Handout - 1 - Introduction Spring 2021

FIN 4720: Futures Markets Spring 2021
Handout #1 Terrence F. Martell, Ph.D.

Mert Demir, Ph.D.
Alex Gansch
Introduction: The Futures Markets

A Forward/Futures contract is an agreement to buy or sell a commodity sometime in the
future with the price determined today.
A Forward contract is a contract negotiated in the present that gives the contract holder
both a right and full legal obligation to conduct a transaction at a specific future time
involving a specific quantity and type of asset at a predetermined price. For example, you
can agree today to sell copper with another party on a specific future date at a specific
predetermined price.
A Futures contract is a type of forward contract with highly standardized and closely
specified contract terms. As in all forward contracts, a futures contract calls for the exchange
of some goods at a future date for cash, with the payment for the goods to occur at that future
date. Futures contracts always trade on an organized market.
Note: Futures and Forward contracts perform same economic function. The difference
between the two types of contracts are institutional in nature. In addition to standardized
terms versus negotiated, there are (could be) differences in regulation, taxation, and certainly
counterparty credit risk.
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Five fundamental types of futures contracts
1. Agricultural and Metallurgical Contracts: Physical goods contracts cover a wide

range of products: grains, seeds, food, fiber, livestock, meat, metals and petroleum.
The months for delivery for seasonal agricultural products are chosen to fit their
harvest patterns. The number of contract months depends on the level of trading
activity.
2. Interest-Earning Assets: in the US, treasury notes, treasury bonds, and Eurodollar
deposits. Interest rate futures started trading in 1975 and have experience tremendous
growth since then. Existing contracts span the entire yield curve, so it is possible to
trade instruments with just about any maturity
3. Foreign Currencies: Japanese yen, British pound, Canadian dollar, Swiss franc,
Australian dollar and Euro currency. Currency trading started in the early 1972.
4. Indexes: Dow index, NASDAQ index, S&P500 index, NIKKEI, Russell, NYSE
composite index, and U.S. dollar index. Index trading started in 1982. By trading
volume, most index futures are for stock indexes. You should know that stock index
contracts in the US do not allow for actual delivery. A trader’s obligation must be
fulfilled by a reversing trade or a cash settlement at the end of trading.
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What is a Commodity?
•1860 – 1960 Storable; Physical

Corn, Copper, Cotton, Coffee
•1960s: Physical; Not so Storable
Meats - Live Cattle
•1970s: Storable; Not so Physical
Currency, US Treasury Bills
•1980s: Storable; Non Physical
Stock Index; $Euro
Notice that the types of commodities eligible for futures has expanded over time!
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Commodity Characteristics Desirable for Futures Trading
1. Large cash market
2. Substantial price volatility
3. Good information on cash prices
4. Large deliverable supply
5. Can we standardize; that is define the cash commodity
Consider the corn contract. Does it meet the characteristics necessary? The Zhengzhou
Commodity Exchange successfully trades a futures contract based on plate glass. Would
plate glass satisfy the characteristics desirable for futures trading?
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Purpose of Futures Markets

There are 3 groups of futures market users
1. Those who wish to discover information about future prices of commodities
2. Those who wish to speculate
3. Those who wish to hedge
There are two main economic functions of futures markets
1. Price discovery
2. Hedging
Price discovery: By using the information contained in futures prices today, market
observers can form estimates of what the price of a given commodity will be at a certain time
in the future. This price information is a by-product of the trading of hedgers and
speculators.
Hedging: Many futures market participants trade futures as a substitute for a cash market
transaction to reduce pre-existing risk. For example, a mine operator who owns a copper
mine can lock in current market price by selling his copper in the futures market.
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Important Insight!
Futures markets facilitate trading among strangers. They reduce both quality risk by
having contract specifications and credit risk by trading through a clearinghouse.
What makes trading among strangers challenging? A lack of trust. If you do not trust
somebody, you will want guarantees, collateral something to offset the lack of information
about the person’s character. This takes time and money and slows trading. Futures markets
facilitate trading by reducing quality risk by standardizing the definition of the commodity
being traded. Futures markets reduce credit risk by establishing clearing houses.
Liquidity is very important in futures markets. Many of the institutional arrangements that
have developed over the years emphasized liquidity. That is why futures markets facilitate
trading among strangers. The greater the number of traders, the greater the liquidity.
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Futures Price Quotations

