CHAPTER 1 Futures Markets Introduction

In this chapter, we introduce futures markets and their key players. This chapter is organized into the following sections:
1. Forward Contracts Versus Futures Contracts 2. Institutions Facilitating Futures Trading 3. Structure of Futures Exchanges 4. Clearinghouses Role in Futures Markets 5. Types of Futures Contracts 6. The Social Function of Futures Markets 7. Futures Markets Regulatory Framework and Taxation

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Forward Contracts
A forward contract is an agreement between two parties (counterparties) for the delivery of a physical asset (e.g., oil or gold) at a certain time in the future for a certain price that is fixed at the inception of the contract.
Forward contracts can be customized to accommodate any commodity, in any quantity, for delivery at any point in the future, at any place.

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EXAMPLE: St. Bernard Puppy

Counterparties: Asset/Commodity: Delivery/Payment Time: Priced Fixed: Buyer: Seller: Trading Volume: Buyers and Seller St. Bernard Pup 6 weeks $400 Dog Fancier has a long position Breeder has a short position Occurs when one trader buys & another sells Number of open contracts obligated for delivery

Open Interest:

If the dog owner had completed similar contracts for six different dogs, the open interest would be 6.

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Future Contracts
Futures contracts are highly uniform and well-specified commitments for a carefully described good (quantity and quality of the good) to be delivered at a certain time and place (acceptable delivery date) and in a certain manner (method for closing the contract) and the permissible price fluctuations are specified (minimum and maximum daily price changes).

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Forward Versus Futures

COMPARISON
Trade on organized exchanges Use standardized contract terms Use associate clearinghouses to guarantee contract fulfillment Require margin payments and daily settlements Close easily Regulated by identifiable agencies Any quantity Any product

FORWARD
No No

FUTURES
Yes Yes

No

Yes

No

Yes

No No Yes Yes

Yes Yes No No

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Futures Contract Standardized Terms

1. Quantity
2. Quality 3. Expiration months 4. Delivery terms

5. Delivery differentials
6. Delivery dates 7. Minimum price fluctuation 8. Daily price limits

9. Trading days and hours

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CBOT Wheat Futures Contract

Quantity: Quality: 5,000 bushels per contract. No. 2 Soft Red, No. 2 Hard Red Winter No. 2 Dark Northern Spring, or No. 1 Northern Spring. July, September, December, March, & May.

Expiration:

Delivery Terms: Wheat must be delivered at a regular or approved warehouse (e.g., warehouses located Chicago Switching District). Delivery: Payment: Any business days in the delivery month. Seller received payment and delivers a warehouse receipt to the buyer.

Price Fluctuation: 1/4 cent per bushel. Daily Price Limit: Trading price on a given day cannot differ from the preceding day's closing price by more than 30 cents/bushel ($1,500/contract). Trading Days: Wheat trades from 9:30 a.m. to 1:15 p.m. Chicago time.
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Institutions Facilitating Futures Contract Trading

There are two types of organizations that facilitate futures trading:
Exchange Exchanges are non-profit or for-profit organizations that offer standardized futures contracts for physical commodities, foreign currency and financial products. Clearinghouse A clearinghouse is agency associated with an exchange, which settles trades and regulates delivery. Clearinghouses guarantee the fulfillment of futures contract obligations by all parties involved.

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The Organized Exchange

Not-for-Profit Organization Structure
Members hold exchange memberships or seats that allow them to:
1. Trade on the exchange 2. Have a voice in the exchanges operation

For-Profit Organization Structure

Members receive shares or stocks. Demutualize Conversion of an exchange from not-for-profit to for-profit.

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Organized Exchange: Trading Systems

Futures contracts trade by two systems:
Open Outcry Open outcry is a trading room where traders literally cry out their bids to locate another trader who is willing to trade with them. Electronic Trading Platforms Contracts are traded through electronic computer networks. Electronic trading represents over 50% of futures contracts trading.

