OBJECTIVES OF STUDY

1. To study and understand the concept of Derivative market

2. To know to concept of risk management in Zephirum
3. To study the various strategies used in Future Derivative Market
4.

Introduction to derivatives

The emergence of the market of derivative products, most notably forwards, futures
and options, can be traced back to the willingness of risk-averse economic agents to guard
themselves against uncertainties arising out of fluctuations in asset prices. By their very
nature, the financial markets are marked by a very high degree of volatility. Through the use
of derivative products, it is possible to partially or fully transfer price risks by locking-in asset
prices. As instruments of risk management, these generally do not influence the fluctuations
in the underlying asset prices. However, by locking-in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash flow situation
of risk-averse investors.

Definition
Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index, or reference rate), in a contractual manner.
The underlying asset can be equity, forex, commodity or any other asset. For e.g.:
Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change
in prices by that date. Such a transaction is an example of a derivative.
The price of this derivative is driven by the spot price of wheat which is the
Underlying.
In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A)
defines derivative to include
A Security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.
A contract which derivatives its value from the prices, or index of prices, of
underlying securities.

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Derivatives are securities under the (SC(R)A) and hence the trading of derivatives is
governed by the regulatory framework under the (SC(R)A).Derivative Products initially
emerged as hedging devices against fluctuations in commodity prices, and commodity-linked
derivatives remained the sole form of such products for almost 300 years. Financial
derivatives came into spotlight in the post 1970 period due to growing instability in the
financial markets. However, since their emergence, these products have become very popular
and by 1990s, they accounted for about two-thirds, of total transactions in derivative
products. In recent times, the market for financial derivatives has grown tremendously in
terms of variety of instruments available, their complexity and also turnover. In the class of
Equity derivatives world over, futures & options on stock indices have gained more
popularity than on individual stocks, especially among institutional investors, who are major
users of index-linked derivatives. Even small investors find these useful due to high
correlation of the popular indexes with various portfolios & ease of use.

Derivative Products
Derivative Contracts have several variants. The most common variants are forwards,
futures, options & swaps.
Forwards
A Forward contract is a customized contract between 2 entities, where settlement
takes place on a specific date in the future at todays pre-agreed price.
Futures
A futures Contract is an agreement between 2 parties to buy or sell an asset at a
certain time in future at a certain price. Futures contract are special type of Forward contracts
in the sense that the former are standardized exchange-traded contracts.
Options
Options are of 2 types- calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or before a
given future date. Puts give the buyer the right but not the obligation to sell a given quantity
of the underlying asset, at a given price on or before a given date.
Swaps
Swaps are private agreements between 2 parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.
The 2 commonly used Swaps are
Interest rate swaps
These entail swapping only the interest related cash flows between the parties in the
same currency.
Currency swaps
These entail swapping both principal and interest between the parties, with the cash
flows in 1 direction being in a different currency than those in the opposite direction.
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Participants in the Derivatives markets

The following 3 broad categories of participants- Hedgers, Speculators, and
Arbitrageurs trade in derivatives market. Hedgers face risk associated with the price of an
asset. They use futures or options market to reduce or eliminate this risk. Speculators wish to
bet on future movements in the price of an asset. Futures & Options contracts can give them
an extra leverage; that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between
prices in 2 different markets. If, for e.g., they see the futures price of an asset getting out of
line with the cash price, they will take offsetting positions in the 2 markets to lock in a profit.

