Lecture 2

Mechanics of Futures and Forward

Markets

Reading: Chapter 2
Hull J. 2013, Fundamentals of futures and options markets, 8th edn., Pearson
Education

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Lecture Outline
• Forward contracts
• Comparison of futures and forward markets
• Futures contracts (specifications)
• Futures exchanges
• Exchange Trading
• Daily settlement
• The margin system
• Futures margin account
• Types of trader and types of order

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Forward Contracts
• A forward contract is an OTC agreement to buy or sell an
asset at a certain time in the future for a certain price
• There is no daily settlement (but collateral may have to be
posted). At the end of the life of the contract one party buys
the asset for the agreed price from the other party
• No money changes hands when first negotiated & the
contract is settled at maturity
• The initial value of the contract is zero

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Evolution of futures markets
• Futures markets evolved as a response to the following kinds of problems
experienced in forward markets:

• Non-standard contract dimensions

• Default risk
• Lack of liquidity

• How Futures Contracts Solve These Problems

• Standardized contract dimension
• Default risk is controlled by the clearing corporation and regulations
• Market liquidity assured by the structure of the mark
Comparison of Forward and Futures market
• Both are in essence agreements to buy or sell the underlying in the
future.
• An example from Hull makes this clear:
 Comparison of Forward and Futures market
However, there are a number of practical differences between the two markets.
These are summarized by Hull as follows (Table 2.3, p.43)

Forward Futures

Private contract between two parties Traded on an exchange

Not standardized
Usually one specified delivery date
Settled at end of contract
Delivery or final settlement usual
Some credit risk
Standardized
Range of delivery dates
Settled daily
Usually closed out prior to maturity
Virtually no credit risk

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Futures contract
Long and Short
• Buying futures is called being long futures.
• Selling futures is called being short futures.
Futures Payoff
• Buying a futures contract (long future) locks in a price now (t=0) for
you to buy the underlying asset (S) for the locked-in futures price (K)
at maturity (t=T).
• The payoff of a long futures (LF) contract at maturity is:
!",$% = '" − )"
• The payoff of a short futures (SF) contract at maturity is the opposite:
!",'% = −!",$% = − '" − )" = )" − '"
• Selling a future (short future) gives you the obligation to sell the
underlying asset (S) to the long future trader for the locked-in futures
price (K) at maturity (t=T).
Futures Profit
• The profit at maturity (π# ) on a futures contract is exactly the same
as the payoff at maturity (%# ) since nothing is paid to enter into the
future at time zero.
• π#,'( = %#,'( = *# − ,#
Exchange Trading
• Futures contracts are exchange traded. Exchange trading has many advantages; one
being that is solves the problem of the 'double coincidence of wants'. The futures
exchange matches buyers and sellers so that individuals don’t have to search for a
counterparty with exactly the opposite requirements – someone who wants to buy the
same thing that you want to sell at the same point in the future.
• Specifications have to be clearly defined:
• What is to be delivered,
• Where it can be delivered, &
• When it can be delivered
• Losses and gains are settled daily (margins)
Why Daily Settlement?
• Exchange traded futures contracts, in addition to being enforceable
by law, almost completely eliminate the risk of counterparty default
because of daily settlement of each contract.
• Rather than daily losses accumulating over time into substantial
liabilities, someone on the losing side of a futures contract must
settle their losses (incrementally) each day via the clearing house.
• This limits the potential loss from counterparty default to a tiny
fraction of the potential total loss from a futures contract.
• Daily settlement is effected by the margin system.
The margin system
• The exchange requires customers to post margin deposits (security
deposits) against their positions
• Daily covering of positions (marking to market) is required
• Delivery of the underlying occurs at the current spot price (when
delivery is made)
• Margin requirements may be greater for speculators or new market
participants
• Margin requirements may be varied by the exchange as market
volatility varies.
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

