Tutorial 2 Suggested Solutions

Topic: Mechanics of Futures Contract Markets

Question 1.
a) Outline the differences between a forward contract and a futures contract.

b) Explain why forward contracts can be traded in the Over-the-counter (OTC) market, while Futures
contracts are traded only through Futures Exchange Market (FEM)?

c) Discuss how the Futures Exchange Market (FEM) can protect its traders from default risks?

Answer:
a) Differences between futures and forwards can be summarized by the following table:

FORWARD FUTURES
Buyer-seller interaction Private contract between 2 parties Exchange traded
Contract specification Non-standard contract Standard contract
Delivery date Usually 1 specified delivery date Range of delivery dates
Settlement Settled at end of contract Settled daily
Closing out of contract By delivery or final cash settlement Prior to maturity
Credit risk/counterparty risk Some credit risk Virtually no credit risk

b) Forward contracts by nature is an agreement to buy or sell an underlying asset at a deferred date.
Therefore, forward contracts can be negotiated between two known counterparties to customize or tailor
their agreement directly (OTM) on the non-standardized Q, Q, S, M (i.e. on Quantity, Quality, Size and
Maturity).

Futures Contracts by nature is an agreement to buy or sell an underlying asset through a futures
exchange market between two unknown counterparties. Therefore, future contracts have to be traded
through a Futures Exchange market (FEM) to discover daily futures price movement against the spot
price and the contract maturity. Moreover, Futures contracts are highly standardized in terms of it Q, Q,
S. M that requires the matching of counterparties connected through FEM.

c) The FEM acts as a clearinghouse that intervenes in each futures contract, guaranteeing to the buyer
that the seller's daily losses will be covered and guaranteeing to the seller that the buyer's daily losses
will be covered through a market mechanism called marked-to-market that rebalances a margin account
of each counterparty in a futures contract. This allows a trader to enter into a transaction without having
to check the creditworthiness of the other party. In turn, to protect themselves against risk of default by
futures parties, the clearinghouse requires that each trader maintain a margin account to cover losses.
Daily rebalancing is performed to prevent loss from accumulating through a maintenance margin level.
The clearinghouse also maintains a cash reserve to cover losses in the event of a failure to cover a loss
by a trader or firm.

(A margin is money deposited by an investor with their broker. It acts as a guarantee that the investor
can cover any daily losses on the futures contract trading. The balance in the margin account is
adjusted daily to reflect gains and losses on the futures contract. If losses are above a certain level,
the investor is required to deposit a further margin. This system makes it unlikely that the investor will
default. A similar system of margins makes it unlikely that the investor’s broker will default on the
contract it has with the clearinghouse member and unlikely that the clearinghouse member will default
with the clearinghouse).

Question 2.
 Assuming that Classic Metal Company (CMC) is taking a short position in Twenty September Gold
Futures contracts to sell 2,000 ounces of raw gold. The current September Gold Futures price
is $200.00 / oz. Each contract size is 100 oz. Each gold futures contract is currently $20,000.
The Initial Margin is $1,000/ contract and the maintenance margin is $750/ contract.

i) What change in the September Gold futures price per ounce will trigger a margin
call?
ii) How much will the margin call require CMC to replenish?
iii) What happens if CMC do not meet the margin call requirement?

Answer:
i) There will be a margin call when $250 / contract is lost from the margin account. (the difference between
the IM and the MM is 1,000 – 750 = $250). This will occur when the price of gold increases by 250 /100
= $2.5 / oz. The price of gold must therefore rise to $202.50 per ounce for a margin call.

ii) Since CMC has taken a short position in 20 September Gold Futures, CMC will require to replenish 2.5
x 100 x 20 = $5,000 to achieve the IM level.

iii) In case CMC do not meet the margin call requirement to replenish $5,000 within the next trading day,
CMC’s short Futures contract will be cancelled and handed over to another trader to keep going. In this
case CMC’s balance margin in account will be confiscated.