History of derivatives markets

Early forward contracts in the US addressed merchants concerns about ensuring that
there were buyers & sellers for commodities. However, credit risk remained a serious
problem. To deal with this problem, a group of Chicago businessmen formed the Chicago
Board of trade (CBOT) in 1848. The primary intention of (CBOT) was to provide a
centralized location known in advance for buyers and sellers to negotiate forward contracts.
In 1865, The CBOT went 1 step further and listed the first exchange traded derivatives
contract in the US; these contracts were called futures contracts. In 1919, Chicago Butter &
Egg Board, a spin-off of CBOT, was recognized to allow futures trading. Its name was
changed to Chicago Mercantile Exchange (CME). The CBOT & the CME remained the 2
largest organized futures exchanges, indeed the 2 largest financial exchanges of any kind in
the world today.
The first stock index futures contract was traded at Kansas City Board of Trade. Currently the
most popular stock index futures contract in the world based on S&P 500 index, traded on
Chicago Mercantile Exchange. During the mid-eighties, financial futures became the most
active derivative instruments generating volumes many times more than the commodity
futures. Index futures, futures on T-bills and Euro-Dollar futures are the 3 most popular
contracts traded today. Other popular international exchanges that trade derivatives are LIFFE
in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex
etc.
Over the past two decades and so, the markets have seen debacle after another, each of which
has brought its lessons from some of which the markets have learned and from many of
which markets still need to learn. The Great Depression of 1930shas brought remainder to all
financial markets or the economies as a whole. The 1987crash taught markets the dangers of
automated trading models and the second and third-order effects of credit crisis. In 1990,
Wall Street learned the horrors of holding huge illiquid investments. In 1994s spectacular
bond market collapse, financial executives saw for the first time how correlated global
markets had become as the fallout from Federal Reserve Board rate hikes swept from the US
through Europe, before devastating Mexico and other emerging markets. The Russian
meltdown in August 1998 was widespread and mounting. Banks and brokerage firms took
turns announcing trading losses from emerging markets, high yield, equities, or dealings with
hedge funds. Most recently, the Global Financial Meltdown, which was started with the US
sub-prime mortgage crisis, has captured almost all economies of the world. Many banks
become bankrupt, many loss their job, increased budgetary deficits are the result of this crisis.
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Thus, it can be said that, the financial market is full of risk and uncertainties. Finance has
never been so competitive, so far-flung, and so quantitative. Information flow has never been
so fast. But with the passage of time, financial markets are becoming more sophisticated in
pricing, isolating, repackaging, and transferring risks. Tools such as derivatives and
securitization contribute to this process, but they pose their own risks. The failure of
accounting and regulation to keep abreast of developments includes yet more risks, with
occasionally spectacular consequences. Practical applications including risk limits, trader
performance-based compensation, portfolio optimization, and capital calculations all
depend on the measurement of risk. In the absence of a definition of risk, it is unclear what,
exactly, such measurements reflect. Charles Tschampion, the MD of the $50 bn GM Pension
fund, once said Investment management is not an art, not science, it is engineering. We are
in the business of managing and engineering financial investment risk; the challenge is to
first not take more risk than we need to generate the returns that is offered. It is a profound
statement that well captures the philosophical and mathematical connotation of Risk. The
terms risk and uncertainty are often used interchangeably though there is a clear distinction
between them. Certainty is a state of being completely confident, having no doubts of
whatever being expected. Uncertainty is just opposite of that. Risk is situation where there are
a number of specific, probable outcomes, but it is not certain as to which one of them will
actually happen. In that context risk is not an abstract concept. It is a variable, which can be
calibrated, measured and compared. Soto define risk, risk entails two essential components;
exposure and uncertainty. Thus, risk is the exposure to uncertainty.