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Example of a Futures Trade
• An investor takes a long position in two, December COMEX gold
futures contracts on June 5
• Contract size is 100 oz.
• Futures price is US$600 per oz.
• Margin requirement (initial margin) is US$2,000/contract (US$4,000
in total)
• Maintenance margin is US$1,500/contract (US$3,000 in total)
• The maintenance margin is the minimum amount that a margin
account is allowed to fall to before a margin call is made requiring the
investor to top up the margin account back to its original level.
Futures Margin Account example
Futures Margin Account example
• At close of trading on June 5, the futures price has fallen from $600
(the price when the investor buys 2 futures contracts) to $597. This
represents a loss of $3 per ounce for a long position.
• The investor has contracted to buy 200 ounces (2 contracts) so his
margin account is reduced by $3(200 ounces) = $600.
• The initial margin per contract is $2000, so the total starting point
margin account balance is $4000. The maintenance margin is $1500
per contract, so in the example the total for two contracts is $3000.
Futures Margin Account example (cont.)
• As we can see from the table, the futures price trends downwards and on June 13
the margin account falls below the level stipulated by the maintenance margin
($3000).
• The investor incurs a margin call at this point and must top up the account back
to $4000 again: the margin call is $1340.
• The next day (June 16), the futures price rises by $ 0.30 so $60 is deposited in the
margin account. This amount could have been withdrawn from the margin
account by the investor if desired, because it is in excess of the initial margin.
• The figures in Table 2.1 assume that excess balances are not withdrawn.
Margin Account Calculations
• Consider the following example: a company enters into a long futures
contract to buy 6000 bushels of wheat for 270 cents per bushel. The
initial margin is $4000. The maintenance margin is $2000.
• What price change (to the nearest cent) would lead to a margin call?
• Under what circumstances would the company have a surplus of
$5000 in the margin account?
Margin Account example
• A margin call occurs if $2000 is lost on the contract;
• Initial margin - maintenance margin
• $4000 - $2000 = $2000.
• The company has a long futures contract; therefore it will lose if the
futures price falls.
• The total value of the contract is 6000 bushels* $2.70 = $16,200.
• The contract would have to be worth $2000 less ($14,200) for a
margin call to be made.
Margin Account example (cont.)
• Let x = the price required for a margin call to be made:
• 6000x = 14,200
• x = $2.37 (rounded)
• The futures price would have to fall below $2.37 for a margin call to be made.
• A $5000 surplus would occur if the contract was worth $5000 more than at the start: $16,200 + $5000 =
$21,200
• We now solve for the price that would cause the contract value to reach $21200.
• 6000x = 21200
• x = $3.53 (rounded)
• If the price rose to $3.53 the company would have $5000 extra in its margin account (above the initial
margin), all or part of which could have been withdrawn from the margin account by the company.
Convergence of Futures to Spot

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
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Convergence of the Futures price to the Spot
Price at Expiry
• If the futures price is above the spot price very close to delivery, an
arbitrage mechanism should ensure that the two prices will converge.
• A trader could sell in the futures market and buy in the spot market. If
traders were doing this, the effect would be to drive up the spot price and
drive down the futures price until they converge.
• If the futures price is below the spot price very close to delivery, simply
buying the underlying via the futures represents a cheaper method of
obtaining the underlying. Or, if an arbitrageur did not require the
underlying, it could simply be sold in the spot market immediately. In
either case, the futures price would be driven up to meet the spot price.
Orders
• Instructions given by clients to brokers
• Similar to share trading orders
• Market Order: a request that a trade be carried out immediately at
the best market price available.
• Limit Order: a particular price is specified. E.g. an investor taking a
long position by means of lodging a limit order of $30 with his broker
expects that the asset will be bought at no more than $30. The
equivalent short position limit order would be to sell at not less than
$30.
• There is a risk that a limit order may not be executed.
Trading volume and Open interest
• Trading volume is the number of contracts traded in a day.
• Open interest is the number of contracts outstanding.
Calculation Example: Open Interest and Trading Volume
• Question: Alice, Bob, Chris and Delta are traders in the futures market. The
following trades occur over a single day in a newly-opened equity index future
that matures in one year which the exchange just made available:
1. Alice buys 3 futures from Bob.
2. Chris buys 2 futures from Delta.
3. Delta buys 1 futures from Alice.
Calculate the trading volume and open interest.
Answer:
• Trading volume is 6 contracts,
the sum of all contracts bought.

• Open interest is 4, best

calculated by adding the traders’
net long positions (positive ‘net’
numbers = 2+2) as below.