Question 3.
Suppose that you take a long position in a September S&P Stock Index Futures at an opening
price of 660.25 points on July 1. The multiplier on the contract is 500 times, so the contract value
at inception is $500(660.25) = $330,125. Assuming you hold the position open until selling it on
July 10 at a settlement price of 672.5 points. The Initial margin requirement is $16,000 and the
maintenance margin is $12,000. The daily settlement points are given in the table below. Assume
that you deposit the initial margin and do not withdraw the excess on any given day. Complete
the table below and identify the profit or loss in these futures transaction.

Date Settlement Total Contract Daily Gain / Loss Cum. Gain / Margin Balance Margin call
points Value ($) ($) Loss ($) ($) Yes / No
1-July 666.50 333,250 3,125 3,125 19,125 No
2-July 670.25 335,125 1,875 5,000 21,000 No
3-July 667.50 333,750 (1,375) 3,625 19,625 No
4-July 660.25 330,125 (3,625) 0.00 16,000 No
7-July 650.00 325,000 (5,125) (5,125) 10,875 Yes 5,125
16,000
8-July 662.25 331,125 6,125 1,000 22,125 No
9-July 665.50 332,750 1,625 2,625 23,750 No
10-July 672.50 336,250 3,500 6,125 27,250 No
Profit (Loss) 12.25 x 500 6.125 6,125 6,125 6,125
Profit or Loss from this transaction can be ascertained from all perspectives. The simplest is the difference between
closing day total contract value minus total contract value at inception. In this case it is $336,250 – 330,125 = $6,125
Question 4.
Sim Lim Rubber Company (SLRC), supplies natural rubber sheets to their known customer
Bandag Tires Company (BTC). The SMR rubber price is currently RM11,500 per ton. BTC requires
500 tones SMR rubber as their raw material for tires on 15 th July 2022. Both the companies
negotiated a fixed price of RM12,000 / ton to transact their product on 15th July 2022.

i) Explain what derivative contract would have been used in this case by each of the
companies?
ii) What is the purpose of SLRC and BTC to enter the derivative contract?
iii) What would be each company’s gain or loss if the SMR spot price is RM13,000/ ton on 15th
July 2022.
Answer:
i) SLRC would use a Short Forward Contract while BTC would use Long Forward contract.

ii) SLRC and BTC would enter into a bilateral agreement called a Forward contract to lock-in the SMR
price agreed today to transact on 15 th July 2022.

iii) If the SMR spot price is RM13,000 / ton on 15 th July 2022, SLRC will lose (12,000 – 13,000) = RM
1,000 while BTC will gain (13,000 – 12,000) = RM1,000.

Question 5.

Company A took a Long position in 10 June Arabica Coffee Beans Futures (ACBF) and Company
B entered the counterparty position on this underlying to open a futures contract today at the
specified ACBF price of USD100 per Kilogram. Each ACBF contract size is 5 bags of 100 Kg each.
The initial margin is set at 5.25% of total contract value at the inception and counterparties must
maintain a minimum of 75% of initial margin throughout the contract life.

i) Calculate the initial margin value that both the counterparties must deposit?
ii) What is the maintenance margin level to keep trading on going?
iii) At what price change Company A will be triggered by a margin call?
iv) At what Price change will Company B need to respond to a margin call?

Answer:

i) Each contract value = 5 bags x 100 kg x USD100 = USD50,000

ii) Maintenance margin level = 0.75 x 26,250 = USD19,687.50

iii) The difference between IM and MM = 26,250 – 19,687.50 = USD6,562.5

Explain carefully the main difference between hedging, speculation, and arbitrage.
Answer:
A trader is hedging when he/she has an exposure to the price movements on an existing asset
(or an asset the is planned to be acquired), and takes a position in a derivative to neutralize the
risk of loss in the deferred date adverse price change.
In a speculation, the trader has no exposure on any existing or planned asset. He / she is betting
on the future movements in the futures contract price of the underlying asset to gain a profit by
taking the risk of loss is prices moved adversely.
Arbitrage involves in taking a position in two or more different market to exploit the mispriced
opportunity to gain riskless profit.

[END OF TUTORIAL WEEK 2]