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Finance 101 Insead Lec 2

Futures contracts are exchange-traded derivatives with standardized terms that are settled daily. They can be used to hedge or speculate on underlying assets. Key characteristics of futures include daily settlement of gains and losses, the ability to close a position before expiration by entering an offsetting contract, and initial and maintenance margin requirements. Most futures positions are closed out before expiration rather than resulting in physical delivery of the underlying asset.

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Dwijesh Rajwade
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94 views

Finance 101 Insead Lec 2

Futures contracts are exchange-traded derivatives with standardized terms that are settled daily. They can be used to hedge or speculate on underlying assets. Key characteristics of futures include daily settlement of gains and losses, the ability to close a position before expiration by entering an offsetting contract, and initial and maintenance margin requirements. Most futures positions are closed out before expiration rather than resulting in physical delivery of the underlying asset.

Uploaded by

Dwijesh Rajwade
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Options,

Futures, and
Other John Hull
Derivatives Module 1.5

Mechanics of Futures Markets

Background Reading: Chapter 2


of Options, Futures and Other Derivatives 8e

1
Futures Contracts
 Exchange traded
 Available on a wide range of underlying assets

 Specifications need to be defined


 What can be delivered,
 Where it can be delivered, &
 When it can be delivered
 Trader with a short position initiates delivery

2
Daily Settlement
 Futures contracts are settled daily at the close of
trading
 If the futures price has gone down the money is
transferred from the longs to the shorts
 If the futures price has gone up the reverse happens

3
Closing Out A Futures Position
A trader can close out a futures position by
entering into offsetting contracts
 In practice most futures positions are
closed out prior to the maturity month

4
Futures Price Converges to Spot Price
During Delivery Month

Futures
Price Spot Price

Spot Price Futures


Price

Time Time

(a) (b)

5
Margin
 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
 Initial margin and maintenance margin specified by
exchange
 Margin must be brought up to initial margin when
the balance in the margin account falls below the
maintenance margin level

6
Example of a Futures Trade
 An investor takes a long position in 2
December gold futures contracts on June 5
 contract size is 100 oz.
 futures price is US$1650
 initial margin requirement is US$6,000/contract
(US$12,000 in total)
 maintenance margin is US$4,500/contract
(US$9,000 in total)

7
A Possible Outcome
Day Trade Settle Daily Cumul. Margin Margin
Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,650.00 12,000
1 1,641.00 −1,800 − 1,800 10,200
2 1,638.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,636.20 −780 −2,760 9,240
7 1,629.90 −1,260 −4,020 7,980 4,020
8 1,630.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,626.90 780 −4,620 15,180

8
A Key Differences Between
Futures and Forwards

 Futures are settled daily


 Forwards are settled at the end of the life
of the contract

9
Margin Cash Flows When Futures
Price Increases

10
Margin Cash Flows When Futures
Price Decreases

11
Some Terminology
 Open interest: the total number of contracts
outstanding
 equal to number of long positions or number of short
positions
 Settlement price: the price at close of trading
each day
 used for the daily settlement process
 Volume of trading: the number of trades in one
day

12
Crude Oil Trading on July 13,
2012

Open High Low Prior Last Change Volume


settle trade
Aug 2012 85.86 87.61 85.58 86.08 87.28 +1.20 223,698
Sept 2012 86.33 88.00 85.95 86.46 87.68 +1.22 87,931

Dec 2012 87.45 89.21 87.39 87.73 88.94 +1.21 31,701

Dec 2013 88.85 90.15 88.78 88.92 89.95 +1.03 11,128

Dec 2014 87.20 87.74 87.20 86.98 87.74 +0.76 2,388

13
Collateralization in OTC Markets
 It is becoming increasingly common for transactions
to be collateralized in OTC markets
 Consider transactions between companies A and B
 These might be be governed by an ISDA Master
agreement with a credit support annex (CSA)
 The CSA might require A to post collateral with B
equal to the value to B of its outstanding transactions
with A when this value is positive.

14
Collateralization in OTC Markets
 If
A defaults, B is entitled to take
possession of the collateral
 The transactions are not settled daily
and interest is paid on cash collateral

15
Clearing Houses and OTC
Markets
 Traditionallymost transactions have been
cleared bilaterally in OTC markets
 Following the 2007-2009 crisis, there has
been a requirement for most standardized
OTC derivatives transactions to be
cleared centrally though clearing houses
known as central clearing parties (CCPs)

16
Bilateral Clearing vs Central
Clearing

Bilateral clearing Central clearing

17
Forward Contracts vs Futures
Contracts

Forward Futures
Private contract between two parties Traded on an exchange
Not standardized Standardized
Usually one specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final settlement usual Usually closed out prior to maturity
Some credit risk Virtually no credit risk

18

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