a contract is entered, the broker will require both parties to deposit some
amount of money (initial margin) in the margin account.
o Initial Margin: The amount that must be deposited in the margin account
at the time the contract is entered.
2. At the end of each trading day, the margin account is adjusted to reflect the
investors’ gain or loss.
o This practice is referred to as daily settlement/mark-to-market.
3. If the balance in the margin account falls below the maintenance margin, the
investor will receive a margin call to top up the margin account to the initial
margin level.
o Maintenance Margin: An amount limit lower than initial margin to
ensure the margin account never becomes negative.
4. If the variation margin is not provided by the end of next day, the broker close
out the position.
o Variation Margin: Extra funds deposited into the margin account.
 Daily settlement is not merely an arrangement between the broker and client.
o If futures price decreases, the margin account of long position is reduced. The
investor’s broker will have to pass this amount to the exchange clearing house
and this money will be passed to broker of investor taking short position.
 Investors are entitled to withdraw any balance in the margin account in excess of the
initial margin.
2.4 Contango and Backwardation
1. Contango
o A situation where it is cheaper to buy now in spot market than agree to
buy it at future date using futures contract.
o Investors are willing to pay more to acquire a commodity in the future.
 Concerns about cost of carry (storage costs, rot and spoil,
depreciation, etc…)
o Traders can profit by buying the commodity from spot market and sell it in
the future.
o Result in an upward sloping forward curve.

2. Backwardation
o A situation where it is more expensive to buy the commodity in spot
market than agree to buy it at a future date using futures contract.
o Can occur as a result of a higher demand currently due to shortage of the
commodity in the spot market.
o Traders can make profit by short selling at current price and buy at lower
futures price.
o Result in a downward sloping forward curve.
  Regardless of contango or backwardation, price will eventually converge to the spot
price as maturity approaches.

2.5 Delivery
 The period during which delivery can be made is defined by the exchange.
 The decision on which delivery will be made is defined by short position holder.
 Procedure:
1. When the decision to delivery is made, his broker will issue a notice of intention
to deliver to the exchange.
2. The exchange will choose the party with a long position to accept the delivery.
o There is no guarantee that it will be the party that he first entered the
contract into will be the one receiving the delivery.
o Counterparty may have already close his position by trading with other
investors.
o Exchange will usually choose the party with oldest outstanding long
position to receive the notice.
3. Parties with long positions must accept the delivery notice.
o If the notice is transferrable, they have a limited amount of time (half an
hour) to find another party with long position to take the delivery in place
of them.
4. Parties taking the delivery is responsible for all costs involved and make
immediate payment.
o Warehouse costs, transportation costs, cold storage costs, etc…
 5. The whole process generally takes about two to three days.
 Three critical days for the contract:
1. First Notice Day
o First day on which a notice of intention for delivery can be submitted to
the exchange.
2. Last Notice Day
o Last day on which a notice of intention for delivery can be submitted to the
exchange.
3. Last Trading Day
o One day before contract’s expiration day, usually a few days before last
notice day.
 To avoid risk of having to take delivery, long investors should close out their position
prior to the first notice day.

2.6 Cash Settlement

 Financial futures are settled in cash because it is inconvenient or impossible to deliver
the underlying asset.
 All outstanding contracts are declared close at a predetermined day.
 Final settlement price equals the spot price of the underlying asset, either the open or
close of the trading day.

2.7 Traders
 Two main types:
1. Futures Commission Merchants (FMCs)
o Follows instructions of their clients and charge a commission for doing so.
2. Locals
o Trading on own account.
 Regardless of the categories, all individuals taking position can be classified into
either hedger, speculator or arbitrageur.
 Speculators can be further classified as:
1. Scalpers
o Watching for very short-term trends and attempt to profit from small
changes in the contract price.
2. Day Traders
 o Hold their position for less than 1 trading day.
o Unwilling to take the risk that adverse news will occur overnight.
3. Position Traders
o Hold their position for much longer period of time.
o Hope to make significant profit from major movement in the market.

2.8 Orders
 Unless otherwise specified, all orders are day orders that expires at the end of the
trading day.
1. Market Order
o A request to carry out trade immediately at the best price available in the
market.

2. Limit Order
o Order can only be executed at a pre-specified price or at one more
favourable to the investor.
o No guarantee that the order will be executed at all because the limit price
may never be reached.
3. Stop-Loss Order
o Order is executed at the best available price once a bid/offer is made at a
pre-specified price or a less favourable price.
o Close out a position if unfavourable price movement takes place to limit
losses.
4. Stop-Limit Order
o Combination of stop-loss order and limit order.
o Specifies both limit price and stop price.
o Stop order is filled at the market price after the stop price has been hit,
regardless of whether the price changes to an unfavourable position.
o Can lead to trades being completed at less than desirable prices
should the market adjust quickly.
 o Combining with limit order, after the stop price is triggered, the limit order
takes effect to ensure that the order is not completed unless the price is at
or better than the limit price the investor has specified.
5. Market-if-Touched (MIT) Order/Board Order
o Executed at the best available price after a trade occurs at a specified
price or a more favourable price.
o Ensure profits are taken if sufficiently favourable market movement
occurs.
6. Market-Not-Held Order/Discretionary Order
o Similar to market order except that execution can be delayed at broker’s
discretion in attempt to get a better price.
7. Time-of-Day Order
o Specifies a particular period of time during the day when the order can be
executed.
8. Open Order/Good-Till-Cancelled Order
o In effect until execution or until the end of trading in a particular contract.
9. Fill-or-Kill Order
o Must be executed immediately on receipt or not at all.

2.9Regulations
 Futures market are regulated by the Commodity Futures Trading Commission
(CFTC).
 Roles:
o Ensure prices are communicated to the public and futures traders report their
outstanding positions if they are above certain level.
o License all individuals who offer their services to the public in futures trading.
 Investigate these individual’s background and impose minimum capital
requirement.
o Deal with complaints of public and ensure disciplinary actions are taken
against individuals when appropriate.
o Responsible for rules requiring that standard OTC derivatives be traded on
swap execution facilities and cleared through central counterparties.