Example: Corn (Wednesday, January 20, 2021 - WSJonline)
Corn (CBT) 5,000 bu.: cents per bu.
MONTH LAST CHG OPEN HIGH LOW SETTLEMENT DATE VOLUME OPEN INT
Corn Mar 2021 523.50 -2.50 525.00 525.25 512.75 526.00 01/19 156,679 745,487
Corn Dec 2021 448.75 -6.25 454.00 454.25 445.50 455.00 01/19 29,465 280,540
- Tuesday, January 19, 2021 is the date for which the prices were recorded.
- Wednesday, January 20, 2021 is the publication date of the data on Wall Street
Journal online.
- Corn contract is traded by CBOT/CBT. (CBOT merged with CME to become CME
Group.)
- One contract is for 5,000 bushels.
- All prices are quoted in cents per bushel.
- March and December are the delivery months. The first row is the contract that
matures next, also called the nearby contract.
- Open, high, low are the opening price, the high price, and the low price for the day,
respectively.
- The settlement price is the price at which the futures contracts are marked-to-market.
Each exchange determines the settlement price of each futures contract to reflect the
true economic price of the futures contract at the end of the trading day.
- “Change” is the change in the settlement price from preceding trading day.
- Open interest is the number of futures contracts that are still not satisfied. These
contracts must be either offset or delivered.
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Patterns of Open Interest
The patterns of open interest are different depending on the particular futures contract. Notice
the difference among the Corn contract, the S&P 500 Mini contract and the Eurodollar
contract.
MONTH VOLUME OPEN INT MONTH VOLUME OPEN INT

Corn Mar 2021 156,679 745,487 Corn Sep 2022 88 3,353
Front Month 156,679 745,487 Corn Dec 2022 688 17,117
Corn May 2021 58,302 373,260 Corn Mar 2023 93 392
Corn Jul 2021 40,423 276,448 Corn May 2023 0 N/A
Corn Sep 2021 8,929 146,598 Corn Jul 2023 69 344
Corn Dec 2021 29,465 280,540 Corn Sep 2023 60 17
Corn Mar 2022 2,712 28,049 Corn Dec 2023 105 1,126
Corn May 2022 583 3,718 Corn Jul 2024 0 N/A
Corn Jul 2022 617 17,063 Corn Dec 2024 0 12
MONTH VOLUME OPEN INT

E-Mini S&P 500 Future Mar 2021 6,447 2,579,582
E-Mini S&P 500 Future Jun 2021 1,824 19,610
E-Mini S&P 500 Future Sep 2021 11 66
E-Mini S&P 500 Future Dec 2021 0 40
E-Mini S&P 500 Future Mar 2022 0 10
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MONTH VOLUME OPEN INT MONTH VOLUME OPEN INT

Eurodollar 3 Month Feb 2021 59 178,320 Eurodollar 3 Month Sep 2025 116 102,173
Eurodollar 3 Month Mar 2021 2,897 1,117,415 Eurodollar 3 Month Dec 2025 18 46,524
Eurodollar 3 Month Apr 2021 30 20,713 Eurodollar 3 Month Mar 2026 1,961 9,712
Eurodollar 3 Month May 2021 2 2,428 Eurodollar 3 Month Jun 2026 840 4,803
Eurodollar 3 Month Jun 2021 908 965,533 Eurodollar 3 Month Sep 2026 2,027 5,063
Eurodollar 3 Month Jul 2021 0 N/A Eurodollar 3 Month Dec 2026 918 3,030
Eurodollar 3 Month Sep 2021 1,082 804,094 Eurodollar 3 Month Mar 2027 154 897
Eurodollar 3 Month Dec 2021 136 754,087 Eurodollar 3 Month Jun 2027 84 535
Eurodollar 3 Month Mar 2022 370 761,651 Eurodollar 3 Month Sep 2027 10 435
Eurodollar 3 Month Jun 2022 153 673,909 Eurodollar 3 Month Dec 2027 5 179
Eurodollar 3 Month Sep 2022 264 530,534 Eurodollar 3 Month Mar 2028 0 152
Eurodollar 3 Month Jun 2023 224 533,559 Eurodollar 3 Month Dec 2028 0 4
Eurodollar 3 Month Sep 2023 274 536,468 Eurodollar 3 Month Mar 2029 0 9
Eurodollar 3 Month Jun 2024 15 221,193 Eurodollar 3 Month Dec 2029 0 N/A
Eurodollar 3 Month Sep 2024 83 203,622 Eurodollar 3 Month Mar 2030 0 N/A
Eurodollar 3 Month Dec 2024 9 219,201 Eurodollar 3 Month Jun 2030 0 N/A
Eurodollar 3 Month Mar 2025 45 162,352 Eurodollar 3 Month Sep 2030 0 N/A
Eurodollar 3 Month Jun 2025 96 127,277 Eurodollar 3 Month Dec 2030 0 N/A
Source: WSJ Market Data
The tables above show the pattern of trading volume for each expiration month.
- Open interest and trading volume are low when the contract is far from maturity and
both of them will increase when the contract approach maturity.
- As the nearby contract comes very close to maturity the open interest and trading
volume falls. This is due to the fact that most traders avoid delivery by rolling their
positions forward.
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Initiate a futures position

Long futures contract: Trader who is going long a futures contract has an obligation to buy
the underlying asset at a predetermined price and time. He will gain (profit) from the futures
contract if the futures price rises.
Short futures contract: Trader who is going short a futures contract has obligation to sell
the underlying asset at a predetermined price and time. He will (gain) profit from the futures
contract if the futures price falls.
Closing a Futures Position

