CHAPTER 2: FUTURES MARKETS By:

Farh Mohamed Salem

INTRODUCTION
Forwards Futures
Traded OTC Traded on organized exchanges

Privately negotiated between parties Standardized contracts

No clearinghouse Clearinghouse

No margins or daily settlement Rely on a system of margins and daily settlement

Can close the position only if the counterparties Can easily and cheaply close the position
separately negotiate a termination agreement
INTRODUCTION
• The buyer of a futures contract is said to be taking a long position, while the seller
of a futures contract is said to be taking a short position.
THE ORGANIZED EXCHANGE
• Traditionally, futures contracts used to be traded by a system, called open outcry, in which the
central marketplace is a trading room where traders cry out their bids to go long and offers to
go short.

• Nowadays, futures trading occurs on electronic trading platforms.

• This organized structure for trading futures contract differs from the organization of forward
markets, where forward markets are loosely organized and have no physical location.
STANDARDIZED CONTRACT TERMS
• Futures contracts are highly uniform and well-specified commitments for a carefully described
good to be delivered at a certain time and in a certain manner.

• Futures contract specifies the quantity and quality of the good that can be delivered to fulfill
the futures contract.

• The contract also specifies the delivery date and the methods for closing the contract, as well
as the minimum and maximum price fluctuations permitted in trading.
• Tick size: is the minimum price fluctuation
• Daily price limit restricts the price movement in a single day

• The standardization/ uniformity of futures contracts helps to promote liquidity.

THE CLEARINGHOUSE
• The clearinghouse is a large financial institution that guarantees that all of the traders in the
futures market will honor their obligations.

• The clearinghouse takes no active position in the market but plays the role of the intermediary
between the buyer and the seller I each transaction.

•The clearinghouse serves this role by taking on the position of buyer to every seller, and the
seller to every buyer and so, the 2 parties do NOT need to trust or even know each other.

•Without the clearinghouse, both partier must deal with each other.
THE CLEARINGHOUSE
MARGIN AND DAILY SETTLEMENT
• In addition to the clearinghouse, there are other safeguards for the futures market,
one of which is the requirements for margin and daily settlement.

• Before trading a futures contract, the prospective trader must deposit funds with a
broker, or performance bond, by the trader and are referred to as margin.

• These funds serve as a good-faith deposit, to ensure that the traders will perform on
their contract obligations.
TYPES OF MARGINS
• There are 3 types of margin:

1. Initial Margin: The amount a trader must deposit before trading any futures. It
approximately equals the maximum daily price fluctuation permitted for the contract being
traded. For most futures contracts, the initial margin may be 5% or even less of the
underlying commodity’s value. Although initial margin may seem so small relative to the
value of the commodity underlying the futures contract, there’s also another safeguard built
into the system in the from of daily settlement or marking-to-market.

2. Maintenance Margin: When the value of the funds on deposit with the broker reaches a
certain level, the trader is required to replenish the margin, bringing it back to its initial
level. This certain level is called the maintenance margin. The demand for more margin is
called a margin call.
TYPES OF MARGINS
• There are 3 types of margin:

3. Variation Margin: The additional amount the trader must deposit in order to reach initial
margin once again. If the trader fails to pay the variation margin, the trader’s futures position
will be closed.
TYPES OF MARGINS
• For example, assume that the initial margin was $1,400 and that the maintenance margin is
$1,100.
•Day 1: Loss of $150
•Day 2: Loss of $200

•After the loss of $150 in day 1, the margin ends up with ($1,400 - $150) = $1,250, which is
still above the maintenance margin.
•After the loss of $200 in day 2, the margin ends up with ($1,250 - $200) = $1,050, which is
below the required the maintenance margin of $1,100 and so the trade receives a margin call
to restore the margin to its initial level.
•Accordingly, the trader must deposit ($1,400 - $1,050) = $350, this amount is the variation
margin.
TYPES OF FUTURE CONTRACTS
• There are 5 main types of futures contracts which are:

1. Physical commodity contracts: Corn, Wheat, Cotton, Rice

2. Foreign currencies: USD-EGP exchange rate
3. Interest-earning assets: T-notes, T-bills
4. Indexes: S&P 500
5. Individual stocks: IBM stock
CLOSING A FUTURE CONTRACTS
• There are 3 ways to close a futures contract which are:

•Delivery
•Offsetting
•Exchange for physicals (EFP)
CLOSING A FUTURE CONTRACTS
• Delivery

• Delivery can either be physical delivery or cash settlement.

