Mechanics of Forwards & Futures

Title
Date

Lifetime Learning… Building Success… Towards Globalization 1

 Explain the Forward Contract Settlement
• A forward contract can be settled in two ways:
Delivery Settlement
• Party that is short the forward
contract (seller)will actually deliver
the underlying asset to the party that
is long the forward contract(buyer).
• The underlying will be delivered on
the settlement date or the expiration
date as specified in the contract. The
underlying will be delivered and the
forward price will be received.
Cash Settlement
• Party for whom the contract has a
negative value will pay the amount of
negative value to the party with the
positive value.
• In other words,
 If the price of the asset is above
the forward price, then
long(buyer) receives the payment.
 If the price of the asset is below
the forward price, then the short
(seller) will receive the payment.
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 Cash Settlement

• Only the difference in SPOT price will be

settled
• If Market Price is Higher, Market moves
towards Buyer’ s benefits
• If Market Price is Lower, Market moves
towards Seller’ s benefits

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 Example of Cash Settlement
• Let's assume that you have just taken up sailing and you want to buy
sailboat in 12 months. John, owns a sailboat and wants to sell it. You and
John enter into a forward contract in which you agree to buy John's boat
for $150,000 and he agrees to sell it to you in 12 months for that price. In
this scenario, as the buyer, you have entered a long forward contract.
Conversely, John, the seller will have the short forward contract
• Assume that at the end of 12 months you have lost interest in sailing. In
this case, you could do cash settlement

• Scenario 1: Market Price > Forward Price; Market Price is $165,000

John pays $15,000 to you
((The difference between your contract's purchase price of $150,000
and the sail boat's current market value of $165,000)

• Scenario 2: Market Price < Forward Price; Market Price is $135,000

You pay John $15,000

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 Margins
• A margin is an amount of a money
that must be deposited with the
clearing house by both buyers and
sellers in a margin account in order
to open a futures contract.

• It ensures performance of the

terms of the contract.

• Its aim is to minimize the risk of

default by either counterparty.

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 Initial Margin
• Deposit that a trader must make before
trading any futures is called Initial Margin

• Both the long and the short parties must

deposit money in their brokerage
accounts.

• Typically 10% of the total value of the contract

• Not a down payment, but instead a security deposit to ensure

the contract will be honored

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 Initial Margin

• Example 1 - Khalid has just taken a long position in a

futures contract for 100 ounces of gold to be delivered
in January. Yousuf has just taken a short position in
the same contract. The futures price is $380 per
ounce.
– The initial margin requirement is 10%
a) What is Khalid’s initial margin requirement?
100*380 = 38000 *.10 = $ 3800

a) What is Yousuf’s initial margin requirement?

100*380 = 38000 *.10 = $ 3800

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 Maintenance Margin
• To ensure that the balance in the margin account never
becomes negative a maintenance margin, which is somewhat
lower than the initial margin, is set.

• Maintenance Margin is the minimum balance which a trader

is expected to have in the account

• If the balance in the margin account falls below the

maintenance margin, the investor receives a margin call and is
expected to top up the margin account to the initial margin
level by the end of the next day

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 Maintenance Margin
Example 2- Khalid has just taken a long position in a
futures contract for 100 ounces of gold to be
delivered in January. Yousuf has just taken a short
position in the same contract. The futures price is
$380 per ounce.

The initial margin requirement is 10% and

Maintenance Margin is 75% of the initial margin

a) What is Khalid’s Maintenance Margin

requirement?
((($380 * 100) * .10) *.75) = $ 2850

a) What is Yousuf’s Maintenance Margin

requirement? 9
 Variation Margin & Margin Call
• Variation Margin - If the balance in the margin
account falls below the maintenance margin,
the investor receives a margin call and is
expected to top up the margin account to the
initial margin level by the end of the next day.
The extra funds deposited are known as a
variation margin.
Additional margin required to bring an
account up to the required level is called
Variation Margin

• Margin call – If amount in the margin A/C falls

below the maintenance level, a margin call is
made to fill the gap.
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Margin

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Explain the concept of Marking to Market with
an example
• At the end of each trading day, the margin
account is adjusted to reflect the investor’s
gain or loss as per the settlement price.
This practice is referred to as Daily
Settlement or Marking to Market

• Profit and loss is settled between the long and the short.

• This ensures that there are no defaults by the parties.

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 Marking to Market
• The process trading derivatives DAILY BASIS
based on the closing day pricing
• If price moves up than previous day pricing,
the buyer account will be credited (Gain) and
Vice-Versa
• If price moves fall than previous day pricing,
the seller account will be credited (Gain) and
Vice-Versa

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 Marking to Market

• At the end of each trading day, all futures

contracts are rewritten to the new closing
futures price.

• In this process, amount is added or subtracted from the

parties’ brokerage accounts so as to offset the change in the
futures price.

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 Marking to Market

Example 3:

• Sep 1,2016, Shabeer takes long position in Gold futures

contract and Myra takes Short Position in the contract.
Contract size is 100 ounces.

• Current futures price is $500 per ounce.

