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INTRODUCTION TO FUTURES

Lakshmi Ananthanarayan
NOV 2013

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Basic Concepts
Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price on designated contract markets Agreement to buy or sell a specified quantity of financial instrument/ commodity in a designated future month at a price agreed upon by the buyer and seller Contracts have certain standardized specifications Futures exchanges use clearinghouses to guarantee that the terms of the futures contracts are fulfilled The clearinghouse is the actual buyer of the contract from the short seller. And the clearinghouse is the actual seller of the long contract. If either party defaults on the contract the clearinghouse steps in and becomes the seller or buyer of last resort
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Types of futures
Classification based on the underlying asset: A foreign currency An interest-earning asset (debenture or time deposit) An index (stock index) A physical commodity (wheat, corn etc.) Futures on individual stock

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Characteristics of futures contract specified by exchange

Asset (includes quality) Price Contract size Amount of asset to be delivered under one contract Delivery arrangements Location important when transportation costs are significant Delivery Month Contracts are referred to by the month in which delivery is to take place Tick size Exchange specifies minimum price fluctuation for the contract Daily price limits Exchange sets the maximum price movement for a contract during a day Limit up, Limit down Position limits

Exchange sets a maximum number of contracts that a speculator may hold in order to
prevent speculators from having an undue influence on the market
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Such limits do not apply to hedgers

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Clearing House Mechanism

Each contract is substituted by two contracts in such a way that the clearing house becomes the buyer to every seller and seller to every buyer

This mechanism effectively removes counterparty risk from the futures transaction
Clearing house will never have open positions in the market Important functions of a clearing house ensuring adherence to system & procedures for smooth trading; minimizing credit risk by being a counterparty to all trades; accounting for all gains / losses

on daily basis; monitoring the speculation margins; ensuring delivery of payment for the assets on the
maturity date for all the outstanding contracts LA

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Margins
Minimization of credit risk of the clearing house imposition of margins Margins are amounts that the buyers and sellers of futures contracts have to deposit as

collateral for their positions upfront posting of collaterals that can be seized should the other
party default akin to performance bonds Marking to market daily procedure of adjusting the margin account balance for daily movements in the futures price involves settlement of gains and losses on the contract

everyday avoids accumulation of large losses over time, potentially leading to an expensive
default Initial margin - Amount required to open a futures contract Maintenance margin minimum margin account balance required to retain the futures

position
Variation margin When the margin account balance falls below the maintenance margin, the investor gets a margin call, and he or she must bring the margin account back to the initial margin amount. This amount is the variation margin

The level of margin called is set by the clearing house and is usually a function of the volatility
of the underlying cash market. It is calculated to cover the maximum expected move in the cash market in one day (i.e. the highest probable loss incurred on a contract between daily margin calls)

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Example 1
An investor instructs a broker to buy a futures contract

on gold for USD 293.60 per ounce with an April

delivery date. Each gold contract represents 100 troy ounces and is quoted on a per ounce basis. Assume that the initial margin is $2,500, the maintenance margin is $2,000 and the futures price drops to $ 291

at the end of the first day and $ 285 at the end of the
second day. Compute the amount in the margin

account at the end of each day for the long position

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and any variation margin needed.

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Example 2
An investor buys 5 futures contracts on gold at MCX of India. Each contract is for 100 gm of gold. The price quotation is Rs 15,550 per 10 gm. The tick size is Re 1. Initial margin is set at 4%, while minimum margin is 90% of the initial margin. Find out the following: a) What is the minimum change in the value of a contract? b) What is the amount of initial margin the investor has to deposit with the exchange? c) At what price level would the investor get the margin call?

d) If the investor had sold the contracts, what price level

would trigger a margin call?
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Example 3
A US firm enters into 6 long Japanese yen futures contract on September 22nd, at a price of $0.00892/. Subsequently, the settlement prices of the contract are:

Date
Sep 22nd Sep 25th Sep 26th Sep 27th Sep 28th

Futures Price ($/)

0.008854 0.008665 0.008456 0.008704 0.008548

The standard size of a contract is 1,25,00,000 yen.

a. Compute the cash flows incurred by the firm at the end of each day because of the marking to market.

b.

If the initial margin is $ 3,000/contract, and the maintenance margin is $

1750/contract, show the firm margin account and amount of additional deposits to be made (assuming no withdrawals).