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Organized Exchange: Trading Players

Speculator
A trader who enters the futures market in pursuit of profit, accepting risk in the endeavor. Hedger A Trader who enters the futures market to reduce some pre-existing risk exposure. Broker An Individual or firm acting as an intermediary by conveying customers trade instructions. Account executives or floor brokers are examples of brokers.

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Major Futures Exchange

Table 1.6 Major Futures Exchanges in the World for 2003 EXCHANGE Eurex (Germany) Chicago Mercantile Exchange (USA) Chicago Board of Trade (USA) Euronext-Liffe (Netherlands) Mexican Derivatives Exchange (Mexico) Bolsa de Mercadorias e Futuros (Brazil) New York Mercantile Exchange (USA) Tokyo Commodity Exchange (Japan) London Metals Exchange (UK). Korea Stock Exchange (South Korea) Sydney Futures Exchange (Australia) National Stock Exchange of India (India) SIMEX (Singapore) International Petroleum Exchange (UK) OM Stockholm (Sweden) Tokyo Grain Exchange (Japan) New York Board of Trade (USA) Bourse de Montreal (Canada) MEFF Renta Variable (Spain) Tokyo Stock Exchange (Japan) Total Top 20 2003 Futures Volume Source: Futures Industry Association. 2003 Volume (Futures Only) 668,650,028 530,989,007 373,,669,290 273,121,004 173,820,944 113,895,061 111,789,658 87,252,219 68,570,154 62,204,783 41,831,862 36,141,561 35,356,776 33,258,385 22,667,198 21,084,727 18,822,048 17,682,999 17,109,363 15,965,175 2,723,882,242 Top 20 % Volume 24.55 19.49 13.72 10.03 6.38 4.18 4.10 3.20 2.52 2.28 1.54 1.33 1.30 1.22 .83 .77 .69 .65 .63 .59 100%

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Clearinghouses
1. Guarantee that the traders will honor their obligations (solves issues of trust).
2. Each trader has obligations only to the clearinghouse, not to other traders. 3. Each exchange uses a futures clearinghouse. 4. Clearinghouses may be part of a futures exchange (division), or a separate entity. 5. Due to 2000 CFMA, clearing arrangements vary across industries. 6. Clearinghouses are perfectly hedged by maintaining no futures market position of their own.

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The Function of Clearinghouses in Futures Markets

Obligations without a clearinghouse

Buyer

Seller

Obligations with a clearinghouse

Buyer

Clearinghouse

Seller

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Major Futures Clearing Organizations

Table 1.7 Major Futures Clearing Organizations

Clearinghouse The Clearing Corporation (CCorp) Chicago Mercantile Exchange Clearinghouse Kansas City Board of Trade Clearing Corporation Energy Clear Corporation MGE Clearinghouse NYMEX Clearinghouse New York Clearing Corporation The Options Clearing Corporation The London Clearinghouse Exempt Commercial Markets and OTC markets Sources: The CFTC web site, www.cftc.gov. Affiliated Exchanges US Futures Exchange and the Merchants Exchange of St. Louis Chicago Mercantile exchange With clearing link to CBOT Kansas City Board of Trade Exempt Commercial Markets Minneapolis Grain Exchange New York Mercantile Exchange New York Board of Trade OneChicago, NQLX, & option exchanges

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Margin and Daily Settlement

Margin
A good-faith deposit (or performance bond) made by a prospective trader with a broker. Margin can be posted in cash, bank letter of credit or short-term U.S. Treasury instruments. Daily Settlement Process by which traders are required to realize any losses in cash immediately (marked-to-the-market). The losses are usually deducted from the margin deposit.

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TYPES OF MARGIN
There are 3 types of margin:
1. Initial Margin Deposit that a trader must make before trading any futures. 2. Maintenance Margin When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin. 3. Variation Margin Additional margin required to bring an account up to the required level.

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Futures Market Obligations

Table 1.2 shows a typical trading situation.

