Chapter 2

Recall the CME Group is composed of the CBOT and CME.

Ex: Trader A buys 5000 bushels of corn for delivery in September (he takes a “long” futures position).
Trader B sells 5000 bushels of corn for September delivery (he takes a “short” futures position.
Closing out a position:
You close out a futures contract by entering the opposite trade. i.e. if long, you submit a sell order, if
short, you enter a buy order. More specifically, Trader A would enter a “sell to close” order.
Specification of a Futures Contract:
The exchange must specify the asset, the contract size, WHERE deliveries can be made and WHEN
deliveries can be made.
In some cases, alternatives are given for the delivery locations or the grade of the asset. Generally, the
short party chooses what happens when alternatives are specified by the exchange. The short party files
a notice of intention to deliver with the exchange, which describes the manner of delivery.
The Asset:
 The exchange must state the grade/grades of the commodity that are available. Ex: Orange juice
futures contracts on ICE must be U.S. Grade A with Brix Value > 62.5. For other commodities,
a variety of grades are allowed with possible price modifications depending on the grade
chosen.
The Contract Size:
 This is the amount of the asset to be delivered under one contract. Interesting note: “mini”
contracts to attract smaller traders such as the Mini NASDAQ 100 Contract is 20x the
NASDAQ 100 index whereas the regular contract is 100x the index.
Delivery Arrangement & Timing
 Place where the delivery will be made is specified by the exchange.
 Exchange must specify the precise period during the month when a delivery can be made. For
many futures contracts this could be a whole month. Exchange specifies when trading in a
particular month’s contract will begin and the last day for which trading can take place.
Price Quotes, Price Limits, Position Limits:
 Price quotes refer to how prices are displayed. i.e. crude oil futures are quoted in dollars &
cents.
 Position limits are a maximum number of contracts a speculator can hold.
 Exchanges specify daily price movement limits.
 If in a day, the price moves down by the DPML, contract is called limit down and trading
ceases.
 If in a day, the price moves up by the DPML, contract is limit up and trading stops.
 A limit up or limit down is broadly called a limit move.

2.3: Convergence of Futures Price to Spot Price

Obviously, as the delivery period for a futures contract is approached, the futures price converges to
the spot price of the underlying asset. When the delivery period is reached, the futures price is either
equal to or very close to the spot price.
If this was not the case, we have two possibilities:
i. The futures price > spot price:
A trader would short the future, buy the asset and make delivery. This leads to a profit
equal to the difference of the futures and spot price. The futures price would drop and
converge.
ii. The futures price < spot price:
A trader would long the future and wait for delivery to be made. This would increase the
futures price and it would converge to the spot price.
How do Margin Accounts Work?
Suppose we have Trader A who goes long on two December gold futures contracts. He buys 200
ounces @ 1250 an ounce. The broker will require Trader A to deposit initial margin at the time the
contract is entered. Assume this amount is $6,000 a contract so $12,000 in total.
At the end of each trading day, the margin account is marked to market and is adjusted for gains/losses.
For example, if the gold futures price decreases by $9, then the trader account will be reduced by
$1800 so he will have $10,200 in the account.
More specifically, when Trader A loses $1800, the broker has to pay the exchange clearing house
$1800 and this money is passed to the broker of a short party.
Similarly, if Trader B is losing money, his broker would pay to the exchange house and this money
would be passed onto the broker of a party with a long position.
The trader can withdraw any balance in the margin account in excess of the initial margin. The broker
sets a maintenance margin, which is lower than the initial margin (around 75% of the initial margin). If
the balance is below the MM, the trader gets a margin call and is expected to furnish funds to reach the
initial margin level by next day. These extra funds are called variation margin. If variation margin isn’t
provided, the broker closes out the position.
Most brokers pay traders interest on the balance in a margin account. For initial margin, a trader can
submit stocks/treasury bills but not margin calls.
A futures contract is settled daily. The trader’s gain/loss is added/subtracted to the margin account at
the end of the day.
Minimum levels for initial/maintenance margin are set by the ECH. Brokers can require greater margin
than the minimal requirements of the ECH. Margin can also be influenced by the trader: a hedger will
often be subject to lower margin requirements than a speculator. Interestingly, day trade and spread
transactions-based trades have lower margin reqs than hedges. Margin requirements are the same for
traders who short futures or long futures.
Clearing House:
A clearing house acts as an intermediary in futures transactions. Brokers who are not members
themselves must channel their business through a member and post margin with the member. 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 to the clearing house initial margin (sometimes
referred to as clearing margin) reflecting the total number of contracts that are being cleared. There is
no maintenance margin applicable to the clearing house member. At the end of 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 (usually by the beginning of the next day); if there has been a gain on the
transactions, the member receives variation margin from the clearing house. Intraday variation margin
payments may also be required by a clearing house from its members in times of significant price
volatility or changes in position.
Suppose, for example, that the clearing house member has two clients: one with a long position in 20
contracts, the other with a short position in 15 contracts. The initial margin would be calculated on the
basis of 5 contracts. The calculation of the margin requirement is usually designed to ensure that the
clearing house is about 99% certain that the margin will be sufficient to cover any losses in the event
that the member defaults and has to be closed out. Clearing house members are required to contribute
to a guaranty fund, in the case a member defaults and doesn’t have sufficient margin.
The whole purpose of the margining system is to ensure that funds are available to pay traders when
they make a profit.
OTC Markets
 No exchange involvement. Credit Risk is an issue, but OTC markets have adopted certain
features to mitigate this: Central Counterparties (CCPS) and Bilateral Clearing
Central Counterparties:
 Members of a CCP provide initial margin and daily variation margin and provide to a guaranty
fund.
 If the OTC market participant isn’t a member of the CCP, it can clear its trades through a CCP
member. This trader will provide margin to the CCP member.
 When Party A and Party B agree to a transaction, it is presented to the CCP. If the CCP accepts,
it is the counterparty to both A & B.
For example: If A agreed to buy an asset from B in one year at a certain price, the CCP agrees to buy
the asset from B in one year at that price and sell it to A in one year at that price. CCP accepts credit
risk for A & B.
Bilateral Clearing:
OTC transactions not cleared through CCPS are cleared bilaterally. Two companies, A and B enter a
master agreement, which includes an annex (credit support annex CSA), which requires A, B or both
to post collateral.
CSA agreements require transactions to be valued each day. For example, if the transaction between A
and B increase in value for A by X (so decrease by X for B), then B is required to provide collateral
worth X to A and v.v. CSA’s usually don’t require initial margin but from 2016, regulations required
both initial margin and variation margin to be provided for transactions between financial institutions.
Futures Trades vs OTC Trades
In futures, initial margin earns interest, but daily variation margin does not since it constitutes the daily
settlement. OTC transactions are not settled daily, so daily variation margin that comes from a CCP
member or due to a CSA earns interest if dmv is paid in cash.
Securities can be used to satisfy margin/collateral requirements but there is a haircut reduction to the
securities value.