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Differences between forwards and futures

Futures contracts always trade on an organized exchange; Forwards OTC Futures contracts have standardized terms; Forwards customized terms

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Futures more liquid; Forwards less liquid

Futures exchanges use clearinghouses to guarantee that the terms of the futures contract is fulfilled

Futures follows daily settlement; Forwards settlement happens at the end of

the period Margins and daily settlement are required with futures trading; Forwards

margins not required

Futures positions can easily be closed. The trader has the option of taking physical delivery. Placing an offsetting trade. And arranging an exchange-for-physicals

transaction. The futures exchange makes exiting a contract relatively easy

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Forward contract markets are self regulating and futures markets are regulated by certain agencies dedicated to this responsibility

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Open Interest

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Open Interest (OI) measures the number of contracts held at the conclusion of a trading session It is a description of participation - traders show their conviction to the market participation by taking their positions home with them, at least overnight Important as many transactions may take place during the day

without initiating new contracts

Open interest is calculated by adding all of the contracts that are
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associated

with

opening

trades
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and

subtracting all of the contracts that are associated with closing trades

An example

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Trade Day 1 A sells 10 contracts which are bought by B Day 2 C sells 5 contracts which are bought by D B exits his position of 10 contracts which are bought by Day 3 E D exits his position of 5 contracts which are bought by Day 4 A to partially close his position E sells his 10 contracts bought by A and C, 5 each to Day 5 fully close their position
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Open Interest 10 15 15 10 0

No. of Contracts Traded 10 5 10 5 10

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Example 4

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The following is an extract from futures price quotations in a financial newspaper as they appeared on August 11, 1989. The quotations are as of the close of trading on August 10, 1989. Explain the various terms and numbers given below. Japanese Yen (IMM): 12.5 million yen; $ per yen(.00)

Lifetime Open High 0.6682 0.6692 0.6684 0.6690 0.6685 0.6685 Low Settle 0.6673 0.6677 0.6676 0.6677 0.6685 0.6676 Change High +0.0002 0.7410 +0.0002 0.7165 .. 0.6850 Open Interest Low 0.6268 54,991 0.6290 3,182 0.6315 1,313

Sept Dec Mar-90

Est vol 16,065; vol Wed 22,580; open int 59,486

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Closing a futures position

Three common ways of liquidating a futures position: Physical delivery or cash settlement

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Offsetting
Exchange of Futures for Physicals (EFP) Physical delivery

Traders have an obligation either to take delivery (a long position) or to

make delivery (a short position) of the underlying commodity Usually the most cumbersome way to fulfill contractual obligations Cash settlement Substitute for physical delivery Available only for futures contracts that specifically designate cash delivery as the settlement procedure

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Traders make the payments at the expiration of the contract to settle any gains or losses

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Closing a futures position

Offsetting Most common way of liquidating an open futures position

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Reverse the initial transaction that established the futures position net
position becomes zero Initial buyer (long) liquidates his position by selling (going short) an identical futures contract (same commodity and same delivery month) Initial seller (short) liquidates his position by buying (going long) an identical futures contract (same commodity and same delivery month) Exchange of Futures for Physicals (EFP) A form of physical delivery Involves the sale of a commodity off the exchange by the holder of short contracts to the holder of long contracts, at mutually agreed-upon terms and at a mutually agreed-upon price
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Also referred to as ex-pit transaction

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Types of orders
June 89 crude oil futures contracts, during May 16, 1989 Market Order

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BUY 1 June 89 Crude MKT

Order to be executed immediately at the best possible price after it reaches the trading floor Limit Order BUY 1 June 89 Crude 20.90 SELL 1 June 89 Crude 20.96

Customer wants to buy (sell) at a specified price below (above) the current market price
Order to be filled either at the price specified on the order or at a better price Market-If-Touched (MIT) SELL 1 June 89 Crude 21.05 MIT

When the market reaches the specified limit price, an MIT order becomes an order for immediate execution
Market-On-Close (MOC) BUY 3 June 89 Crude MOC

Instruction to the broker to execute the order during the official closing period for the contract
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Actual execution price need not be the last sale price which occurred, but it must fall within the range of closing prices for the month for the said contract

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Types of orders
Stop-Loss Order

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BUY 2 June 89 Crude 21.15 stop SELL 2 June 89 Crude 20.95 stop

Order to buy or sell when the price reaches a specified level Buy-stop market order is placed at a price above the present market price. Typically used to limit a loss (or to protect an existing profit) on a short sale. For example, if an trader sells a stock short hoping the stock price goes down in order to book profits at a lower price, the trader may use a buy stop order to protect himself against losses if the price goes too high Sell-stop market order is placed at a price below the present market price. Order to sell at the best available price after the price goes below the stop price. For example, if an trader holds a stock currently valued at Rs.100 and is worried that the value may drop, he/she can place a sell stop order at Rs.90. If the share price drops to Rs.90, the exchange will sell the order at the next available price. This can limit the traders losses (if the stop price is at or below the purchase price) or lock in some of the profits
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Types of orders
Exchange for Physical (EFP) Order SELL 2 June 89 Crude 21.10 EFP to XYZ Co. Off-the-exchange transaction Exchange of futures position for a physical position Discretionary Order

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BUY 2 June 89 Crude 20.92 with 1 Point Disc Broker is given some discretion to buy or sell when the market is falling very steeply or rising very fast to avoid losses

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Types of orders
Not Held Order

