Chapter 5: Mechanics of Futures Markets

Dr Nguyen Dinh Dat

The content
• The specification of contracts.
• The operation of margin accounts.
• The organization of exchanges.
• The regulation of markets.
Introduction
• CME Group (www.cmegroup.com)
• The InterContinental Exchange (www.theice.com)
• Eurex (www.eurexchange.com)
• BM&F BOVESPA (www.bmfbovespa.com.br),
• The Tokyo Financial Exchange (www.tfx.co.jp).
How a futures contract comes into existence
CORN FUTURES

Seller
Buyer

NEW YORK 5,000 bushels of corn KANSAS

Closing Out Positions
The vast majority of futures contracts do not lead to delivery.

+ The reason is that most traders choose to close out their positions prior to the
delivery period specified in the contract.
+ Closing out a position means entering into the opposite trade to the original one
(reversing trade).
SPECIFICATIONS OF A FUTURES CONTRACT

When developing a new contract, the exchange must specify in some detail the
exact nature of the agreement between the two parties.
The Asset
When the asset is a commodity, there may be quite a variation in the
quality of what is available in the marketplace. When the asset is
specified, it is therefore important that the exchange stipulate the
grade or grades of the commodity that are acceptable.
The contract size
The contract size specifies the amount of the asset that has to be delivered under one
contract. This is an important decision for the exchange.

If the contract size is too large, many investors who wish to hedge relatively small
exposures or who wish to take relatively small speculative positions will be unable to
use the exchange.

If the contract size is too small, trading may be expensive as there is a cost associated
with each contract traded.
Delivery Arrangements

The place where delivery will be made must be specified by the exchange. This is
particularly important for commodities that involve significant transportation costs.

When alternative delivery locations are specified, the price received by the party
with the short position is sometimes adjusted according to the location chosen by
that party. The price tends to be higher for delivery locations that are relatively far
from the main sources of the commodity.
Delivery Months
A futures contract is referred to by its delivery month. The exchange must specify
the precise period during the month when delivery can be made. For many futures
contracts, the delivery period is the whole month.

The delivery months vary from contract to contract and are chosen by the exchange
to meet the needs of market participants.

For example, corn futures traded by the CME Group have delivery months of
March, May, July, September, and December.
Price Quotes
The exchange defines how prices will be quoted.
For example, in the US crude oil futures contract, prices are quoted in dollars and
cents.

Treasury bond and Treasury note futures prices are quoted in dollars and thirty-
seconds of a dollar.
 Price Limits and Position Limits
For most contracts, daily price movement limits are specified by the exchange. If in a day
the price moves down from the previous day’s close by an amount equal to the daily
price limit, the contract is said to be limit down. If it moves up by the limit, it is said to be
limit up.

For most contracts, daily price movement limits are specified by the exchange. If in a day
the price moves down from the previous day’s close by an amount equal to the daily
price limit, the contract is said to be limit down. If it moves up by the limit, it is said to be
limit up.

Position limits are the maximum number of contracts that a speculator may hold.
The purpose of these limits is to prevent speculators from exercising undue influence on
the market.
THE OPERATION OF MARGIN ACCOUNTS
An investor who contacts his or her broker to buy two December gold futures
contracts. The current futures price is $1,450 per ounce. The contract size is 100
ounces, the investor has contracted to buy a total of 200 ounces at this price.

The broker will require the investor to deposit funds in a margin account. The
amount that must be deposited at the time the contract is entered into is
known as the initial margin. This is $6,000 per contract, or $12,000 in total.

At the end of each trading day, the margin account is adjusted to reflect the
investor’s gain or loss. This practice is referred to as daily settlement or marking
to market.
Note that daily settlement is not merely an arrangement between broker and
client. When there is a decrease in the futures price so that the margin account of
an investor with a long position is reduced by $1,800, the investor’s broker has to
pay the exchange clearing house $1,800 and this money is passed on to the broker
of an investor with a short position.