Table 1.2 Futures Market Obligations

The oat contract is traded by the Chicago Board of Trade. Each contract is for 5,000 bushels, and prices are quoted in cents per bushel. (a) Party 1 Party 2 Sells 1 SEP contract for oats at 171 cents per bushel Clearinghouse Agrees to delivery to Party 1 a SEP contract for oats at a price of 171 cents per bushel Clearinghouse Agrees to receive from Party 2 1 SEP contract for oats and to pay 171 cents per bushel Buys 1 SEP contract for oats at 171 cents per bushel (b) Party 1 Buys 1 SEP contract for oats at 171 cents per bushel (c) Party 2

Sells 1 SEP contract for oats at 171 cents per bushel

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Futures Market Obligations

Based on Table 1.2, a trader purchases an oat Contract at 171 cents/ bushel at the close of day 0. The initial margin is $1,400. DAY 1
Contract closed @ 168 cents/bushel. Loss: 3 cents/bushel or $150 . Required maintenance margin: $1,100. Initial Margin (-) Daily Settlement New Margin Balance $1,400 150 $1,250

DAY 2
Loss: 4 cents/bushel or $200 Margin Balance (-) Daily Settlement New Margin Balance $1,250 200 $1,050

Traders margin is below the maintenance margin. Margin call occurs. Variation Margin needed:
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$350
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Account Equity & Margin Requirements

Figure 1.3 illustrates the account equity and margin requirements at different price levels.
Insert figure 1.3 here

Notice that the trader would have received two margin calls.

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Margin Cash Flows

Trader A

Clearing member

Clearinghouse

Non-clearing member

Trader B

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Closing a Futures Position

There are 3 ways to close a futures position:
1. Delivery or cash settlement 2. Offset or reversing trade 3. Exchange-for-physicals (EFP) or ex-pit transaction

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Closing a Futures Position: Delivery or Cash Settlement

Delivery
Most commodity futures contracts are written for completion of the futures contract through the physical delivery of a particular good. Cash settlement Most financial futures contracts allow completion through cash settlement. In cash settlement, traders make payments at the expiration of the contract to settle any gains or losses, instead of making physical delivery.

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Completion of Futures Contracts

Table 1.3 Completion of Futures Contracts
via Delivery or Cash Settlement October 1, 2002BSeptember 30, 2003 Delivered or Settled in Cash Commodity Group Grains Oilseeds Livestock Other Agricultural Energy/Wood Metals Financial Instruments Currencies All Commodities Volume 28,917,090 30,917,636 7,190,906 15,560,473 94,635,656 18,602,108 760,292,234 30,032,897 986,149,000 Contracts 98,235 51,143 36,107 95,344 839,221 209,186 7,115,757 682,095 9,125,088 Percentage 0.33 0.17 0.50 0.61 0.89 1.12 0.94 2.27 0.93

Source: Commodity Futures Trading Commission, Annual Report, 2003.

Notice that very few contracts are delivered or settled in cash.

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Delivery Differential
Sometimes the quantity and quality do not exactly match the quantity and quality specified in the contract. In these cases, shorts are given the option of delivering nonstandard commodities at non-standard delivery points. However, they may have to pay a surcharge or delivery differential relative to standard terms of the futures contracts. There are 2 types of delivery differential:
1. Quality Differentials 2. Location Differential

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Delivery Differential
Example: CBOT Corn Contract
Quality differential Grade differential based on the standard par delivery grade. Premium grade: Premium grade price differential : Price: Par grade: Par grade price: Lower grade: Lower grade Price differential : Price: No. 1 Yellow 1.5cents/bushel $3.015/bushel No. 2 Yellow $3/bushel No. 3 Yellow 1.5 cents/bushel or $2.985/bushel

Location differential Based relative to the standard delivery point or points specified in the futures contracts. Premium Location: 2 cents/bushel for delivery at terminals between Lockport & Seneca, Illinois Terminals between Chicago & Burns Harbor, Indiana
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Par Location:

Closing a Futures Position: Offset or Reversing Trade

If you previously sold a futures contract, you can close out your position by purchasing an identical futures contract. The exchange will cancel out your two positions. Table 1.4 illustrates a reversing trade.