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RISK MANAGEMENT PROCESS

Market integration, liberalization, globalization and technical advancement has resulted with
an increased competition in the market and the corporate are hence exposed to risk. Thus a
proper and unbiased assessment of risk is a prerequisite for a sound management process.
Moreover, with the advancement of communication system and technology, the markets over
the world are getting interconnected. Thus making an effective risk management system is
the need of the hour. Risk management is the process in which risk is minimized with the
application of certain tools. The risk management process essentially comprises of certain
steps, such as, identification, assessment, prioritization, followed by coordinated and
economical application of resources to minimize, monitor and control it. These steps are
described below
The risk management process starts with the identification of the factors which are exposed to
risk. It is always of primary concerns to identify the factors which are more vulnerable and
weak points in the system.
Risk measurement An institutions system for measuring the various risks of derivatives
activities should be both comprehensive and accurate. Risk should be measured and
aggregated across trading and non-trading activities on an institution-wide basis to the fullest
extent possible. While the use of a single prescribed risk measurement approach for
management purposes may not be essential, the institutions procedures should enable
management to assess exposures on a consolidated basis. Risk measures and the risk
measurement process should be sufficiently robust to reflect accurately the multiple types of
risks facing the institution. Risk measurement standards should be understood by relevant
personnel at all levels of the institution - from individual traders to the board of directors and should provide a common framework for limiting and monitoring risk-taking activities.
5. With regard to dealer operations, the process of marking derivatives positions to market is
fundamental to measuring and reporting exposures accurately and on a timely basis. An
institution active in dealing foreign exchange, derivatives and other traded instruments should
have the ability to monitor credit exposures, trading positions and market movements at least
daily. Some institutions should also have the capacity, or at least the goal, of monitoring their
more actively traded products on a real-time basis. 6. Analysing stress situations, including
combinations of market events that could affect the banking organisation, is also an important
aspect of risk measurement. Sound risk measurement practices include identifying possible
events or changes in market behaviour that could have unfavourable effects on the institution
and assessing the ability of the institution to withstand them. These analyses should consider
not only the likelihood of adverse events, reflecting their probability, but also "worst-case"
scenarios. Ideally, such worst-case analysis should be conducted on an institution-wide basis
by taking into account the effect of unusual changes in prices or volatilities, market illiquidity
or the default of a large counterparty across both the derivatives and cash trading portfolios
and the loan and funding portfolios. 7. Such stress tests should not be limited to quantitative
exercises that compute potential losses or gains. They should also include more qualitative
analyses of the actions management might take under particular scenarios. Contingency plans
outlining operating procedures and lines of communication, both formal and informal, are
important products of such qualitative analyses

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ASSESSMENT
After identifying the risk exposure points, it then to be assessed, i.e. to what extent it is
susceptible to that particular risk that has to be measured. Assessment of risk helps in
knowing the extent of vulnerability of a particular factor which is risk exposed.
PRIORITIZATION
The next step of risk management process is the prioritization of factors which are more
vulnerable. The assessment of risk results in identifying the factors which are more risk
exposed and then these factors are prioritized from risk management point of view.
APPLICATION OF RESOURCES TO MINIMIZE RISK
After identifying the most vulnerable factor, the management team applies economic
resources to minimizing the risk. This is the most important stage of risk management as any
wrong step can result a more susceptible situation.
MONITOR
The final step of risk management is monitoring the risk management process. Simply
applying the resources to minimize the risk is not the last step of risk management, as it is
needed to analyze the success of the risk management process. For this reason the entire
process is monitored and if anything goes wrong, it is rectified.