There are 3 ways to get out of the futures position once trader initiates it.
1. Delivery
2. Reverse or offsetting trade: we buy/sell exactly the same contract that was
sold/bought originally.
3. Exchange for physicals (EFP): Trader finds another trader with an opposite position
to his own in both cash and futures market and delivers the goods and settles up
between themselves off the exchange. This is the exception to the CFTC regulations
that require that all trades take place on an exchange.
Think of an EFP as a contract settled by delivery but the commodity used to settle the
futures obligation does not exactly match the characteristics specified in the futures
contract. I call it a “non-standardized delivery”.
Example: A trader goes long 2 May futures contract for corn. There are 3 ways to get out of
the futures position:
- Delivery: He may choose to wait until May and take delivery of 5,0002 = 10,000
bushels of corn.
- Reverse Trade: He may sell two of the futures contracts on or before last trading day
of this contract.
- Exchange for physicals: He may buy corn from another trader who needs to sell
10,000 bushels of corn and has shorted 2 May futures contracts. After the trade takes
place, both traders have to inform clearinghouse to close the position of both parties.
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The Reversing Trade
Trader A's Initial Position Trader B

Bought 2 May contracts for corn at 232.5 Sold 2 May contracts for corn at 232.5
1-Apr cents per bushel cents per bushel
Trader A's Reversing Trade Trader C
Sells 2 May contracts for corn at 250 Buys 2 May corn contracts at 250
10-Apr cents per bushel cents per bushel
Note what happened. The initial position is between Trader A and Trader B. The final
position is between Trader C and Trader B. Did anyone ask B if C could substitute for A?
How trading affects open interest. There are four traders, A, B, C, and D.
Table 1: Transactions
Transaction Date Buyer Seller Contracts
1 6-Jul A B 5
2 6-Jul C B 10
3 7-Jul D A 10
4 7-Jul B D 5
5 8-Jul B A 7
Table 2: Open interests after each transaction

Net Position of Total Open
A B C D Interest
After TXN 1 +5 -5 5
After TXN 2 +5+0=+5 -5 - 10 = - 15 + 10 5+10 = 15
After TXN 3 + 5 - 10 = - 5 - 15 + 0 = - 15 + 10 + 0 = + 10 + 10 10+10 = 20
After TXN 4 -5+0=-5 - 15 + 5 = - 10 + 10 + 0 = + 10 + 10 - 5 = + 5 10+5 = 15
After TXN 5 - 5 - 7 = - 12 - 10 + 7 = - 3 + 10 + 0 = + 10 +5+0=+5 10+5 = 15
If both buyer and seller are initiating a new position, open interest goes up (see Transaction
1). If both buyer and seller are initiating an increasing position, open interest goes up (see
Transaction 2). If one party is increasing a position, while the other party is reducing a
position, open interest does not change.
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An Exchange-for-Physicals Transaction-Basic Concept (Non-Standard Delivery)
Before the EFP

Trader A (Hedger) Trader B(Hedger)
Long 2 corn futures Short 2 corn futures
Wants to acquire actual corn Owns corn and wants to sell
EFP Transaction
Trader A Trader B
Agrees with Trader B to purchase corn and cancel futures Agrees with Trader A to sell corn and cancel futures
Receives corn; pays Trader B Delivers corn; receives payment from Trader A
Reports EFP to exchange; Exchange adjusts books to Reports EFP to exchange; Exchange adjusts books
show that Trader A is out of the market to shows that Trader B is out of the market
Note this is a non-standard delivery for no other reason than Trader A is not an
approved delivery location.
Completion of Futures Contract via Delivery/Cash Settlement

(Source: CFTC Annual Report to Congress FY 2004)
Commodity Group Traded Volume Delivery/Cash Settlement Percentage

Financial Instruments 949,483,708 (77.47%) 8,535,903 0.90%
Energy/Wood Products 104,527,384 (8.53%) 1,582,021 1.51%
Oilseed Products 37,091,132 (3.03%) 38,566 0.10%
Currencies 43,430,189 (3.54%) 768,374 1.77%
Grain 38,917,200 (3.18%) 74,252 0.19%
Metals 23,371,676 (1.91%) 197,646 0.85%
Other Agricultural 20,643,927 (1.68%) 117,408 0.57%
Livestock Products 8,172,833 (0.67%) 41,982 0.51%
Total 1,225,638,049 (100%) 11,356,152 0.93%
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TABLE 1
The annual Sugar and Cotton futures volumes vs. delivery for the last eleven years
Sugar 11 Cotton No. 2
Calendar Futures Futures
Year Volume Delivered % Volume Delivered %
2008 27,019,704 47,795 0.18% 6,162,963 18,225 0.30%

