1 Mechanics of Futures Markets Chapter 2

2 Chapter Outline 2.1 Trading Futures contracts 2.2 Specifications 2.3 Convergence of futures price to spot price 2.4 Operation of margins 2.5 Newspaper quotes 2.6 Keynes and Hicks 2.7 Delivery 2.8 Types of traders 2.9 Regulation 2.10 Accounting and tax 2.11 Forward contracts vs. futures contracts

3 2.1 Trading Futures contracts The Chicago Mercantile Exchange (CME) is by far the largest. Others include: –The Philadelphia Board of Trade (PBOT) –The MidAmerica Commodities Exchange –The Tokyo International Financial Futures Exchange –The London International Financial Futures Exchange

4 The Chicago Mercantile Exchange Expiry cycle: March, June, September, December. Delivery date 3 rd Wednesday of delivery month. Last trading day is the second business day preceding the delivery day. CME hours 7:20 a.m. to 2:00 p.m. CST.

5 CME After Hours Extended-hours trading on GLOBEX runs from 2:30 p.m. to 4:00 p.m dinner break and then back at it from 6:00 p.m. to 6:00 a.m. CST. Singapore International Monetary Exchange (SIMEX) offer interchangeable contracts. There’s other markets, but none are close to CME and SIMEX trading volume.

6 2.2 The Specification of the futures contract The Asset The Contract Size Delivery Arrangements Delivery Months Price Quotes Daily Price Movement Limits Position Limits –Limits on speculators, but not hedgers.

7 2.2 The Specification of the futures contract Standardizing Features: –Contract Size –Delivery Month Daily resettlement –Minimizes the chance of default Initial Margin –About 4% of contract value, cash or T-bills held in a street name at your brokerage.

8 Selected Futures Contracts

9 Basic Futures Relationships Open Interest refers to the number of contracts outstanding for a particular delivery month. Open interest is a good proxy for demand for a contract. Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month, currency) are outstanding.

Convergence of futures price to spot price At maturity, it must be the case that the futures price converges to the then-prevailing spot price. If not, an arbitrage occurs. maturity spot futures maturity spot futures

11 maturity spot futures

Operation of margins Margins help us avoid contract defaults. To enter into a futures contract, the investor must deposit money into a margin account. At the end of each day, the margin account is adjusted to reflect the trader’s gain or loss. This daily resettlement is referred to as marking to market.

13 Daily Resettlement: An Example Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate). Currently $1 = ¥140. The 3-month forward price is $1=¥150.

14 Daily Resettlement: An Example Currently $1 = ¥140 and it appears that the dollar is strengthening. If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will make money if the yen depreciates. The contract size is ¥12,500,000 Your initial margin is 4% of the contract value:

15 Daily Resettlement: An Example If tomorrow, the futures rate closes at $1 = ¥149, then your position’s value drops. Your original agreement was to sell ¥12,500,000 and receive $83,333.33: You have lost $ overnight. But ¥12,500,000 is now worth $83,892.62:

16 Daily Resettlement: An Example The $ comes out of your $3, margin account, leaving $2, This is short of the $3, required for a new position. Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.

Wall Street Journal Price Quotes Expiry month Opening price Highest price that day Lowest price that day Closing priceDaily Change Highest and lowest prices over the lifetime of the contract. Number of open contracts Normal market

Keynes and Hicks Argued that if hedgers tend to hold short positions and speculators tend to hold long positions, the futures price of an asset will be below its expected future spot price. –This is because speculators require compensation for bearing risk and hedgers are willing to pay to reduce risk. When the futures price < expected future spot price, the situation is known as normal backwardation. The opposite situation is called contango.

Delivery Most futures contracts are closed out early. The delivery period is specified by the exchange and varies from contract to contract. The short makes the decision on when to deliver and his broker issues a notice of intention to deliver to the exchange clearinghouse. The exchange then chooses a party with a long position to accept delivery.

Delivery In the case of a commodity, taking delivery usually means accepting a warehouse receipt in return for immediate payment. In the case of financial futures, delivery is usually made by wire transfer. For all contracts, the settlement price is usually the settlement price immediately preceding the date of the notice of intention to deliver. –It can be adjusted up or down for location, grade et c.

21 3 critical days There are three critical days for a contract. 1.The first notice day –The first day on which a notice on intention to make delivery can be submitted to the exchange. 2.The last notice day 3.The last trading day –Generally a few days before the first notice day.

Types of traders Commission brokers –Follow the instructions of their clients and charge a commission for doing so. Locals –Trade on their own account. Individuals taking positions –Scalpers –Day traders –Position traders

23 Types of Orders Limit order Stop-loss order Stop-limit order Market-if-touched order Discretionary order (market-not-held order) Fill-or-kill –Unless specified, an order is a day order and expires a the end of the trading day. –An open order or good-till-cancelled order is in effect until executed or the expiry.

Regulation In the U.S. futures markets are currently regulated by the CFTC. –Licenses futures exchanges –Approves contracts –Licenses individuals who offer their services to the investing public. NFA SEC Treasury department

25 Trading irregularities Market corner –Take a big long position in the futures contract. –Gain control of the underlying supply. –At maturity, the shorts will have to pay any price to satisfy their obligations Futures Markets are also a great place to launder money –The zero sum nature of futures is the key to laundering the money.

26 James B. Blair outside counsel to Tyson Foods Inc., Arkansas' largest employer, gets Hillary’s discretionary order. Robert L. "Red" Bone, (Refco broker), allocates trades ex post facto. Submits identical long and short trades winners losers Money Laundering: Hillary Clinton’s cattle futures

Accounting and tax Comprehensive treatment is far beyond the scope of this course. Accounting treatment is different for hedgers and speculators. Tax –Gains and losses –Timing or recognition of the gain or loss.

Forward contracts vs. futures contracts A futures contract is like a forward contract: –It specifies that a certain commodity will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward: –Futures are standardized contracts trading on organized exchanges with daily resettlement (“marking to market”) through a clearinghouse.