Introduction &

Mechanics of
Futures Markets

1
Learning Outcomes

Upon successful completion of session,

learners will be able to;
 Understand the concepts of future contracts.
 Will be able to explain the functioning of the
future contracts markets.
 Explain the phenomenon of Mark to market
 Differentiate between Forward and Future
contracts.
2
Futures Contracts
Exchange-traded “forward contracts”
Typical features of futures contracts
Standardized, with specified delivery dates, locations, procedures
A clearinghouse
• Matches buy and sell orders
• Keeps track of members’ obligations and payments
• After matching the trades, becomes counterparty

Differences from forward contracts

Settled daily through the mark-to-market process  low credit risk
Highly liquid  easier to offset an existing position
Highly standardized structure  harder to customize

5-3
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

4
Basic Terms
Long Position – Buyer
Short Position – Seller
Going Long – the act of buying
Going short – the act of selling
Tick Size – The contract stipulate the
minimum price fluctuation or tick size, e.g. for
wheat one tick is 0.25 cent per bushel. So
with 5000 bushels contract the tick size will
be $12.50 per contract.
Basic information
Daily price limit – the contract also specifies
the daily price limit which restricts the price
movements in a single day, e.g. For wheat
the trading price on a given day cannot differ
from preceding day’s closing prices by more
than 20 cents per bushel or $1000 per
contract.

6
Convergence of Futures to Spot

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)

7
Check out the video to know more about Future M
arket

https://www.youtube.com/watch?v=fBN1SXqAp7Y

8
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. The maintenance
margin is usually about 75% of
the initial margin.

9
Margin Cash Flows
A trader has to bring the balance in the margin account up
to the initial margin when it falls below 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
A futures contract is in effect closed out and
rewritten at a new price each day.

10
Example of a Futures Trade
An investor takes a long position in 2
(contracts) December gold futures
contracts on June 5
contract size is 100 oz.
futures price is US$1,450
initial margin requirement is US$6,000/contract
(US$12,000 in total)
maintenance margin is US$4,500/contract
(US$9,000 in total)

11
A Possible Outcome

12
Margin Cash Flows When Futures
Price Increases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

13
Margin Cash Flows When Futures Price
Decreases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

14
Check out the video to know
more about margins

https://institute.cmegroup.com/modules/the-benefits-of-f
utures-margins

15
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
16
Key Points About Futures
They are settled daily
Closing out a futures position involves
entering into an offsetting trade

17
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

18
Bilateral Clearing vs Central
Clearing House

19
Forward Contracts vs Futures Contracts

FORWARDS 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 Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

20
Types of Orders
Limit order – This order specifies a particular
price (maximum and minimum). Thus if the
limit price is $30 or an investor wanting the
buy, the order will be executed only at a price
of $30 or less.
Stop order or stop loss order – 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 fall to $30.
21
Types of Orders

Stop limit order - Two prices need to be

specified in this order. Buy or sell at a
specified limit price only when stop price has
been reached.

22
Check out the video to know recap about Future contract

https://www.youtube.com/watch?v=
CC9VeHrI3Es

23
Hedging Strategies using
Futures - Long & Short Hedges
A long futures hedge is appropriate when
you know you will purchase an asset in
the future and want to lock in the price
A short futures hedge is appropriate
when you know you will sell an asset in
the future and want to lock in the price

24
Hedge Ratio
Hedge ratios is the ratio of the size of the
position taken in future contracts to the size
of the exposure.

25
Optimal Hedge Ratio
This is also known as minimum variance hedge ratio.
Proportion of the exposure that should optimally be hedged is

where
S
S is the standard deviation
h   S, the change in the spot price
*
of
during the hedging period,  F
F is the standard deviation of F, the change in the futures
price during the hedging period
 is the coefficient of correlation between S and F.

26
What determines the hedge
ration
Size of Position
Relative senstivity of the spot and future
markets
The risk you want to reduce.

27
Example
Suppose that the standard deviation of
quarterly changes in the prices of a
commodity is $0.65, the standard deviation of
quarterly changes in a futures price on the
commodity is $0.81, and the coefficient of
correlation between the two changes is 0.8.
What is the optimal hedge ratio for a three-
month contract? What does it mean?

28
 065
08   0642
081
This means that the size of the futures position should
be 64.2% of the size of the company’s exposure in a
three-month hedge.
29