Chapter 8: The Structure of Forward and Futures Markets

It is like watching your favorite soap opera. You know all the characters. You know the plot. But you never really know how the day is going to end. Turk Ozdek Futures, July 2001, p. 86

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Important Concepts in Chapter 8

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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

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The Development of Forward and Futures Markets

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Chicago Futures Markets The Development of Financial Futures The Development of Options on Futures Markets The Parallel Development of Over-the-Counter Markets x interbank market x growth of forward markets

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The Over-the-Counter Forward Market

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customized private essentially unregulated credit risk market size: $18 trillion face value, $400 billion market value at year-end 2001

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Organized Futures Trading

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Contract Development Contract Terms and Conditions x contract size x quotation unit x minimum price fluctuation x contract grade x trading hours Delivery Terms x delivery date and time x delivery or cash settlement

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Organized Futures Trading (continued)

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Daily Price Limits and Trading Halts x limit moves x circuit breakers Other Exchange Responsibilities x minimum financial responsibility requirements x position limits x rules governing the trading floor

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Futures Exchanges
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See Table 8.1, p. 279 for list of exchanges. Global and after-hours trading Estimated world-wide volume in 2001 was 1.8 billion contracts.

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Futures Traders
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General Classes of Futures Traders x futures commission merchants x locals x dual trading Classification by Trading Strategy x hedger/speculator x spreader x arbitrageur

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Futures Traders (continued)

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Classification by Trading Style x scalpers x day traders x position traders Off-Floor Futures Traders x individuals x institutions x Others: Introducing Broker (IB), Commodity Trading Advisor (CTA), Commodity Pool Operator (CPO), Associated Person (AP)

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Futures Traders (continued)

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The Cost and Profitability of Exchange Membership x seats x See Figure 8.1, p. 283 for history of CBOT, CME, and NYMEX seat prices. x leasing a seat at around 1.0 - 1.5 %/mo. of seat price x profitability of membership Forward Market Traders x over-the-counter x primarily institutions

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The Mechanics of Futures Trading

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Placing an Order x pit x open outcry x electronic systems The Role of the Clearinghouse x See Figure 8.2, p. 285. x margin deposits

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The Mechanics of Futures Trading (continued)

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Daily Settlement x initial margin x maintenance margin x concept of margin vs. performance bond x settlement price x variation margin x See Table 8.2, p. 287 for example. x open interest

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The Mechanics of Futures Trading (continued)

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Delivery and Cash Settlement x three-day delivery process x alternative deliverable grades x offsetting x exchange for physicals x forward market procedures

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Futures Price Quotations

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Newspapers and web sites

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Types of Futures Contracts

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Agricultural Commodities Natural Resources Miscellaneous Commodities Foreign Currencies Treasury Bills and Eurodollars Treasury Notes and Bonds Equities Managed Funds Hedge Funds Options on Futures

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Transaction Costs in Forward and Futures Trading

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Commissions Bid-Ask Spread Delivery Costs

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The Regulation of Futures Markets

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Regulation is nearly always at the federal level; e.g., x Commodity Futures Trading Commission (U.S.) x Financial Services Authority (U.K.) x Financial Services Agency (Japan) Objective of most federal regulation 3 ensuring public information available 3 authorization and licensing of contracts and exchanges 3 contract approval 3 market surveillance

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The Regulation of Futures Markets (continued)

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Arbitration of disputes is sometimes done through the federal government and the courts but often through selfregulatory organizations such as the National Futures Association in the U. S. Note: Forward markets are regulated only indirectly and, thus, are largely unregulated.

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Summary

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Appendix 8: Taxation of Futures Contracts

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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 10.

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