Mechanics of Futures

Markets
Difference

FORWARD FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash-usually Contract usually closed out prior to maturity

Some credit risk Virtually no credit risk

Futures Contracts

 Available on a wide range of assets

 Exchange traded
 Specifications need to be defined:
 What can be delivered,
 Where it can be delivered, &
 When it can be delivered
 Settled daily
Specification of a future contract

 Assets
 Contract size
 Delivery arrangements
 Delivery months
 Price Quotes
 Price limits and position limits
FUTURES PRODUCTS AVAILABLE IN INDIA

 Single stock futures

 Equity index futures
 Interest rate futures
 Commodity futures
 Currency futures
 Volatility futures
Contract details- Equity Market
 Product: Index and individual securities(206 approved by
NSE)
 Index futures: (6) nifty 50, Indices of Bank
(12),Infrastructure (25), IT(20) Midcap 50,PSE(20), CPSE
(10)
 Trading cycle : 3 months, Price step Rs0.05
 Lot size: index 50, individual varies
 Expiry date: Last Thursday of the expiry month
 Price band: Operating range of 10% of base price for index
and 20% for individual securities
 Qty freez: based on Index level
CURRENCY FUTURES
4 pairs i.e USD-INR, GBP-INR,
EUR-INR,JPY-INR
Lot size: 1000 for USD,BPB,EUR and
100000 for JPY
Tick size: Re 0.0025 0.25 paise

Trading cycle: 12 months

Currency--contd
Operating Range: 3% of base price upto 6 month and
5% beyond 6 months
Position Limit : 15% of OI
Margin: ( based on SPAN)
1% of the MTM value of OI for USD/INR
0.3% for EUR/INR
0.5% for GBP/INR
0.7% for JPY/INR
INTREST RATE FUTURES

6 years,10 years and 13 years GOI securities

91days Treasury Bill
Tick Size Re 0.01
Value of each contract Rs 2,00,000
Lot size 2000
Operating range +/- 2%
Settlement price as stipulated by NSCCL from
time to time and settled in cash
Commodity futures
 Traded on NCDEX, NMCX and MCX
 Bullion, Base Metal, Energy and agricultural commodities.
GOLD
Price: Ex Ahamedabad
Tick size : Re 1 per 10gm
Trading unit 1 Kg. Maximum : 10 Kg. OI 5 ton
Price limit : 3% further enhancement 6%
Cooling period :15 Minutes,
Initial Margin :4 % of SPAN
Convergence of Futures to Spot

a) Contango b)Normal backwardation

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)

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Margins

 A margin is cash or marketable securities deposited by an

investor with his or her broker

 The balance in the margin account is adjusted to reflect

daily settlement

 Margins minimize the possibility of a loss through a default

on a contract
Margin Cash Flows
 A trader has to bring the balance in the margin account up
to the initial margin when it reaches the maintenance
margin level
 A member of the exchange clearing house only has an
initial margin and is required to bring the balance in its
account up to that level every day.
 These daily margin cash flows are referred to as variation
margin
 A member is also required to contribute to a default fund
 Span Margin
 May provide addition to base capital
 Initial Margin= Span +Premium margin(buyer of the option +
assignment margin(net settlement value)
 Exposure margin (index)= 3% of notional value of future
contract
 Option = 3% of OI
 Individual securities- 5% or 1.5 Std Dev of notional value of
open position
Operation of margin account for long
position in 2 gold futures
 Initial margin 6000 per contract

 Maintenance margin 4500 per contract

 Day 1 price 1450

 Closed out on 16 th day at 1426.90

A Possible Outcome
Day Trade Settle Daily Cumul. Margin Margin
Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,450.00 12,000
1 1,441.00 −1,800 − 1,800 10,200
2 1,438.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,436.20 −780 −2,760 9,240
7 1,429.90 −1,260 −4,020 7,980 4,020
8 1,430.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,426.90 780 −4,620 15,180

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Margin Cash Flows When Futures Price
Increases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

17
Margin Cash Flows When Futures Price Decreases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

18
Some Terminology

Open interest: the total number of contracts outstanding

equal to number of long positions or number of short
positions

Settlement price: the price just before the final bell each
day
used for the daily settlement process

Volume of trading: the number of trades in one day

The Operation of Derivative Exchanges

Three major operations of an exchange are:

Trading

Clearing

Settlement
The Trading System

Fully automated screen-based system

Based on order-driven market

Provides transparency

Orders are time-stamped as they arrive and stored in

order books if not marked

Storage based on price-time priority, according to best

price and time
Types of Orders

 Market order
 Limit order
 Stop-loss order
 Immediate or cancel order/Fill or kill
 Good-till day order
 Good-till cancelled order
 Good-till dateDiscretionary
 Time of day
 Open
Order Matching Rules
 The best buy order will be matched with the best sell order

 Anorder may match partially with another order, resulting

in multiple trades

 Orderswill be entered by members, and will remain in the

system until matched

 Anynew order will be matched first with orders remaining in

the system
Order Conditions

 On the basis of time:

 Day orders
 Immediate or Cancel orders

 On the basis of price:

 Limit price/orders
 Market price/orders
 Stop-loss price/orders
 Sell orders
Clearing System

