Ch02HullOFOD7thEd Updated

Mechanics of Futures
Markets
Chapter 2
Options, Futures, and Other

Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 1
Futures Contracts
Agreement to buy or sell an asset for

a certain price at a certain time
Similar to forward contract
Whereas a forward contract is traded
OTC, a futures contract is traded on
an exchange

John C. Hull 2008 2
One who agrees to buy in future has long
futures position.
One who agrees to sell in future has a short
futures position.
Future price is determined by demand and
supply forces.
If at a particular time, more traders wish to sell
in future, price will go down. more buyers will
enter the market
If at a particular time, more traders wish to buy
in future,price will go up. new sellers will enter
the market
 This way balance between sellers and buyers will maintain.
3
Closing out positions
Closing out a position means entering into the opposite
trade to the original one.
Most traders close out their positions prior to the delivery
period in the contract.
The one buying a july future contract in march can close
position by selling it any time before july say april.
The one selling a july future contract in march can close
position by buying a future contract any time before july
say may.
Traders loss/gain is determined by changes in future
prices between march and the day when contract is
closed out.
John C. Hull 2008 4
Futures Contracts
Available on a wide range of assets
Exchange traded
Specifications need to be defined:
◦ What can be delivered (asset),
◦ Contract size (How much asset will be delivered under one contract)
◦ Where it can be delivered, &
◦ When it can be delivered
◦ Alternatives (grade of asset/ delievery location)
Settled daily
Short position decided what happen in case of
alternatives in contract

John C. Hull 2008 5
“notice of intention to deliver” is filed in
exchange by the short position trader
that shows which grad of asset will be
delivered at what location.

John C. Hull 2008 6
Asset

John C. Hull 2008 7
Contract Size

John C. Hull 2008 8
Delievery

John C. Hull 2008 9
Delivery months
 Exchange specifies the period during a month
when delivery can be made.
 For many future contracts delivery period is whole
month.
 Delievery months vary from contract to contract to
meet needs of diverse market participants.
 For an asset delievery month can be multiple like
june august December etc.
 Exchange specifies when trading in a particular
month can start and last day on which trading can
take place fora given contract

John C. Hull 20 08 10
Price
 Exchange defines how prices can be quoted for
futures.
 A price limit is the maximum range that a futures
contract is allowed to move up or down within a
single day.
 A price move is the move in either direction equal
to the daily price limit.
 It is set by the exchange to prevent excessive daily
volatilities in the futures market.
 When a product reaches its highest price allowed,
the product is “limit up,” when it reaches the
lowest price allowed, it is “limit down.”
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When the product is limit up or down,
different actions can occur. The trading
might be stopped for that single day, or
the market might temporarily halt until
the price limit is expanded(changed by
exchange)
Price limits are re-calculated for every
trading day.
Different futures contracts will have
different price limit rules.
John C. Hull 2008 12
Position limits
Maximum number of contracts
speculator/trader can hold.
The primary goal is to avoid the
manipulation of prices for personal
benefit at the expense of others.

Convergence of Future price to
Spot price
The price of the futures contract and the
spot price will be roughly equal or close on
the delivery date.
Convergence happens because the market
will not allow the same commodity to trade
at two different prices at the same place at
the same time. For example, you rarely see
two gasoline stations on the same block
with two very different prices for gas at the
pump. Car owners will simply drive to the
place with the lowest price.Options, Futures, and Other
The futures price of a commodity is set in advance
between producer and buyer.
The spot price is the commodity's value when it is
ready for delivery.
The difference in the two values is where arbitrage
traders make their money.
When future price is higher than spot price, traders
see an arbitrage opportunity. That is, they will short
futures contracts, buying the underlying asset, and
then make the delivery.
futuresprices drop because the supply of
contracts available for trade increases.

Subsequently, buying the underlying
asset causes an increase in the overall
demand for the asset and the spot
price of the underlying asset will
increase as a result.
he same sort of effect occurs when
spot prices are higher than futures,
except that arbitrageurs would in that
case short sell the underlying asset
and long the futures contracts.