2009 27,300,259 66,754 0.24% 3,574,995 3,409 0.10%
2010 29,133,632 38,248 0.13% 5,732,906 13,716 0.24%
2011 24,629,369 45,010 0.18% 5,288,454 6,992 0.13%
2012 27,126,728 64,212 0.24% 6,130,362 2,910 0.05%
2013 29,813,680 63,396 0.21% 6,155,024 8,161 0.13%
2014 27,396,597 27,700 0.10% 5,787,883 3,626 0.06%
2015 34,394,482 90,316 0.26% 6,726,586 896 0.01%
2016 33,115,334 59,021 0.18% 7,318,168 1,272 0.02%
2017 30,961,148 106,465 0.34% 7,907,507 2,603 0.03%
2018 37,011,007 47,495 0.13% 8,876,095 2,633 0.03%
Source: Intercontinental Exchange (ICE) Futures US.
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NYMEX : COPPER DELIVERY POINTS
Southwire is a big copper wire manufacturer located in Georgia. The company is concerned
about increasing copper prices. They protect themselves by going long copper. Why would
they not be likely to take delivery? Under what circumstances would they take delivery?
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NY Harbor ULSD (Heating Oil) Futures
Product HO
Symbol
Venue CME Globex, CME ClearPort, Open Outcry (New York)
Hours CME Globex: Sunday – Friday 6:00 p.m. – 5:15 p.m. (5:00 p.m. – 4:15 p.m.
(All Times Chicago Time/CT) with a 45-minute break each day beginning
are New at 5:15 p.m. (4:15 p.m. CT)
York
Time/ET)
CME Sunday – Friday 6:00 p.m. – 5:15 p.m. (5:00 p.m. – 4:15 p.m.
ClearPort: Chicago Time/CT) with a 45-minute break each day beginning
at 5:15 p.m. (4:15 p.m. CT)
Open Outcry: Monday – Friday 9:00 AM to 2:30 PM (8:00 AM to 1:30 PM CT)
Contract Unit 42,000 gallons
Price U.S. dollars and cents per gallon

Quotation
Minimum $0.0001 per gallon

Fluctuation
Maximum Initial Price Fluctuation Limits for All Contract Months. At the commencement of
Daily Price each trading day, there shall be price fluctuation limits in effect for each contract
Fluctuation month of this futures contract of $0.25 per gallon above or below the previous
day's settlement price for such contract month. If a market for any of the first
three (3) contract months is bid or offered at the upper or lower price fluctuation
limit, as applicable, on CME Globex it will be considered a Triggering Event
which will halt trading for a five (5) minute period in all contract months of the HO
futures contract, as well as all contract months in all products cited in the
Associated Products Appendix of rule 150.07. Trading in any option related to
this contract or in an option contract related to any products cited in the
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Associated Products Appendix which may be available for trading on either CME
Globex or on the Trading Floor shall additionally be subject to a coordinated
trading halt.
Termination Trading in a current month shall cease on the last business day of the month
of Trading preceding the delivery month.
Trading at Trading at settlement is available for spot (except on the last trading day), 2nd,
Settlement 3rd and 4th months and subject to the existing TAS rules. Trading in all TAS
(TAS) products will cease daily at 2:30 PM Eastern Time. The TAS products will trade
off of a "Base Price" of 0 to create a differential (plus or minus 10 ticks) versus
settlement in the underlying product on a 1 to 1 basis. A trade done at the Base
Price of 0 will correspond to a "traditional" TAS trade which will clear exactly at
the final settlement price of the day.
Trade at Platts TAM trading based on the Platts 3:15PM (Eastern Time) Futures
Marker Assessment, will be available in the first two (2) contract months of HO and in
(TAM) calendar spreads between the first and second contract months.
TAM trading is analogous to our existing Trading at Settlement (TAS) trading

wherein parties will be permitted to trade at a differential that represents a not-
yet-known price. TAM trading will use a marker price, whereas TAS trading uses
the Exchange-determined settlement price for the applicable contract month. As
with TAS trading, parties will be able to enter TAM orders at the TAM price or at
a differential between one and ten ticks higher or lower than the TAM price.
Trading at marker is available for spot month on the last trading day.
NY Harbor ULSD Futures (HO) spot, 2nd and 3rd months and nearby/second
month, second/third month and nearby/third month calendar spreads.
No-Activity Periods:
4:30 p.m. London time – 5:50 p.m. Eastern time Monday – Thursday
4:30 p.m. London time Friday – 5:20 p.m. Eastern time Sunday
Listed Current Year + 3 Years + 1 Month

Contracts
Settlement Physical
Type
Settlement Daily NYMEX Energy Futures Settlement Procedure (PDF)
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Procedure Final NYMEX Energy Futures Settlement Procedure (PDF)
Delivery Please see rulebook chapter 150

