Chapter 8: The Structure of Forward and

Futures Markets

Futures traders tend to be superstitious—when on a good

run they are reluctant to change their mojo, this includes
washing their jackets. Traders will wear their lucky jackets
until they fall apart or their luck runs out. Some traders
have even been buried in their lucky jackets, reflecting a
hope that the good luck their jackets provided in the trading
pits on Earth could be retained for eternity in that Great
Trading Pit in the sky.
Jim Overdahl
Futures Fall Special Issue 2005, p. 14

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 1

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 Important Concepts in Chapter 8
 Definitions and examples of forward and futures contracts
 Institutional characteristics of forward and futures markets
 Futures contracts available for trading
 Placing an order, margins, daily settlement
 The role of the clearinghouse
 Accessing futures price quotations
 Magnitude and effects of transaction costs

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 2

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 Development of Forward and Futures Markets

 Chicago Futures Markets

 Development of Financial Futures
 Development of Options on Futures Markets
 Parallel Development of Over-the-Counter Markets
 interbank market
 growth of forward markets

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 3

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 Over-the-Counter Forward Market

 customized
 private
 essentially unregulated
 credit risk
 market size: $84 trillion face value, $1.3 trillion market
value at year-end 2010
 See Figure 8.1 for notional amount of forward market
 See Figure 8.2 for market value of forward market

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 4

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 Organized Futures Trading
 Contract Development (See Figure 8.3 for the daily volume of the
VIX futures contract)
 Contract Terms and Conditions
 contract size
 quotation unit
 minimum price fluctuation
 contract grade
 trading hours
 Delivery Terms
 delivery date and time
 delivery or cash settlement

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 5

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 Organized Futures Trading (continued)

 Daily Price Limits and Trading Halts

 limit moves
 circuit breakers
 Other Exchange Responsibilities
 minimum financial responsibility requirements
 position limits
 rules governing the trading floor

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 6

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 Derivatives Exchanges

 Global and after-hours trading

 Estimated world-wide volume in 2010 was 11.2 billion
contracts
 43% Asia Pacific Region
 13% North America
 3.7 billion at Korea Exchange
 3.1 billion at CME Group

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 7

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 Futures Traders

 General Classes of Futures Traders

 futures commission merchants
 locals
 dual trading
 Classification by Trading Strategy
 hedger/speculator
 spreader
 arbitrageur

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 8

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 Futures Traders (continued)
 Classification by Trading Style
 scalpers
 day traders
 position traders
 Off-Floor Futures Traders
 individuals
 institutions
 Others: Introducing Broker (IB), Commodity Trading
Advisor (CTA), Commodity Pool Operator (CPO),
Associated Person (AP)
 Forward Market Traders
 over-the-counter
 primarily institutions

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 9

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 Mechanics of Futures Trading

 Placing an Order
 pit
 open outcry
 electronic systems
 Role of the Clearinghouse
 See Figure 8.4.
 margin deposits

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 10

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 Mechanics of Futures Trading (continued)

 Daily Settlement
 initial margin
 maintenance margin
 concept of “margin” vs. performance bond
 settlement price
 variation margin
 See Table 8.1 for example.
 open interest

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 11

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 Mechanics of Futures Trading (continued)

 Delivery and Cash Settlement

 three-day delivery process
 alternative deliverable grades
 offsetting
 exchange for physicals
 forward market procedures

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 12

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 Futures Price Quotations

 Newspapers (such as The Wall Street Journal)

 Web sites

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 13

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 Types of Futures Contracts
 Agricultural Commodities
 Natural Resources
 Miscellaneous Commodities
 Foreign Currencies
 Federal funds and Eurodollars
 Treasury Notes and Bonds
 Swap Futures
 Equities
 Managed Funds
 Hedge Funds
 Options on Futures

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 14

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 Transaction Costs in Forward and Futures
Trading
 Commissions
 Bid-Ask Spread
 Delivery Costs

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 15

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 Regulation of Futures Markets
 Regulation is nearly always at the federal level; e.g.,
 Commodity Futures Trading Commission (U.S.)
 Financial Services Authority (U.K.)
 Financial Services Agency (Japan)
 Objective of most federal regulation
 ensuring public information available

 authorization and licensing of contracts and

exchanges
 contract approval

 market surveillance

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 16

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 Regulation of Futures Markets (continued)
 Arbitration of disputes is sometimes done through the
federal government and the courts but often through self-
regulatory organizations such as the National Futures
Association in the U. S.
 Note: Forward markets are regulated only indirectly and,
thus, are largely unregulated.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 17

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OTC Central Clearing

 Dodd-Frank Act of 2010 further motivated efforts in the

OTC derivatives markets for central clearing
 OTC central clearing should provide more transparency to
this opaque market and more accountability
 Several clearing corporations are competing for OTC
derivatives central clearing
 OTC central clearing is like the spoke and hub system used
by some airlines

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 18

 Summary

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 19

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Appendix 8: Taxation of Futures Contracts

 Treated as 60 % capital gains and 40 % ordinary income.

 Capital gains subject to 28 % maximum.
 Must be marked to market at year end.
 New single stock futures are taxed the same as individual
stocks.
 Hedge transactions covered in Chapter 11.

Chance/Brooks An Introduction to Derivatives and Risk Management, 9th ed. Ch. 8: 20

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