Convergence of Futures to Spot
(Figure 2.1, page 26)
Futures
Price Spot Price
Spot Price Futures

Price
Time Time
(a) (b)

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

Example of a Futures Trade
(page 26-28)
An investor takes a long position in 2

December gold futures contracts on
June 5
◦ contract size is 100 oz.(2*100=200oz)
◦ futures price is US$600/oz
◦ Initial margin requirement is
US$2,000/contract (US$4,000 in total)
◦ maintenance margin is US$1,500/contract
(US$3,000 in total)

By end of June 5 future price drops
from $600 to $597.
Investor’s loss is $600 (200*3)
(600-597=3)
Balance in margin account will be
reduced by 600$ to $3400 from $4000.
 The broker will pay 600 to exchange
which will transfer this money to short
position party broker.vice versa
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By end of June 5 future price increase from
$600 to $603.
Investor’s gain is $600 (200*3)
Balance in margin account will be increased
by 600$ to $4600 from $4000.
Investor can withdraw amount from margin
account that is excess of initial margin
requirement.
Maintenance margin which is lower than
initial margin is also set so that margin
account donot become negative.
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If maintenance balance in margin
account falls below maintenance
margin, then investor gets a margin
call to topup margin a/c to initial
margin
If the investor does not provide the
variation margin (extra required
funds) the broker closes out the
position.

More information
Many brokers allow investor to earn
interest on balance in margin account.
Instead of cash investor can deposit
securities with broker. Treasurey bills
90%of face value & stocks 50% of
Market value.
Minimum level of initial margin and
maintenance margin is set by
exchange.
Brokers can require higher margins than
sent by the exchange but never lower
than that.
Margin levels are determined by the
variability of underlying asset. More
variability higher margin.
Maintenance margin is usually 75%of
the initial margin.
Margin requirements are same for long
and sort positions.

Clearing house
A clearing house acts as an intermediary in futures
transactions.
 It guarantees the performance of the parties to each
transaction.
 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.
 Investor mainatinas margin account with broker.Broker
maintains margin account with member of clearing
house.Member maintain margin account with clearing
house. . This last margin is called a clearing margin.
Some Terminology
Open interest: the total number of contracts
outstanding(not settled yet)
◦ equal to number of long positions or number of
short positions
Settlement price: the closing price each day
◦ used for the daily settlement process
Volume of trading: the number of contracts
traded in 1 day.
If the volume on a certain day is higher than the
open interest, that means that positions were
closed out that day.

Day trading in which trader show intention to
broker to closeout position same day.
Spread transaction in which a trader
simultaneously buy and sell contract on same
asset for some maturity
Clearing house
Markets were the future price is an increasing

function of the time to maturity are known as
normal markets. A price that decreases with
the maturity of the futures is known as a
inverted market.

A futures commission merchant
trades on behalf of a client and
charges a commission.
A local commission merchant
trades on his or her own behalf.

Questions
When a new trade is completed what are
the possible effects on the open interest?
Can the volume of trading in a day be
greater than the open interest?

Types of Orders
• Market orders
– Buy or sell at the best current price
– Provides immediate liquidity
– A market buy order indicates the investor is willing
to pay the lowest offering price available at the time
on the exchange.
– a market sell order indicates a willingness to sell
immediately at the highest bid available at the time
the order reaches an exchange.

• Limit orders
– Order specifies the buy or sell price
– Time specifications for order may vary(how long
order will be outstanding)
• Instantaneous - “fill or kill”, part of a day, a
full day, several days, a week, a month, or
good until canceled (GTC)
 Ifthe limit price to buy is $30 then
order will be executed only at 30 or
below.

– Stop loss
• Conditional order to sell stock if it drops to a
given price.
• Does not guarantee price you will get upon sale

– Stop loss limit order

Q-What does a stop order to sell at $2
mean? When might it be used? What
does a limit order to sell at $2 mean?
When might it be used?
A stop order to sell at $2 is an order to
sell at the best available price once a
price of $2 or less is reached. It could be
used to limit the losses from an existing
long position. A limit order to sell at $2 is
an order to sell at a price of $2 or more.

Forward Contracts vs Futures
Contracts
TABLE 2.3 (p. 39)
FORWARDS FUTURES
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk


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Mechanics of Futures

Options, Futures, and Other

Agreement to buy or sell an asset for

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Spot Price Futures

Options, Futures, and Other

Options, Futures, and Other

An investor takes a long position in 2

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Markets were the future price is an increasing

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

Options, Futures, and Other

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