Period
Position NYMEX Position Limits

Limits
Rulebook 150
Chapter
Exchange These contracts are listed with, and subject to, the rules and regulations of
Rule NYMEX.
Source: http://www.cmegroup.com/trading/energy/refined-products/heating-oil_contract_specifications.html
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Chapter 150
NY Harbor ULSD Futures
150100. SCOPE OF CHAPTER
This chapter is limited in application to NY Harbor ULSD futures. The procedures for trading, clearing, delivery
and settlement not specifically covered herein or in Chapter 7 shall be governed by the general rules of the
Exchange.
The provisions of these rules shall apply to all ULSD bought or sold for future delivery on the Exchange with
delivery in New York Harbor.
The terms “seller” and “buyer” shall mean the seller of the physical product and the buyer of the physical product,
respectively.
The term "contract value" shall mean the amount equal to the settlement price on the last day of trading in a
futures contract times 42,000 times the number of contracts to be delivered.
For purposes of these rules, unless otherwise specified, times referred to herein shall refer to and indicate New
York time.
150101. CONTRACT SPECIFICATIONS
The term “ASTM” refers to the American Society for Testing Materials.
150101.A Grade and Quality Specifications through April 2013 Contract Month - No. 2 Heating Oil
The oil shall be a hydrocarbon oil free from alkali, mineral acid, grit, fibrous or other foreign matter and shall meet
the following physical and chemical properties.
The term “API” refers to the American Petroleum Institute.
The term “DuPont” refers to Petroleum Chemical Division, E.I. DuPont de Nemours & Company (Inc.), Petroleum
Laboratory Test Methods.
1. Gravity: API 30 degrees Fahrenheit minimum (ASTM Test Method D-287)
2. Flash: 130 degrees Fahrenheit minimum (ASTM Test Method D-93)
3. Viscosity: Kinematic, Centistokes at 100 degrees Fahrenheit, minimum 2.0, maximum 3.6 (ASTM Test Method
D-445)
4. Water and Sediment: .05% maximum (ASTM Test Method D-1796 or D-2709)
5. Pour Point: 0 degrees Fahrenheit maximum for contract months September through March; 10 degrees
Fahrenheit maximum for contract months April through August, (ASTM Test Method D-97)
6. Distillation: 10% Point, 480 degrees Fahrenheit maximum; 90% Point, 640 degrees Fahrenheit maximum, End
Point 690 degrees Fahrenheit maximum (ASTM Test Method D-86)
7. Sulfur: 0.20% maximum (ASTM Test Method D-129, D-1552, D-1266, D-2622 or D-4294)
8. Stability: (i) Thermal Stability: 90 minutes 300 degrees Fahrenheit Pad rating 7 maximum (DuPont Test
Method); or (ii) Oxidation Stability: mg/100ml., 2.5 maximum (ASTM Test Method D-2274);
9. Haze Rating: 25 degrees Celsius (77 degrees Fahrenheit), Procedure 2, 2 maximum (ASTM Test Method D-
4176);
10. Carbon Residue: Weight% on 10% Bottom, 0.35 maximum (ASTM Test Method D-524 or D-4530);
11. Ash: 0.01 wt. % maximum (ASTM Test Method D-482);
12. Corrosion: 3 hours 50 degrees Celsius (122 degrees Fahrenheit), 1 maximum (ASTM Test Method D-130).
13. Cloud Point: 15 degrees Fahrenheit maximum for contract months September through March; 20 degrees
Fahrenheit maximum for contract months April through August. (ASTM Test Method D-2500)
14. Dye: All heating oil delivered against this contract, regardless of sulfur content, shall be dyed in satisfaction of
the dyeing requirements as prescribed by the Internal Revenue Service (IRS) for tax-free sales or uses of diesel
fuel (using the Petro Spec dye analyzer or the IRS Test Method), pursuant to Section 4082 of the Internal
Revenue Code of 1986, as amended.
150101.B. Grade and Quality Specification Effective with the May 2013 Contract Month and Beyond –
Ultra Low Sulfur Diesel (“ULSD”)
The oil delivered shall be a pure hydrocarbon oil free from renewable fuel, biodiesel, alkali, mineral acid, grit, fibrous or
other foreign matter, meeting the "Delivery" specifications of the Colonial Pipeline's Fungible Grade 62 for Ultra Low
Sulfur Diesel, and being properly designated for sale in New York Harbor in accordance with U.S. Environmental
Protection Agency (EPA) regulations. Delivery test results may vary by the smaller of ASTM reproducibility for a given test
or any test tolerance as allowed for downstream parties by state or EPA regulations at the point of delivery. The ULSD
delivered shall fully comply with specifications of the Colonial Pipeline Fungible Grade 62 for on-road ULSD,
including the requirement that the on-road diesel fuel must contain no renewable diesel or biodiesel.
Source: http://www.cmegroup.com/rulebook/NYMEX/1a/150.pdf
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Corn Futures Contract
Corn Futures
Contract Size 5,000 bushels (~ 127 Metric Tons)
Deliverable #2 Yellow at contract Price, #1 Yellow at a 1.5 cent/bushel premium #3 Yellow

Grade at a 1.5 cent/bushel discount
Pricing Unit Cents per bushel
Tick Size 1/4 of one cent per bushel ($12.50 per contract)
(minimum
fluctuation)
Contract March (H), May (K), July (N), September (U) & December (Z)
Months/Symbols
Trading Hours CME Globex (Electronic Sunday – Friday, 7:00 p.m. – 7:45 a.m. CT
Platform) and
Monday – Friday, 8:30 a.m. – 1:15 p.m.
CT
Open Outcry (Trading Floor) Monday – Friday, 8:30 a.m. – 1:15 p.m.
CT
Daily Price Limit $0.40 per bushel expandable to $0.60 when the market closes at limit bid or
limit offer. There shall be no price limits on the current month contract on or
after the second business day preceding the first day of the delivery month.
Settlement Daily Grains Settlement Procedure (PDF)