Table 1.4 The Reversing Trade

May 1 Party 1's Initial Position Bought 1 SEP contract for oats at 171 cents per bushel Party 1's Reversing Trade Sells 1 SEP contract for oats at 180 cents per bushel Party 2 Sold 1 SEP contract for oats at 171 cents per bushel Party 3 Buys 1 SEP oats contract at 180 cents per bushel

May 10

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Closing a Futures Position: Exchange-forPhysicals (EFP)

Two traders agree to a simultaneous exchange of a cash commodity and futures contracts based on that cash commodity. Table 1.5 illustrates a EFP transaction.

Table 1.5 An Exchange-for-Physicals Transaction

Before the EFP Trader A Long 1 wheat futures Wants to acquire actual wheat Trader B Short 1 wheat futures Owns wheat and wishes to sell EFP Transaction Trader A Trader B Agrees with Trader B to purchase Agrees with Trader A to sell wheat and wheat and cancel futures cancel futures Receives wheat; pays Trader B Delivers wheat; receives payment from Trader A Reports EFP to exchange; exchange a- Reports EFP to exchange; exchange djusts books to show that Trader A is adjusts books to show that Trader B is out of the market out of the market

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Types of Futures Contracts

In this section, we will examine the following types of futures contracts:
Physical Commodity Foreign Currency Interest-Earning Asset

Index (Stock Index)

Individual Stocks

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Future Contracts: Physical Commodity

Contracts on physical commodities include:
1. Agricultural contracts 2. Metallurgical contracts 3. Energy contracts

These commodities, excluding electricity, are physically settled and are highly storable. Trading varies from commodity to commodity.

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Future Contracts: Physical Commodity

AGRICULTURAL
Grains - corn, oats, rice, wheat Livestock - live hogs, cattle Forest - lumber and plywood Textiles - cotton Foodstuffs - rice cocoa, coffee, orange juice, sugar

METALLURGICAL
Gold Silver Aluminum Platinum

ENERGY
Heating oil Crude oil Natural gas Unleaded gasoline

Coal, propane
Electricity

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Futures Contracts: Foreign Currency and Interest-Earning Asset

Foreign Currency
Australian dollar Brazilian Real Russian Ruble New Zealand dollar Swedish Krona South African Rand Norwegian Krone British pound

Interest-Earning Assets
Treasury bills Notes Bonds Eurodollar deposits Interest rate swaps Fed funds Municipal bonds

Canadian dollar
Japanese yen Swiss franc Mexican peso Euro

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Futures Contracts: Index Based

Traders must fulfill their obligation by reversing trade or cash settlement at the end of trading.
EXAMPLE OF INDEX BASED CONTRACTS US Exchanges Broad-Based stock indexes S&P 500 Dow Jones Industrial Average Russell 2000 NASDAQ 100 Style-Based Indexes S&P Barra Growth S&P Barra Value Foreign Exchanges Foreign Stock Indexes British FTSE 100 French CAC 40 Dow Jones Euro Stoxx 50 German DAX Brazillian Bovespa stock Japanese Nikkei 225 Korean KOSPI 200

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Future Contracts on Individual Stocks

Permitted for trade in United States after the passage of the Commodity Futures Modernization Act of 2000 (CFMA).

Also called single stock futures in the United States and universal futures in Great Britain.

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Relative Importance of Commodity Types

INSERT FIGURE 1.5 HERE

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Changing Commodity Trading Volume

INSERT FIGURE 1.6 HERE

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Social Function of Futures Markets

Futures markets meet the needs of three groups of users:
1. Those who wish to discover information about future prices of commodities 2. Those who wish to speculate 3. Those who wish to hedge

There are two main social functions of futures markets:

1. Price discovery 2. Hedging Speculation is not regarded as a social function by itself, but it may have socially useful by-products.

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Social Function of Futures Markets

PRICE DISCOVERY
Futures market information helps people make better estimates of future prices. Futures market information helps people with their production or consumption decisions. Example: silver Mine HEDGING Hedging is the prime social rationale for futures trading. Hedgers have a pre-existing risk exposure that leads them to use futures transactions as a substitute for a cash market transaction. By doing so, they are able to reduce or eliminate their risk. Example: wheat Farmer

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Regulation of Futures Markets

CEA
Grain Futures Act of 1922, superseded by the Commodity Exchange Act (CEA) of 1936. The CEA was last amended by the Commodity Futures Modernization Act of 2000 (CFMA). CFMA Promotes competition and innovation in futures markets. Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform (the three Ps).