• Assume initial margin is $3,000 per contract and

maintenance margin is $2,000 per contract.

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 Margins Requirements & MTM
For Shabeer

Shabeer
Future Gain Gain Cumulati
Margin Margin
Date Price per /Loss per /Loss for ve Gain
Balance Call
ounce pounce contract or Loss
500 3000
1-Sep 494 -6 -600 -600 2400
2-Sep 495 1 100 -500 2500
3-Sep 488 -7 -700 -1200 1800 1200
4-Sep 490 2 200 -1000 3200
5-Sep 493 3 300 -700 3500
6-Sep 500 7 700 0 4200
7-Sep 505 5 500 500 4700
8-Sep 512 7 700 1200 5400 16
 Margins Requirements & MTM
For Myra
Future Gain Gain Cumulati
Margin Margin
Date Price per /Loss per /Loss for ve Gain
Balance Call
ounce pounce contract or Loss
500 3000
1-Sep 494
2-Sep 495
3-Sep 488
4-Sep 490
5-Sep 493
6-Sep 500
7-Sep 505
8-Sep 512
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 Future Gain
Gain Cumulat
Price /Loss Margin Margin
Date /Loss for ive Gain
per per Balance Call
contract or Loss
ounce pounce
500 3000
1-Sep 494 6 600 600 3600
2-Sep 495 -1 -100 500 3500
3-Sep 488 7 700 1200 4200
4-Sep 490 -2 -200 1000 4000
5-Sep 493 -3 -300 700 3700
6-Sep 500 -7 -700 0 3000
7-Sep 505 -5 -500 -500 2500
8-Sep 512 -7 -700 -1200 1800 1200
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 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.

• For example, the New York investor who bought a July corn futures
contract on March 5 can close out the position by selling (i.e., shorting)
one July corn futures contract on, say, April 20.

• The Kansas investor who sold (i.e., shorted) a July contract on March 5
can close out the position by buying one July contract on, say, May 25. In
each case, the investor’s total gain or loss is determined by the change
in the futures price between March 5 and the day when the contract is
closed out.

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Let’s Test Our Understanding

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 Questions

Q1 : In which ways forward contract can be settled

Q2 : Define Initial Margin

Q3 : Define Maintenance Margin

Q4 : Khalid has just taken a long position in a futures contract for 100
ounces of gold to be delivered in January. Yousuf has just taken a
short position in the same contract. The futures price is $400 per
ounce. Calculate the initial margin requirement for Khalid and Yousuf
(assuming 10%)

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 Questions

Q5 : Khalid has just taken a long position in a futures contract for 100
ounces of gold to be delivered in January. Yousuf has just taken a
short position in the same contract. The futures price is $400 per
ounce. Calculate the initial margin requirement for Khalid and Yousuf
(assuming 75% of initial margin)

Q6 : Closing out a position means

a) entering into the opposite trade to the original one
b) entering into the same trade to the original one
c) entering into the original trade
d) entering into any trade

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 Questions

Q7 : If amount in the margin A/C falls below the maintenance level,

a) a margin call is made to fill the gap
b) no call is made
c) trader can trade
d) none of the above

Q8 : The extra funds deposited to top up the margin account to the

initial margin level is called ________________

Q9 : If the price of the asset is above the forward price, then

long(buyer) receives the payment in Cash Settlement (T/F)

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 Questions

Q10 : If the price of the asset is below the forward price, then the short
(seller) will receive the payment in Cash Settlement (T/F)

Q11 : In ____________________settlement, party that is short the

forward contract (seller)will actually deliver the underlying asset to the
party that is long the forward contract(buyer)

Q12 : In Cash settlement; If the price of the asset is above the forward
price, then
a) (seller) will receive the payment
b) long(buyer) receives the payment
c) Exchange makes the payment
d) None of the above
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 Questions
Q13 : Additional margin required to bring an account up to the
required level is called
a) Margin call
b) Variation Margin
c) Maintenance Margin
d) Initial Margin

Q14: Marking to Market ensures that there are defaults by the

parties
(T/F)

Q15. At the end of each trading day, the margin account is adjusted
to reflect the investor’s gain or loss as per the settlement price. This
practice is referred to as _____________ 25
 Questions

Q16 : Consider Khalid (who is long) and Yousuf (who is short) in the contract for
100 ounces of gold. At the beginning of the day, the contract specified a price of
$400 per ounce Assuming Initial Margin -10% of the contract value and
maintenance margin as 75% of initial margin.
Please calculate the MTM effect and Margin call for Khalid and Yousuf when the
future price change as specified below:
Trading Day Future Price
Day 1 380

Day 2 385

Day 3 375

Day 4 400

Day 5 420

Day 6 430

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 Order
• When you place a stock trade, you can set
conditions on how the order is executed, as
well as price restrictions and time limitation
on the execution of the order.