Prices:
Settlement price: The price at which the contact trades at before the end of the trading day. “Last
Trade”
Open Interest: number of contracts outstanding.
Normal Market: Futures prices are an increasing function of the maturity of the contract.
Inverted market: prices decline with maturity.
Delivery:
The decision of when to deliver is made by the trader with the short position, call him Trader A. A’s
broker issues a notice of intention to deliver to the ECH, which specifies where and how these
contracts will be delivered. The exchange chooses a party with long position to accept delivery. It
could be Trader B but it could be Trader C etc. (due to these traders closing out their position). The
party with the oldest outstanding long contract has to accept such a notice. If the notices are
transferrable, Trader B has some time to find a delivery is responsible for warehousing costs,
feeding and looking after animals, etc. The price paid is usually the most recent settlement price.
Issuance of Notice to Deliver to Delivery takes 2-3 days.
First Notice Day: First day on which a notice of intention to make delivery can be submitted to the
exchange. The last day this can be done is the Last Notice Day.
The Last Trading Day: Generally a few days before the Last Notice Day.
We recap, to avoid delivery, a trader that is long should close out their position prior to the first notice
day.
Financial Futures:
Some futures ie mini NASDAQ100 are settled in cash because there isn’t anything physical to
exchange it. The final settlement price is equal to the spot price of the underlying asset at either the
open or close of the trading day.
Types of Traders: Futures Commissions Merchants and Locals.
FCM’s: execute client instructions and charge a commission. Locals: do it on their own account.
Not that clients of FCM’s and locals can be hedgers, speculators etc. Speculators can more be
classified as scalpers, day-traders, or position traders (hold position more a long time).
Orders:
Limit Order: Order executed at a specific price. i.e. a limit of $30, means execute only if price<$30.
Stop-Loss/Stop Order: A conditional order that turns into market order once the stop-loss level is
triggered. Thus, if the stock blows past the stop-loss level due to a spike in volatility or major news
event, the sell order could be executed significantly below the anticipated level.
Stop-Limit Order: The order becomes a limit order once a bid/offer is made at the price equal or less to
the stop price. You need to specify the stop price and the limit price.
Market-if-touched/board Order: Executed at the best available price after a trade occurs at a specified
price or a more favorable price.
Discretionary/Market-not-held Order: Market order but broker may delay filling to try to get a better
price.
Time-of-Day: Specifies a time of day an order can be placed.
Open-Order/Good-till-Cancelled: In effect until executed or until the end of trading in that contract.
Fill-or-Kill: Executed immediately or killed.
2.9 Regulation:
Regulated by the CFTC, NFA. Dodd-Frank expanded the role of the CFTC.