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RISK ASSOCIATED WITH DERIVATIVES TRADING

The continuing discussion of risks and its management in derivative markets illustrates that
there is little agreement on what the risks are and how to control it. One source of confusion
is the sheer profusion of names describing the risks arising from derivatives. Besides the
price risk of losses on derivatives from change in underlying asset values, there is default
risk, settlement risk, and operational risk. Last, but certainly not the least, is the specter
of systemic risk that has captured so much congressional and regulatory attention. All these
risks associated with derivatives market are described below,
Credit risk (including settlement risk): Broadly defined, credit risk is the risk that a counter
party will fail to perform on an obligation to the institution. The institution should evaluate
both settlement and pre settlement credit risk at the customer level across all products. On
settlement day, the exposure to counterparty default may equal the full value of any cash
flows or securities the institution is to receive. Prior to settlement, credit risk is measured as
the sum of the replacement cost of the position, plus an estimate of the institutions potential
future exposure from the instrument as a result of market changes. Replacement cost should
be determined using current market prices or generally accepted approaches for estimating
the present value of future payments required under each contract, given current market
conditions. Potential credit risk exposure is measured more subjectively than current
exposure and is primarily a function of the time remaining to maturity and the expected
volatility of the price, rate or index underlying the contract. Dealers and large derivatives
participants should assess potential exposure through simulation analysis or other
sophisticated techniques, which, when properly designed and implemented can produce
estimates of potential exposure that incorporate both portfolio-specific characteristics and
current market conditions. Smaller end-users may measure this exposure by using "add-ons"
based on more general characteristics. In either case, the assumptions underlying the
institutions risk measure should be reasonable and, if the institution measures exposures
using a portfolio approach, it should do so in a prudent manner. An institution may use master
netting agreements and various credit enhancements, such as collateral or third-party
guarantees, to reduce its counterparty credit risk. In such cases, an institutions credit
exposures should reflect these risk-reducing features only to the extent that the agreements
and recourse provisions are legally enforceable in all relevant jurisdictions. This legal
enforceability should extend to any insolvency proceedings of the counterparty. The
institution should be able to demonstrate that it has exercised due diligence in evaluating the
enforceability of these contracts and that individual transactions have been executed in a
manner that provides adequate protection to the institution. Credit limits that consider both
settlement and pre-settlement exposures should be established for all counterparties with
whom the institution conducts business. As a matter of general policy, business with a counter
party should not commence until a credit line has been approved. The structure of the creditapproval process may differ among institutions, reflecting the organisational and geographic
structure of each institution. Nevertheless, in all cases, it is important that credit limits be
determined by personnel who are independent of the derivatives function that these personnel
use standards consistent with those used for other activities and that counterparty credit lines
are consistent with the organisations policies and consolidated exposures. 6. If credit limits
are exceeded, exceptions should be resolved according to the institutions policies and
procedures. In addition, the institutions reports should adequately provide traders and credit
officers with relevant, accurate and timely information about the credit exposures and
approved credit lines. 7. Similar to bank loans, OTC derivatives products can have credit
exposures existing for an extended period. Given these potentially long-term exposures and
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the complexity associated with some derivatives instruments, an institution should consider
the overall financial strength of its counterparties and their ability to perform on their
obligations.
Market risk
Is the risk to an institutions financial condition resulting from adverse movements in the
level or volatility of market price? The markets risks created - or hedged - by a future or swap
are familiar, although not necessarily straightforward to manage. They are exposures to
changes in the price of the underlying cash instrument and to changes in interest rates. By
contrast, the value of an option is also affected by other factors, including the volatility of the
price of the underlying instrument and the passage of time. In addition, all trading activities
are affected by market liquidity and by local or world political and economic events. Market
risk is increasingly measured by market participants using a value-at-risk approach, which
measures the potential gain or loss in a position, portfolio or institution that is associated with
a price movement of a given probability over a specified time horizon. The institution should
revalue all trading portfolios and calculate its exposures at least daily. Although an institution
may use risk measures other than value-at-risk, the measure used should be sufficiently
accurate and rigorous, and the institution should ensure that it is adequately incorporated into
its risk management process. An institution should compare its estimated market risk
exposures with actual behaviour. In particular, the output of any market risk models that
require simulations or forecasts of future prices should be compared with actual results. If the
projected and actual results differ materially, the assumptions used to derive the projections
should be carefully reviewed, or the models should be modified, as appropriate. The
institution should establish limits for market risk that relate to its risk measures and that are
consistent with maximum exposures authorised by its senior management and board of
directors. These limits should be allocated to business units and individual decision-makers
and be clearly understood by all relevant parties. Exceptions to limits should be detected and
adequately addressed by management. In practice, some limit systems may include additional
elements such as stop-loss limits and guidelines that may play an important role in controlling
risks. An institution whose derivatives activities are limited in volume and confined to enduser activities may need less sophisticated risk measurement systems than those required by a
dealer. Senior management at such an institution should ensure that all significant risks
arising from its derivatives transactions can be quantified, monitored and controlled. At a
minimum, risk management systems should evaluate the possible impact on the institutions
earnings and capital which may result from adverse changes in interest rates and other market
conditions that are relevant to risk exposure and the effectiveness of derivatives transactions
in the institutions overall risk management.
Liquidity risk
An institution faces two types of liquidity risk in its derivatives activities: one related to
specific products or markets and the other related to the general funding of the institutions
derivatives activities. The former is the risk that an institution may not be able to, or cannot
easily, unwind or offset a particular position at or near the previous market price because of
inadequate market depth or because of disruptions in the marketplace. Funding liquidity risk
is the risk that the institution will be unable to meet its payment obligations on settlement
dates or in the event of margin calls. Because neither type of liquidity risk is necessarily
unique to derivatives activities, management should evaluate these risks in the broader
context of the institutions overall liquidity. When establishing limits, the institution should
be aware of the size, depth and liquidity of the particular market and establish guidelines
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accordingly. In developing guidelines for controlling liquidity risks, an institution should