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BUY 2 June 89 Crude 20.92 Not Held Broker is given the discretion to wait to buy if he feels that the prices will go further down or wait to sell if he feels that the prices may go further up
Spread Order

Spread BUY 2 June 89 Crude SELL 2 July 89 Crude, 90 cents premium Entitles the broker to buy and sell two different contracts at the same time with a spread premium
Time Order

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Day Orders Good Till Cancelled (GTC) Good This Week (GTW) Good This Month (GTM) Good Through Date (GTD)

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FUTURES PRICES

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Cost-of-Carry Relationship
The extent to which the futures price exceeds the cash price at any moment is determined by the cost-of-carry Costs associated with purchasing and carrying (or holding) a commodity for a specified period of time Carrying charges can be further classified into storage, insurance, transportation and financing costs

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Futures Price = Cash price + financing costs per unit + storage costs per unit
Ft,T = Ct + Ct * St,T * T-t + Gt,T
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Where, Ft,T = Futures Price at time t, which is to be delivered at time period T Ct = Cash Price at time t St,T = Annualised interest rate on borrowings Gt,T = Storage costs

T-t = Time period

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Futures price arrived at with cost-of-carry is referred to as full carry futures price

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Cost-of-Carry Relationship
The formula assumes the following: Simple interest financing cost

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No information or transaction costs associated with buying or selling either

futures or the physical commodity Unlimited ability to borrow or lend money

All borrowing and lending is done at the same interest rate

No credit risk associated with buying or selling either the futures contract or the physical commodity (assumes no margins required on futures contracts) Commodities can be stored indefinitely without any change in the characteristics of the commodity (such as its quality) No taxes

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Cost-of-Carry Relationship
On April 11, 1989, the cash price of silver was 582.5 cents. AT the close of trading on April 11, the settlement price of the December 89 silver futures contract

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was 624.1 cents. The time from April 11 to mid-December is approximately 8

months. The annualized borrowing rate on April 11, 1989 was about 10.70. Finally, the cost of storing silver is negligible and assumed to be zero. 582.5+582.5*0.1070*8/12+0 = 624.05

Another way of looking at the cost-of-carry relationship is that the difference

between the futures price and the cash price should equal the cost of carry
Carry = Ft,T - Ct

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Relationship between Cash Price and Futures Price

Cash-futures arbitrage Cash and near-month futures price should differ only by the transaction costs associated with doing a cash-futures arbitrage Assuming no transaction costs, taxes etc., actual futures price should be exactly equal to cash price plus the cost-ofcarry

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If actual futures prices were not equal to these constructed

full-carry prices, there would exist profitable, no risk cash/futures arbitrage opportunities
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Examples - Cash-futures arbitrage

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5. In the month of April 1989, silver was trading in the cash market at 582.5 cents per ounce. The prevailing interest rate was 10.7% p.a. December 1989 futures were trading at 628 cents. Identify the arbitrage

opportunity and the net gain / loss from the arbitrage

activity.

6. In the above example, if the futures were trading at

620 cents, then what would be the arbitrage opportunity and the gain / loss from the said activity?
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Basis, Contango and Backwardation

Basis is the difference between cash and futures prices Basis = Current Cash Price Futures Price When the futures contract is at expiration, the futures price and the spot price of the commodity should be the same, hence the basis must be zero. This behaviour pattern of the basis over a period of time is referred to as convergence If the futures prices are accurately described by a full-carry relationship, the basis is negative, since futures prices are higher than cash prices. This condition is referred to as a contango market, meaning that the relationship between futures and cash prices is determined solely by the cost-of-carry

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If futures prices are lower than cash prices, the basis is positive. This is referred to
as Backwardation. This condition prevails only if the futures prices are determined by some factors other than the cost-of-carry

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A contango market is characterized by progressively rising futures prices as the

time to delivery becomes more distant, and a backwardation market by progressively lower futures prices as the time to delivery becomes more LAdistant

Basis

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Perfect and Imperfect hedge Loss in the physical market is fully offset by the gains in the position in the futures market and vice versa perfect hedge

Reasons for imperfect hedge:

Mismatch of asset and Quality

Mismatch of quantities
Mismatch of period of hedging

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Example 7
Today is 24th March. A refinery needs 1,050 barrels of crude oil in the month of September. The current price of crude oil is Rs 3,000 per

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barrel. September futures contract at MCX is trading at Rs 3,200. The

firm expects the price to go up further and beyond Rs 3,200 in September. It has the option of buying the stock now. Alternatively, it

can hedge through futures contract.

If the cost of capital, insurance and storage is 15% per annum, examine if it is beneficial for the firm to buy now? (Use continuous compounding) If the firm decides to hedge through futures, find out the effective

price it would pay for crude oil, if at the time of lifting the hedge (1)
the spot and futures price are Rs 2,900 and Rs 2,910 respectively, (2) LA LA the spot and futures price are Rs 3,300 and Rs 3,315 respectively.