• Video

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 Orders Types
Market Order:
• An investor makes a market order through a broker or
brokerage service to buy or sell an investment immediately
at the best available current price.
• A market order is the default option and is likely to be
executed because it does not contain restrictions on the
price or the time frame in which the order can be executed.
A market order is also sometimes referred to as an
unrestricted order.
• When using a market order, you're almost guaranteed that
your order will be executed. When you call your broker and
say, "Buy 10 shares of ABC stock," the broker will enter the
trade as a market order and you will buy ABC at whatever
price it is trading at when the order is fulfilled.
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 Orders Types

Limit Order:
• A limit order is an order to buy (or sell) at a
specified price or better.
• A buy limit order (a limit order to buy) can
only be executed at the specified limit
price or lower.
• Conversely, a sell limit order (a limit order to sell) will be
executed at the specified limit price or higher.
• Thus, 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.
• There is, of course, no guarantee that the order will be executed
at all, because the limit price may never be reached
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 Orders Types

Stop Order:
• Also called stop-loss order.

• It is an order whereby the investor

instructs the broker to automatically sell
the stock if it drops to a certain 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.

• The purpose of a stop order is usually to close out a position if

unfavorable price movements take place. It limits the loss that
can be incurred.
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Video 1
Video 2

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 Orders Types
Stop–limit Order :
• A stop-limit order combines the features
of a stop order and a limit order
• Once a stock reaches the stop price, a limit
order is automatically triggered to buy/sell
at a specific target 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. If the stop price and the limit price are the same, the
order is sometimes called a stop-and-limit order.
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 Orders Types – Time In Force- Video
Some orders specify time conditions. Unless
otherwise stated, an order is a day order and
expires at the end of the trading day.
• Day Order: A day order is an order to buy or
sell a security that automatically expires if not
executed on the day the order was placed. If it
is not filled, it is canceled, and it is not filled if
the limit or stop order price was not met during
the trading session. It is one of several different
order duration types that determines how long
the order is in the market before it is canceled.

• Good till-Canceled (GTC) Order: A good-till-canceled order is active

until the trade is executed or the trader cancels the order. Brokers
typically cancel GTC orders automatically if they have not been filled in
30 to 90 days. 34
 Orders Types – Time In Force
• Good-Till-Date (GTD) Order: A GTD order
remains active until a user-specified date,
unless it has been filled or canceled

• Immediate-Or-Cancel (IOC) Order: An IOC

requires all or part of the order to be executed
immediately; otherwise, the order (or any unfilled
parts of the order) will be canceled.

• Fill-Or-Kill (FOK) Order: FOK order must be filled immediately in its

entirety or it will be canceled. Partial fills are not accepted with this
type of order duration.

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Let’s Test Our Understanding

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 Questions

Q17 : Order that instructs the broker to buy (or sell) at the best
price that is currently available is called
a) Market Order
b) Limit Order
c) Stop Order
d) Stop-Limit Order

Q18 : A buy order that can only be executed at the specified limit
price or lower is called
a) Market Order
b) Limit Order
c) Stop Order
d) Stop-Limit Order
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 Questions

Q19 : Order whereby the investor instructs the broker to

automatically sell the stock if it drops to a certain price is called
a) Market Order
b) Limit Order
c) Stop Order
d) Stop-Limit Order

Q20 : Order that combines the features of a stop order and a limit
order is called
a) Market Order
b) Limit Order
c) Stop Order
d) Stop-Limit Order
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 Questions

Q21 : Order that automatically expires at the end of the regular

trading session if it has not been executed is called
a) GTC Order
b) Day Order
c) IOC Order
d) FOK Order

Q22 : Order that is active until the trade is executed or the trader
cancels the order is called
a) Day Order
b) GTC Order
c) IOC Order
d) FOK Order
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 Questions

Q23 : Order that remains active until a user-specified date, unless

it has been filled or canceled is called
a) Day Order
b) GTD Order
c) IOC Order
d) FOK Order

Q24 : Order that requires all or part of the order to be executed

immediately is called
a) Day Order
b) GTD Order
c) IOC Order
d) FOK Order
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 Questions

Q25 : Order that must be filled immediately in its entirety or it will be

canceled is called
a) Day Order
b) GTD Order
c) IOC Order
d) FOK Order

Q26 : Let's assume that you own 100 shares of Company XYZ stock, for
which you have paid $10 per share. You are expecting the stock to hit $12
sometime in the next month, but you do not want to take a huge loss if the
market turns the other way.
You direct your broker to set order at $8.50. If the stock goes up, you will
realize all of the benefits. If the stock goes down and touches $8.50, your
broker will automatically place a market order to sell your shares. Which
type of order is this?

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 Questions

Q27 : Let's say you bought stock ABC at $50 per share. You don't
want to lose more than $5 per share, so you set a stop-limit order for
$45.

If the stock dips to $45, the stop price triggers a limit order to sell at
$45. If a rapid price decline takes the stock lower than $45, the limit
order will ensure that you don't sell at the lower price. The limit
order will only execute when the stock reaches $45 again. Which
type of order is this?

Q28 : Sell Order that will be executed at the specified limit price or
higher is called _____________

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 Questions

Q29 : Order that can only be executed at the specified limit price or
lower is called _____________

Q30 : GTD order stands for

a) Good till Done
b) Good Till Duration
c) Good Till Date
d) None of the above

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