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The CFMAs Three Tiers of Regulation

First Tier- Agricultural Commodities Futures on commodities (agricultural commodities) that Congress judged to be potentially susceptible to manipulation and that are offered to members of the public. Second Tier- Exempt Futures Contracts Futures contracts on metals and energy that are judged to be less susceptible to manipulation. Third Tier- Trade Principal to Principal Basis Contracts on financial products (swaps) that are privatelynegotiated between large, sophisticated contract counterparties.

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Futures Markets Levels of Regulation (Market Regulators)

1. Brokers
2. Exchanges and clearinghouses 3. National Futures Association (NFA), industry selfregulatory body 4. Commodity Futures Trading Commission (CFTC), federal governmental agency

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Market Regulators: Brokers

The Broker is responsible for:
1. Knowing the customer's position and intentions. 2. Ensuring that the customer does not disrupt the market or place the system in jeopardy. 3. Keeping the customer's trading activity in line with industry regulations and legal restrictions.

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Market Regulators: Exchange & Clearinghouses

Futures exchanges and clearinghouses formulate and enforce rules to:
1. Prohibit fraud 2. Prohibit dishonorable conduct 3. Prevent defaulting on contract obligations

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Abusive Trading Practices

Table 1.8 Abusive Trading Practices
Pre-arranged trading Accommodation trading Trading before customers orders, front running Bucketing Agreeing to some aspect of a transaction before it is openly executed on the exchange floor. Entering transactions to assist another floor participant in accomplishing improper trading objectives. Trading for one's personal account or an account in which one has an interest, while having in hand any executable customer order in that contract. Failing to introduce an order to the marketplace, traditionally occurring when a broker noncompetitively takes the other side of a customer order to the detriment of the customer or other members. Entering transactions to provide the appearance of trading activity without resulting in a change in market position. Trading after the official close of trading.

Wash trading

Curb trading

Source: Government Accounting Office, Automation Can Enhance Detection of Trade Abuses but Introduces New Risks, September 1989.

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Market Regulators: National Futures Association (NFA)

The NFA seeks to prevent fraudulent and manipulative acts by:
1. Screening and test applicants for registration. 2. Requiring members who handle customer funds to maintain adequate capital. 3. Requiring members to keep accurate trading records.

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Market Regulators: Commodity Futures Trading Commission (CFTC)

CFTC protects market participants from manipulation, abusive trading practices, and fraud by enforcing regulatory oversight of:
1. Futures exchanges 2. Futures clearinghouses 3. NFA

The heart of the CFTCs market surveillance is its largetrader electronic reporting system. This reporting system helps identify potential concentrations of market power within a market and to enforce speculative position limits.

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Insert figure 1.7 here

Figure 1.7 shows the place of the CFTC in the regulatory structure of the futures industry in the United States.

Insert Figure 1.7 here

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Recent Regulatory Initiatives

FASB ACCOUNTING RULES
In 1998, The FASB adopted new rules for disclosure of risk positions in firms derivatives positions.

CFMA 2000
Allows futures trading on individual stocks and narrow-based stock indexes.
Clarifies the legal status of privately-negotiated swap transactions. Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform.

Allows exchanges to bring new contracts to market without prior regulatory approval.
Establishes a set of standards, that permit futures exchanges and clearinghouses to use different methods to achieve federal requirements. Gives the CFTC clear authority to stop certain illegal, foreign exchange transactions aimed at defrauding small investors.

Gives the CFTC separate oversight authority with respect to clearinghouse organizations.

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Recent Regulatory Initiatives

TAXATION OF FUTURES TRADING
1981 LAW Futures positions must be marked-to-market at the end of the year.

ACT of 1986 Stipulates that short-term and long-term capital gains will be taxed at one rate.

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