Similarly, when there is an increase in the futures price, brokers for parties with
short positions pay money to the exchange clearing house and brokers for parties
with long positions receive money from the exchange clearing house.
The Clearing House and Its Members
A clearing house acts as an intermediary in futures transactions. It guarantees the
performance of the parties to each transaction. The clearing house has a number of
members.

The main task of the clearing house is to keep track of all the transactions that take
place during a day, so that it can calculate the net position of each of its members.

The clearing house member is required to provide initial margin reflecting the total
number of contracts that are being cleared.
There is no maintenance margin applicable to the clearing house member. Each day
the transactions being handled by the clearing house member are settled through
the clearing house.

If in total the transactions have lost money, the member is required to provide
variation margin to the exchange clearing house; if there has been a gain on the
transactions, the member receives variation margin from the clearing house.
OTC markets
Over-the-counter (OTC) markets,are markets where companies agree to derivatives
transactions without involving an exchange. Credit risk has traditionally been a feature
of OTC derivatives markets. Consider two companies, A and B, that have entered into a
number of derivatives transactions.

If A defaults when the net value of the outstanding transactions to B is positive, a loss
is likely to be taken by B.

if B defaults when the net value of outstanding transactions to A is positive, a loss is

likely to be taken by company A. In an attempt to reduce credit risk, the OTC market
has borrowed some ideas from exchange-traded markets.
Central Counterparties

The clearing house agrees to

1. Buy the asset from B in one year for the agreed price, and
2. Sell the asset to A in one year for the agreed price.
TYPES OF TRADERS AND TYPES OF ORDERS

There are two main types of traders executing trades:

Futures commission merchants (FCMs) and locals.

- FCMs are following the instructions of their clients and charge a commission for
doing so;
- Locals are trading on their own account.

Individuals taking positions, whether locals or the clients of FCMs, can be

categorized as hedgers, speculators, or arbitrageurs.
Types of trader
Speculators can be classified as scalpers, day traders, or position traders.

Scalpers are watching for very short-term trends and attempt to profit from small
changes in the contract price. They usually hold their positions for only a few
minutes.

Day traders hold their positions for less than one trading day. They are unwilling to
take the risk that adverse news will occur overnight.

Position traders hold their positions for much longer periods of time. They hope to
make significant profits from major movements in the markets.
 Orders

A market order is a request that a trade be carried out immediately at the best
price available in the market.

A limit order specifies a particular price. The order can be executed only at this
price or at one more favorable to the investor.

For example, if the limit price is $30 for an investor wanting to buy, the order will
be executed only at a price of $30 or less.
A stop order or stop-loss order also specifies a particular price. The order is
executed at the best available price once a bid or offer is made at that particular
price or a less favorable price.

Suppose a stop order to sell at $30 is issued when the market price is $35. It
becomes an order to sell when and if the price falls to $30. In effect, a stop order
becomes a market order as soon as the specified price has been hit.
A stop–limit order is a combination of a stop order and a limit order. The order
becomes a limit order as soon as a bid or offer is made at a price equal to or less
favorable than the stop price. Two prices must be specified in a stop–limit order:
the stop price and the limit price.

Suppose that at the time the market price is $35, a stop–limit order to buy is issued
with a stop price of $40 and a limit price of $41. As soon as there is a bid or offer at
$40, the stop–limit becomes a limit order at $41.
Question 1: What does a stop order to sell at $2 mean? When might it be
used? What does a limit order to sell at $2 mean? When might it be used?
Question 2: Suppose that you enter into a short futures contract to sell July
silver for $17.20 per ounce. The size of the contract is 5,000 ounces. The
initial margin is $4,000, and the maintenance margin is $3,000. What
change in the futures price will lead to a margin call?
What happens if you do not meet the margin call?
Question 3: Explain how margin accounts protect investors against the
possibility of default.