• Cash settlement involves traders making payments at expiration of the contract to settle any
gains or losses.
•Both physical delivery and cash settlement close the contract in the expiration period.
CLOSING A FUTURE CONTRACTS
• Offsetting (Reversing trade)

• To complete a futures contract obligation through offsetting, the trader transacts in the futures
market to bring his/ her net position in a particular futures contract back to zero

May 1st Party 1 Party 2

Bought one SEP oats contract Sold one SEP oats contract
May 10th Party 1 does not wish to actually Party 3
receive the oats and wants to exit the Buys one SEP oats contract
futures market earlier SO, he takes a
reversing position by selling one SEP
oats contract
OPEN INTEREST
• Open Interest is the number of futures contracts for which delivery is currently obligated. In
other words, it’s the total number of contracts outstanding for each maturity month. Subsequent
trading can increase or decrease the open interest.

Time Action Open Interest

T=1 Trader A buys while trader B sells one 1
gold contract
T=2 Trader C buys while trader D sells 3 gold 4
contracts
T=3 Trader A sells while trader D buys one 3
gold contract
T=4 Trader C sells and Trader E buys one gold 3
contract
TYPES OF FUTURES CONTRACTS
1.Physical commodity contracts.
2.Foreign currencies.
3.Interest earning assets.
4.Indexes.
5.Individual stocks.
QUESTIONS
TRUE OR FALSE QUESTIONS
1. The main purpose of margin is to provide a financial safeguard to ensure that
traders will perform on their contract obligations.
(True)

2. The clearinghouse serves its role by adopting the position of buyer to every seller
and seller to every buyer.
(True)
TRUE OR FALSE QUESTIONS
3. The variation margin is the amount a trader must deposit before trading any futures.
(False)

4. If the initial margin $1500, maintenance margin $1200. If the trader incurred a loss of
$200, the clearinghouse will require a margin call.
(False)

5. There are only 2 ways to close a futures position either by delivery or through offsetting.
(False)
MULTIPLE CHOICE QUESTIONS
1. A highly standardized contract for the delivery of a physical asset or cash settlement at a
certain time in the future for a certain price can be referred to as:

A. Options
B. Futures contracts
C. Forward contracts
D. Swaps

Answer is B
MULTIPLE CHOICE QUESTIONS
2. Future contracts are marked to market:

A. Daily
B. Monthly
C. Weekly
D. Yearly

Answer is A
MULTIPLE CHOICE QUESTIONS
3. The amount of money a trader must deposit before trading any futures contract is referred to
as:

A. Initial margin
B. Maintenance margin
C. Variation margin
D. None of the above

Answer is A
MULTIPLE CHOICE QUESTIONS
4. Given that the initial margin is $1,200 and the maintenance margin is $1,000. An investor who
lost $3000 from his first day in the market will be required to pay

A. $100
B. $200
C. $300
D. $400

Answer is c
MULTIPLE CHOICE QUESTIONS
5. Which of the following is least likely a characteristic of futures contracts?

A. They’re backed by a clearinghouse

B. They require weekly settlement of gains and losses
C. They have highly standardized contract terms

Answer is B
MULTIPLE CHOICE QUESTIONS
6. A trader who enters the futures market in search of profits and, by doing so, willing to accept
increased risks is called:

A. hedger
B. speculator
C. arbitrageur

Answer is B
MULTIPLE CHOICE QUESTIONS
7. If the margin balance in a futures account with a long position goes below the maintenance
margin account:

A. A deposit is required to return the account margin to initial margin

B. A deposit is required which will bring the account to maintenance margin
C. A margin deposit equals its maintenance margin is required within 2 business days

Answer is A
MULTIPLE CHOICE QUESTIONS
8. A future contract is ……….. than forward contract.

A. Riskier
B. Equally risky
C. Less risky

Answer is C