1. Options, Futures, and Other Derivatives
Tenth Edition
Chapter 2
Futures Markets and Central Counterparties
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2. Futures Contracts Available on a wide range of assets Exchange traded
Specifications need to be defined:
What can be delivered,
Where it can be delivered, and
When it can be delivered
Settled daily

3. Convergence of Futures to Spot (Figure 2.1, page 29)
Price
Time
(a)
Spot Price
Time
(b)
Futures
Price
Spot Price

4. Margins
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
Margins minimize the possibility of a loss through a default on a contract

5. Margin Cash Flows
A trader has to bring the balance in the margin account up to the initial margin when it falls below the maintenance margin level
A member of the exchange clearing house only has an initial margin and is required to bring the balance in its account up to that level every day.
These daily margin cash flows are referred to as variation margin
A member is also required to contribute to a default fund

6. Example of a Futures Trade (page 29-31)
An investor takes a long position in 2 December gold futures contracts on June 5
contract size is 100 oz
futures price is US$1,250
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 (Table 2.1, page 30)
Day
Trade Price ($)
Settle Price ($)
Daily Gain ($)
Cumul. Gain ($)
Margin Balance ($)
Margin Call ($) 1
1,250.00
Blank
12,000
1,241.00
−1,800
− 1,800
10,200 2
1,238.30
−540
−2,340
9,660
….. …… 6
1,236.20
−780
−2,760
9,240 7
1,229.90
−1,260
−4,020
7,980
4,020 8
1,230.80
180
−3,840
12,180 16
1,226.90
780
−4,620
15,180

8. Margin Cash Flows When Futures Price Increases
Long Trader
Broker
Clearing House
Member
Short Trader

9. Margin Cash Flows When Futures Price Decreases
Long Trader
Broker
Clearing House
Member
Short Trader

10. 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 just before the final bell each day
used for the daily settlement process
Volume of trading: the number of trades in one day

11. Key Points About Futures
They are settled daily
Closing out a futures position involves entering into an offsetting trade
Most contracts are closed out before maturity

12. Crude Oil Trading on May 3, 2016 (Table 2.2, page 37)
Blank
Open
High
Low
Prior Settle
Last Trade
Change
Volume
Jun 2016
44.92
45.35
43.36
44.78
43.51
−1.27
503,259
Aug 2016
46.02
46.45
44.63
45.91
44.82
−1.09
50,439
Dec 2016
47.09
47.55
45.99
46.24
−0.85
41,447
Dec 2017
48.75
49.17
47.83
48.72
48.16
−0.56
13,032
Dec 20158
50.27
50.40
49.30
49.99
49.59
−0.40
1,618

13. OTC Transactions: Bilateral Clearing vs Central Clearing

14. Bilaterally Cleared Transactions
Usually governed by an ISDA Master agreement with a credit support annex (CSA).
The agreement explains the rights of one party if the other party defaults.
The CSA defines the collateral which must be posted.
If one party defaults, the other party is entitled to keep any collateral that has been posted up to what is necessary to settle its claims.
Traditionally CSAs have required variation margin but not initial margin (e.g., LTCM in Business Snapshot 2.2).

15. New Regulations
New regulations for trades between financial institutions that are not cleared centrally require the financial institutions to have CSAs where both initial margin and variation margin are posted.
The initial margin is posted with a third party.

16. Delivery
If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses.
A few contracts (for example, those on stock indices and Eurodollars) are settled in cash.

17. Questions
When a new trade is completed what are the possible effects on the open interest?
Problem 2.22.

18. Types of Trades Types of Investors Futures Commission Merchants (FCMs)
Locals
Types of Investors
Speculators
Scalpers
Day Traders
Position Traders
Hedgers
Arbitrageurs
There are two main types of traders executing trades: futures commission merchants (FCMs) and locals. FCMs are following the instructions of their clients and charge a
commission for doing so; locals are trading on their own account.
Individuals taking positions, whether locals or the clients of FCMs, can be categorized as hedgers, speculators, or arbitrageurs, as discussed in Chapter 1. Speculators can
be classified as scalpers, day traders, or position traders. Scalpers are watching for very short-term trends and attempt to profit from small changes in the contract price. They usually hold their positions for only a few minutes. Day traders hold their positions for less than one trading day. They are unwilling to take the risk that adverse news will occur overnight. Position traders hold their positions for much longer periods of time.
They hope to make significant profits from major movements in the markets.

19. Types of Orders Discretionary Market Order Time of day Limit Open
Fill or kill
Market Order
Limit
Stop-loss
Stop-limit
Market-if touched

20. Regulation of Futures
In the US, the regulation of futures markets is primarily the responsibility of the Commodity Futures and Trading Commission (CFTC).
Regulators try to protect the public interest and prevent questionable trading practices.

21. Forward Contracts vs Futures Contracts (Table 2.3, page 43)
Forwards
Futures
Private contract between 2 parties
Exchange traded
Non-standard contract
Standard contract
Usually 1 specified delivery date
Range of delivery dates
Settled at end of contract
Settled daily
Delivery or final cash
settlement usually occurs
prior to maturity
Some credit risk
Virtually no credit risk
Contract usually closed out

22. Foreign Exchange Quotes
Futures exchange rates are quoted as the number of USD per unit of the foreign currency.
Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are quoted as USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.

23. Practice Questions

24. Problem 2.14.
Explain what a stop-limit order to sell at with a limit of means.
Problem 2.15.
At the end of one day a clearing house member is long 100 contracts, and the settlement price is $50,000 per contract. The original margin is $2,000 per contract. On the following day the member becomes responsible for clearing an additional 20 long contracts, entered into at a price of $51,000 per contract. The settlement price at the end of this day is $50,200. How much does the member have to add to its margin account with the exchange clearing house?

25. Problem 2.23.
Suppose that on October 24, 2018, a company sells one April 2019 live-cattle futures contracts. It closes out its position on January 21, The futures price (per pound) is cents when it enters into the contract, cents when it closes out its position, and cents at the end of December One contract is for the delivery of 40,000 pounds of cattle. What is the total profit?
Problem Trader A enters into futures contracts to buy 1 million euros for 1.1 million dollars in three months. Trader B enters in a forward contract to do the same thing. The exchange rate (dollars per euro) declines sharply during the first two months and then increases for the third month to close at Ignoring daily settlement, what is the total profit of each trader? When the impact of daily settlement is taken into account, which trader does better?

26. Problem 2.30.
A company enters into a short futures contract to sell 5,000 bushels of wheat for 750 cents per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price change would lead to a margin call? Under what circumstances could $1,500 be withdrawn from the margin account?

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