 Clearing means that a transaction is clearly recorded, and

provides for orderly settlement

 Is done by the clearing corporation, a subsidiary of the

derivatives exchange

 E.g. in the NSE, the National Securities Clearing

Corporation Limited (NSCCL) is the clearing agency
Members of the Clearinghouse

 Clearing members are authorized to clear trades

undertaken by traders
 Trading members are members who can trade on behalf of
clients, and match orders that members receive
 A clearing member performs:
a. Clearance
b. Settlement
c. Risk management
 The clearing corporation provides qualifications for a
trader to be a clearing member
Clearing Mechanisms

 When a trading member matches an order received from a client,

the trading member will approach a clearing member to clear the
trade

 The clearing member takes the position of counterparty for every

contract that they clear

 The exchange will keep record of all trades cleared by a clearing

member
Settlement
 Settlement means that parties will be settling their obligations under
the contract

 Daily mark-to-market settlement of margins typically updates margin

accounts, and issues margin calls when necessary

 Final settlement occurs when contracts are closed out, or on maturity

date

 If the final settlement calls for delivery, the party that has an open
position to deliver will be called upon to do so

 If the final settlement is for cash, the losing party will pay the
winning party
Trading Process
 The contract is brokered and an order will be placed

 The broker enters the order in the order book

 When the order is matched, the broker will clear the transaction
through a clearing member

 The broker will ask the client to post a margin

 The margin account will be updated daily through the daily settlement
price, and a margin call will be issued when necessary
Trading Process (Continued)

 If the client wants to close the position, he or she will

inform the broker, who will match the order, close the
margin account, and pay the balance

 If the contract is held until maturity, the margin account

will be closed with the final settlement amount and
balance given to the client
Key Points About Futures

 They are settled daily

 Closing out a futures position involves
entering into an offsetting trade
 Most contracts are closed out before
maturity

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Crude Oil Trading on May 14, 2021

Open High Low Prior Last Change Volume

Settle Trade

Jun 2021 94.93 95.66 94.50 95.17 94.72 −0.45 162,901

Aug 2021 95.24 95.92 94.81 95.43 95.01 −0.42 37,830

Dec 2021 93.77 94.37 93.39 93.89 93.60 −0.29 27,179

Dec 2022 89.98 90.09 89.40 89.71 89.62 −0.09 9,606

Dec 2023 86.99 87.33 86.94 86.99 86.94 −0.05 2,181

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Clearing Houses and OTC Markets

 Traditionally most transactions have been cleared bilaterally in

OTC markets
 Following the 2007-2009 crisis, the has been a requirement for
most standardized OTC derivatives transactions between dealers
to be cleared through central counterparties (CCPs)
 CCPs require initial margin, variation margin, and default fund
contributions from members similarly to exchange clearing
houses

33
Bilateral Clearing vs Central Clearing
House

34
 Delivery
 If a futures contract is not closed out before maturity, it is usually
settled by delivering the assets underlying the contract. When there
are alternatives about what is delivered, where it is delivered, and
when it is delivered, the party with the short position chooses.

 A few contracts (for example, those on stock indices and Eurodollars)

are settled in cash

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 Foreign Exchange Quotes
 Direct Quote
 Futures exchange rates are quoted as the number of Rs per unit of the foreign currency
 Forward exchange rates are quoted in the same way as spot exchange rates.
This means that GBP, EUR, AUD, and NZD are quoted as Rs per unit of foreign currency.
 Indirect Quote
 Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per Re

36
 1.You would like to speculate on the rise of certain stock. You have Rs 8000 to invest. The
current price of a certain stock is Rs 40. A 3 month call with a strike price of Rs 45. Cost Rs
2. Identify two alternative investment strategies. List out the potential gain and losses from
each.

 Q.2. Suppose a April put option to sell share of company for Rs 500 cost Rs 40 and is
held until April. Under what circumstance the seller of the option (i.e party in the short
position) make a profit. Under what circumstances the option will be exercised ?.Draw a
diagram illustrating how the profit from the short position is dependent on the share price
at the maturity of option

 Q.3. A March call option to buy a share for $ 50 cost $ 2.5 is held until March . Under what
circumstances will the holder of the option make profit ?.

 Under what circumstance will the option be exercise ? Draw a diagram illustrating how the
profit from the long position depends on the share price at the maturity of the option.
 On January 2, when the futures contract on CIPLA stock started trading for
expiry on March 31, Kishore sold 10 contracts to Raghav, Raja sold 15
contracts to Jeeva, and Rama sold 20 contracts to Bose. On January 3, Jeeva
bought 5 contracts from Raghav and Bose sold 10 contracts to Asjeet.
Calculate the open interest in this contract on January 2 and January 3

  
 Jan 2:
Kishore sold 10 contracts
Raghav bought 10 contracts-5
Raja sold 15 contracts
Jeeva bought 15 contracts+5
Rama sold 20 contracts
Bose bought 20 contracts-10

 Open interest: total sold contracts = 45 = total bought contracts.

Jan 3:
Jeeva buys 5 contracts
Raghav sold 5 contracts
Bose sold 10 contracts
sold to Asjeet 10 contracts

Bought Sold

Raghav 5 Kishore 10

Jeeva 20 Raja 15

Bose 10 Rama 20

Asjeet 10  

Total: 45 Total: 45