Procedure Final Corn Settlement Procedure (PDF)
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Corn Futures
Last Trade Date The business day prior to the 15th calendar day of the contract month.
Last Delivery Second business day following the last trading day of the delivery month.
Date
Product Ticker CME Globex (Electronic ZC

Symbols Platform) C=Clearing
Open Outcry (Trading Floor) C
Exchange Rule These contracts are listed with, and subject to, the rules and regulations of
CBOT.
Source: http://www.cmegroup.com/trading/commodities/grain-and-oilseed/corn_contract_specifications.html
Exchange and Clearinghouse

Futures contracts always trade on an organized exchange. Exchange members have a right
to trade directly on the exchange.
To manage the risk associated with the futures contracts, each futures exchange has an
associated clearinghouse. The clearinghouse may be constituted as a separate corporation or
it may be part of the futures exchange, but each exchange is closely associated with a
particular clearinghouse.
The members of an exchange may be classified as clearing members or non-clearing

members. A clearing member is a member of the exchange who is also a member of the
clearinghouse. The clearinghouse deals only with clearing members. As a consequence, any
non-clearing member must clear his or her trades through a clearing member. This will have
significant implications for customer who hold positions in a DCO (Designated Clearing
Organization), the official government designation for a clearinghouse.
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Role of Clearinghouse
- The Chicago Mercantile Exchange defines the clearing relationship as “The accounts
of individual member, clearing firms and nonmember customers doing business
through the CME must be carried and guaranteed to the clearinghouse by a clearing
member.”
- The clearinghouse is substituted as the buyer to the seller and the seller to the buyer,
with the clearing member assuming the opposite side of each transaction.
- Market professionals understand that a clearinghouse reduces credit risk and allows
for offset of positions by inserting itself between buyers and sellers. It is this function
that contributes significantly to liquidity by permitting trading without regard to the
credit risk of the ultimate counterparty to the trade
Goods Goods
Clearinghouse
Buyer Seller
Funds Funds
Clearinghouse Risk Management (Waterfall)

Clearinghouses manage their risk by using the following risk management
techniques/procedures:
• Marking-to-market in cash each day all open futures positions.
• Requiring original margin on deposit at the clearinghouse before any clearing
member can carry a position at the clearinghouse.
• Relating the size of positions a clearing member can carry to the amount of the
capital the clearing member has.
• Margin calls during the day.
• The guarantee fund.
• Assessment process.
• Rules and procedures of the clearinghouse.
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Marking to Market
Daily Resettlement of a Futures Contract
Date Beginning Clearing member Clearing member Settlement Settlement

Time Representative Representative Time Price .
12/12 9:00 am Buyer Seller 2:30 pm $495/oz

Execution at $500/oz A B NY time
for 100 oz
12/13 9:00 am A CH B 2:30 pm $491/oz

$5/oz $5/oz
12/14 9:00 am A CH B 2:30 pm $497/oz

$4/oz $4/oz
12/15 9:00 am A CH B 2:30 pm $498/oz

$6/oz $6/oz
12/16 9:00 am A CH B Delivery

$1/oz $1/oz
$498/oz
A B
Buyer Seller
100 oz gold
A receives 100 oz gold on December 16. Effectively, he pays $500 for the gold (498+5+4-6-1=500).
However, the cash flows are unpredictable.
A Forward Contract Three points:

1. The price you enter the futures
Date Buyer Seller contract at is the price you pay
. for the commodity.
12/12 A B 2. The markets settle up each day
Agree to buy gold at forward price $500/oz.
as the loser pays the winner.
3. The timing of the price moves
$500/oz matter in the amount of interest
12/16 A B income or the interest expense
Buyer Seller incurred.
100 oz gold
23
Mert Demir, Ph.D.
Alex Gansch
Two types of margin
Original margin (Initial margin-Performance Bond): Original margin must be deposited

before any trading takes place. Initial margin often equals about one day’s expected price
fluctuation. The original margin may be posted in cash, a bank letter of credit, or in short-
term U.S. Treasury instruments. The trader who posts this margin retains title to it. If one has
deposited a security as the margin, then the trader earns the interest that accrues while the
security has served as the margin.
Variation margin is the amount of money trader has to deposit to cover any mark-to-market
loss. Variation margin will bring the account back up to the initial margin level. Variation
margin must be paid in cash only that is same day funds. From the example in previous page,
Buyer A has to deposit variation margin = ($500 - $495) × 100 = $500 per one contract at the
end of December 12.
Futures Contract & Leverage

Leverage means that you commit only small amount of money in order to control a futures
contract that has very large nominal size. To illustrate the point, suppose that wheat is $3.00
per bushel and you have to deposit $1,500 initial margin to enter long one futures contract on
wheat, and that the nominal size of the wheat is $3.00  5000 bushels per contract = $15,000
per contract.
Assume further that, one month later, the settlement price of the futures contract rise to $3.30
which is only 10% from the original price. However, now our capital will equal (initial
margin + profit from futures = $1,500 + ($3.30-$3.00) 5,000 = $3,000. Ten percent change
in the value of the futures contract will affect the investor account by 100%
To reduce your leverage, you can always post more margin than required to establish your
position.
24
Mert Demir, Ph.D.
Alex Gansch
Margin Cash Flows
Clearing Clearing House

Trader A Member
Non-clearing
Trader B
Member Arrows indicate flow of margin funds
• If you are not a clearing member, you are a customer.

