FINANCIAL DERIVATIVES 6/21/2017

UNIT 2 FUTURES CONTRACT 6/21/2017

INTRODUCTION Futures markets were designed to solve the problems that exist in forward markets. Unlike forward contracts, the futures contracts are standardized and exchange traded. 6/21/2017

MEANING A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. The standardized items in a futures contract are: · Quantity of the underlying · Quality of the underlying · The date and the month of delivery · The units of price quotation and minimum price change · Location of settlement 6/21/2017

Specifications of the Futures Contracts When developing a new contract, exchange must specify the exact nature of the agreement between the two parties It must specify The asset The contract size Where delivery will be made When delivery will be made 6/21/2017

Specifications of the Futures Contracts As a general rule, it is the party with the short position (the party that has agreed to sell the asset) that chooses what will happen when alternatives are specified by the exchange. When the party with the short position is ready to deliver, it files a notice of intention to deliver with the exchange. This notice indicates selections, it has made with respect to the grade of asset that will be delivered and the delivery location 6/21/2017

http://nptel.ac.in/courses/110105071/3 6/21/2017

Intermission 6/21/2017

Specifications of the Futures Contracts THE ASSET: When the asset is a commodity, there may be quite a variation in the quality of what is available in the market place. Exchange stipulates the grade or grades of the commodity that are acceptable For some commodities a range of grades can be delivered, but the price received depends on the grade chosen. The financial assets in futures contracts are generally well defined and unambiguous. For eg., there is no need to specify the grade of a Japanese yen. 6/21/2017

Specifications of the Futures Contracts THE CONTRACT SIZE: The contract size specifies the amount of the asset that has to be delivered under one contract. This is an important decision for the exchange. If the contract size is too large, many investors who wish to hedge relatively small exposures. If contract size is too small, trading may be expansive as there is a cost associated with each contract traded. 6/21/2017

Specifications of the Futures Contracts DELIVERY ARRANGEMENTS: The place where delivery will be made must be specified by the exchange. Very important for commodities that involve significant transportation costs. When alternative delivery locations are specified, the price received by the party with the short position is sometimes adjusted according to the location chosen by that party. 6/21/2017

Specifications of the Futures Contracts DELIVERY MONTHS: Futures contract is referred to by its delivery month. The exchange must specify the precise period during the month when delivery can be made. For many futures contracts, the delivery period is the whole month. The delivery months vary from contract to contract and are chosen by the exchange to meet the needs of market participants. 6/21/2017

Specifications of the Futures Contracts PRICE QUOTES: The exchange defines how. prices will be quoted. For eg. Crude oil prices on the New York Mercantile Exchange are quoted in dollars and cents. PRICE LIMITS AND POSITION LIMITS: For most contracts, daily price movement limits are specified by the exchange. In a day, the price moves down from the previous day’s close by an amount equal to the daily price limit, the contract is said to be limit down. 6/21/2017

Specifications of the Futures Contracts PRICE LIMITS AND POSITION LIMITS: If it moves up by the limit, it is said to be limit up. A limit move is a move in either direction equal to the daily price limit. The purpose of price limits is to prevent large price movements from occurring because of speculative excesses. Limits can become an artificial barrier to trading when the price of the underlying commodity is advancing or declining rapidly. Position limits are the maximum number of contracts that a speculator may hold. The purpose of these limits is to prevent speculators from exercising undue influence on the market. 6/21/2017

Specifications of the Futures Contracts SPECIFICATIONS OF A FUTURES CONTRACT Following are the specifications required of a futures contract: Expiration Expiration (also known as maturity or expiry date) refers to the last trading day of the futures contract. After the expiry of a futures contract, final settlement and delivery is made according to the rules laid down by the exchange in the contract specifications document. Contract Size Contract size, or lot size, is the minimum tradable size of a contract. It is often one unit of the defined contract. For example, current contract size of PMEX sugar contract is 10 Tons. This implies that trading one contract creates a position of 10 tons of sugar. PMEX rice contract has a contract size of 25 tons. Initial Margin Initial margin is the minimum collateral required by the exchange before a trader is allowed to take a position. Initial margins can be paid in various forms as laid down by the exchange and varies from commodity to commodity as well as from time to time. The level of initial margin is dependent on the price volatility of the contract. More volatile commodities generally have higher margin requirements. Price Quotation Price Quotation is the units in which the traded price of a contract is displayed. It can be different from the trading size of a contract and is often based on industry practices and conventions. While the contract size of PMEX sugar contract is 10 tons, its price is quoted in Rupees per 100 kgs. PMEX Palm Oil contract has a size of 25 tons but its price quotation follows local trade practices and is displayed as Rupees per maund. 6/21/2017

Specifications of the Futures Contracts Tick Size Tick Size is the minimum movement allowed by the exchange in Price Quotation. For example, the tick size of PMEX 100gms gold futures contract is Re. 1, whereas it is $0.01 or 1cent for the PMEX 10oz gold futures contract. Tick Value Tick Value refers to the minimum profit or loss that can arise from holding a position of one contract. Tick value depends on the size of the contract and its tick size. While it is often explicitly mentioned in contract specifications, it can be calculated by the formula: Tick Value = Contract Size x Tick Size Mark to Market Mark to market refers to the process by which the exchange calculates and values all open positions according to pre-defined rules and regulations. Mark-to-market is an essential feature of exchange-traded futures contracts whereby the exchange ensures that all profit and losses are recognized by pricing them according to accurate market conditions. It is also an important feature for the risk management of positions of participants. Delivery Date Delivery date or delivery period refers to the time specified by the exchange during or by which the seller has to make delivery according to contract specifications and regulations. Delivery date is often later than expiry date of a contract, especially in case of physically delivered commodities. Daily Settlement Daily settlement refers to the process whereby the exchange debits and credits all accounts with daily profits and losses as calculated by the mark-to-market process. Daily settlement is necessary in order to recover losses and pay profits to respective accounts 6/21/2017