• If you are actively participating in a market, deal with a clearing member.
• Know your Clearing Member. There is no government sponsored insurance like there
is in the securities business (SIPC). What does “know” mean? What is their
reputation for good business practices? What is the size of their capital?
Segregation of Accounts – in the United States
•At Brokerage firm or FCM (Futures Commission Merchant)

– Individual customer accounts must be kept separate
– Can’t use one customer’s money to margin another customer’s position
•At Clearinghouse: each clearing member has two accounts:

1. House account - all proprietary trades
2. Customer account - all customer trades
Clearinghouse cannot use customer account to cover losses in the house account. But,
clearinghouse can use house account to cover customer position.
Notice that all customer deposits and positions for a clearing member are in one account at
the clearing house. The default of one customer could jeopardize the other customers of that
clearing member. This is a consequence of the fact that the clearinghouse does not know the
positions or money of individual customers.
25
Mert Demir, Ph.D.
Alex Gansch
Clearing House (CCP)

Customer Sells 10
A December
gold
Customer
contracts
B
Buys 1
December CCP
gold contract
Customer
C
Buys 9
December
gold
contracts
Prudential
Goldman Sachs Securities, Inc.
CP CP
At clearinghouse
- Goldman Sachs: long 1 Dec
- Prudential: (Gross) long 9 Dec. and short 10 Dec.
(Net) short 1 Dec.
If customer B defaults and Prudential default, customer C will not be protected by

clearinghouse. Clearinghouse will become Goldman Sachs’ counterparty, and hold short 1
Dec. futures contract.
What would happen to the risk faced by the clearing house if it tried to protect
customer C?
26
Mert Demir, Ph.D.
Alex Gansch
The differences between futures and forward contracts:
Forwards Futures
Counterparty Credit Risk High Low
Contract Terms Flexible Inflexible
Delivery Expected Yes No
Timing Flexibility No Yes
Regulation Low High
Liquidity Requirements Low High
Capital Requirements High Low
• Forwards are private contracts in the over-the-counter market and do not trade on organized
exchange. Futures contracts trade on organized exchange. Thus, forwards have default risk
(counterparty credit risk). The seller may not deliver, and the buyer may not accept delivery.
With futures contracts, performance is guaranteed by the exchange’s clearinghouse.
• Forwards are customized to satisfy the needs of the parties involved. Futures contracts are
highly standardized. A futures contract specifies the quantity, quality, delivery date, and
delivery mechanism.
• Most futures contracts are satisfied through offset or via a reversing trade. Less than one
percent of futures contracts traded have been settled by delivery/cash settlement.
• If a futures contract has choices in it (these choices are called delivery options), these choices
typically belong to the short. Futures trader with short position has flexibility to choose
delivery date. For example, a trader who is going short a wheat futures contract can deliver
wheat anytime in the delivery month. For forward contracts, the delivery date is determined
to be a specific date.
• Futures markets are highly regulated by governments. There are rules and regulations that
traders have to follow. Furthermore, each clearinghouse develops its own safeguards to
protect all clearing members. Forward markets are more loosely organized and typically have
no physical location where trading takes place.
• The most powerful mechanism to reduce default risk in futures market is the requirements for
margin and daily cash settlement. However, the requirement for marking-to-market in cash
requires liquidity.
• Because there is counter party credit risk in the forward market, each party is required to have
a sufficient level of capital or provide some collateral.
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Mert Demir, Ph.D.
Alex Gansch
Regulation of Futures Markets
There are four identifiable tiers of regulation in the futures market

• The broker/clearing member: Merrill Lynch, Prudential, etc.
• The exchange and clearinghouse: CME, ICE, etc.
• An industry self-regulatory body, the National Futures Association (NFA)
• A federal government agency, The Commodities Futures Trading Commission
(CFTC).
These tiers overlap, but each of them has its specific duties.
The Broker represents his or her customers to the exchange and clearinghouse. The broker is
responsible for knowing the customer’s position and intentions, for ensuring that the
customer does not disrupt the market or place the system in jeopardy, and for keeping the
customer’s trading activity in line with industry regulations and legal restrictions.
Futures Exchanges and Clearinghouses

The exchanges and clearinghouses control the conduct of exchange and clearing members.
To do so, the exchanges formulate and enforce rules for the members and rules for trading on
the exchange, for example, CME financial safeguard.
National Futures Association (NFA: www.nfa.futures.org) is the self-regulatory body of

futures markets, designed to protect the integrity of the industry and to promote the interests
of the industry. The following parties are required to be member of the NFA: futures
commission merchants (FCMs), commodity pool operators, introducing brokers, commodity
trading advisors, and associated persons. Exchange, banks and commodity business firms
may voluntarily join the NFA. However, one must be a member of the NFA in order to do
commodity-related business with public.
Commodity Futures Trading Commission (CFTC: www.cftc.gov) regulates futures

market trading rules and has the power to intervene in the market when it believes that
manipulation is present. It has developed 23 core principles with which exchanges and
clearing houses must comply. 12
1
http://www.goodwinprocter.com/Dodd-
Frank/Publications/Newsletter%20Articles/Financial%20Services%20Articles/2012_05/29_02.aspx
2
http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_12_DCMRules/index.htm
28
Mert Demir, Ph.D.
Alex Gansch
Overlapping Futures Market Regulation
CFTC
Exchange
Member who
Clearing
also is Clearing
Association Member
Exchange
Member, but
Exchange not Clearing
Member NFA
Non-Exchange FCM,
Commodity Pool
Operators, Trading
advisors, etc.
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Mert Demir, Ph.D.
Alex Gansch
Commodity Futures Contracts: Some Types of Orders

(Source: NYMEX/COMEX: A practical guide to hedging)
Market Order – An order to buy or sell without regard to a specific price.
Limit Order – An order to buy or sell at a specified price. This order can be executed
only at the specified price or better.
Open Order – Also known as “good until canceled” (GTC). An open order also
specifies a price at which the order is to be executed, but it stands until executed or canceled.
Stop Order – This type of order becomes a market order to buy or sell only if prices
reach a specific level: to buy only if prices rise to a stipulated level or to sell only if prices
drop to a stipulated level.
Examples of Abusive Trading Practices
Pre-arranged trading agreeing to some X aspect of a transaction before it is openly

executed.
Accommodation trading entering transactions to assist another participant in

accomplishing improper trading objectives
Trading before customers trading for one’s personal account or an account in which
orders, front running one has an interest, while having in hand any executable
customer order in that contract
Bucketing failing to introduce an order to the market place, traditionally

occurring when a broker noncompetitively takes the other
side of a customer order to the detriment of the customer or
other members
Wash trading entering transactions to provide the appearance of trading

activity without resulting in a change in market position
Cross-trading matching customer orders without offering them

competitively to the market
30

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FIN 4720: Futures Markets Spring 2021

Handout #1 Terrence F. Martell, Ph.D.

Introduction: The Futures Markets

Five fundamental types of futures contracts

1. Agricultural and Metallurgical Contracts: Physical goods contracts cover a wide

•1860 – 1960 Storable; Physical

Commodity Characteristics Desirable for Futures Trading

1. Large cash market

2. Substantial price volatility

3. Good information on cash prices

4. Large deliverable supply

5. Can we standardize; that is define the cash commodity

Purpose of Futures Markets

Futures Price Quotations

Patterns of Open Interest

MONTH VOLUME OPEN INT MONTH VOLUME OPEN INT

MONTH VOLUME OPEN INT

MONTH VOLUME OPEN INT MONTH VOLUME OPEN INT

Initiate a futures position

Closing a Futures Position

The Reversing Trade

Trader A's Initial Position Trader B

Table 2: Open interests after each transaction

An Exchange-for-Physicals Transaction-Basic Concept (Non-Standard Delivery)

Before the EFP

Completion of Futures Contract via Delivery/Cash Settlement

Commodity Group Traded Volume Delivery/Cash Settlement Percentage

2008 27,019,704 47,795 0.18% 6,162,963 18,225 0.30%

NYMEX : COPPER DELIVERY POINTS

NY Harbor ULSD (Heating Oil) Futures

Venue CME Globex, CME ClearPort, Open Outcry (New York)

Open Outcry: Monday – Friday 9:00 AM to 2:30 PM (8:00 AM to 1:30 PM CT)

Contract Unit 42,000 gallons

Price U.S. dollars and cents per gallon

Minimum $0.0001 per gallon

NY Harbor ULSD (Heating Oil) Futures

TAM trading is analogous to our existing Trading at Settlement (TAS) trading

Listed Current Year + 3 Years + 1 Month

Settlement Daily NYMEX Energy Futures Settlement Procedure (PDF)

NY Harbor ULSD (Heating Oil) Futures

Procedure Final NYMEX Energy Futures Settlement Procedure (PDF)

Delivery Please see rulebook chapter 150

Position NYMEX Position Limits

Corn Futures Contract

Contract Size 5,000 bushels (~ 127 Metric Tons)

Deliverable #2 Yellow at contract Price, #1 Yellow at a 1.5 cent/bushel premium #3 Yellow

Pricing Unit Cents per bushel

Settlement Daily Grains Settlement Procedure (PDF)

Product Ticker CME Globex (Electronic ZC

Open Outcry (Trading Floor) C

Exchange and Clearinghouse

The members of an exchange may be classified as clearing members or non-clearing

Clearinghouse Risk Management (Waterfall)

Date Beginning Clearing member Clearing member Settlement Settlement

12/12 9:00 am Buyer Seller 2:30 pm $495/oz

12/13 9:00 am A CH B 2:30 pm $491/oz

12/14 9:00 am A CH B 2:30 pm $497/oz

12/15 9:00 am A CH B 2:30 pm $498/oz

12/16 9:00 am A CH B Delivery

A Forward Contract Three points:

Two types of margin

Original margin (Initial margin-Performance Bond): Original margin must be deposited