consider the possibility that it could lose access to one or more markets, either because of
concerns about the institutions own creditworthiness, the creditworthiness of a major
counterparty or because of generally stressful market conditions. At such times, the institution
may have less flexibility in managing its market, credit and liquidity risk exposures. An
institution that makes markets in over-the-counter derivatives or that dynamically hedges its
positions requires constant access to financial markets and that need may increase in times of
market stress. The institutions liquidity plan should reflect the institutions ability to turn to
alternative markets, such as futures or cash markets, or to provide sufficient collateral or
other credit enhancements in order to continue trading under a broad range of scenarios. An
institution that participates in over-the-counter derivatives markets should assess the potential
liquidity risks associated with the early termination of derivatives contracts. Many forms of
standardised contracts for derivatives transactions allow counterparties to request collateral or
to terminate their contracts early if the institution experiences an adverse credit event or
deterioration in its financial condition. In addition, 2 dynamic hedging refers generally to the
continuous process of buying or selling instruments to offset open exposures as market
conditions change (e.g. an option writer selling an underlying asset as its price falls). Under
conditions of market stress, customers may ask for the early termination of some contracts
within the context of the dealers market-making activities. In such situations, an institution
that owes money on derivatives transactions may be required to deliver collateral or settle a
contract early and possibly at a time when the institution may face other funding and liquidity
pressures. Early terminations may also open up additional, unintended, market positions.
Management and directors should be aware of these potential liquidity risks and should
address them in the institutions liquidity plan and in the broader context of the institutions
liquidity management process.
Operations risk
Operations risk is the risk that deficiencies in information systems or internal controls will
result in unexpected loss. This risk is associated with human error, system failures and
inadequate procedures and controls. This risk can be exacerbated in the case of certain
derivatives because of the complex nature of their payment structures and calculation of their
values. The board of directors and senior management should ensure the proper dedication of
resources (financial and personnel) to support operations and systems development and
maintenance. The operations unit for derivatives activities, consistent with other trading and
investment activities should report to an independent unit and should be managed
independently of the business unit. The sophistication of the systems support and operational
capacity should be commensurate with the size and complexity of the derivatives business
activity. Systems support and operational capacity should be adequate to accommodate the
types of derivatives activities in which the institution engages. This includes the ability to
efficiently process and settle the volumes transacted through the business unit, to provide
support for the complexity of the transactions booked and to provide accurate and timely
input. Support systems and the systems developed to interface with the official databases
should generate accurate information sufficient to allow business unit management and senior
management to monitor risk exposures in a timely manner. Systems needs for derivatives
activities should be evaluated during the strategic planning process. Current and projected
volumes should be considered together with the nature of the derivatives activity and the
users expectations. Consistent with other systems plans, a written contingency plan for
derivatives products should be in place. With the complexity of derivatives products and the
size and rapidity of transactions, it is essential that operational units be able to capture all
relevant details of transactions, identify errors and process payments or move assets quickly
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and accurately. This requires a staff of sufficient size, knowledge and experience to support
the volume and type of transactions generated by the business unit. Management should
develop appropriate hiring practices and compensation plans to recruit and retain high calibre
staff. Systems design and needs may vary according to the size and complexity of the
derivatives business. However, each system should provide for accurate and timely
processing and allow for proper risk exposure monitoring. Operational systems should be
tailored to each institutions needs. Limited end-users of derivatives may not require the same
degree of automation needed by more active trading institutions. All operational systems and
units should adequately provide for basic processing, settlement and control of derivatives
transactions. The more sophisticated the institutions activity, the more need there is to
establish automated systems to accommodate the complexity and volume of the deals
transacted, to report position data accurately and to facilitate efficient reconciliation.
Segregation of operational duties, exposure reporting and risk monitoring from the business
unit is critical to proper internal control. Proper internal control should be provided over the
entry of transactions into the database, transaction numbering, date and time notation and the
confirmation and settlement processes. Operational controls should also be in place to resolve
disputes over contract specifications. In this regard, an institution must ensure that trades are
confirmed as quickly as possible. The institution should monitor the consistency between the
terms of a transaction as they were agreed upon and the terms as they were subsequently
confirmed. The operations department, or another unit or entity independent of the business
unit, should be responsible for ensuring proper reconciliation of front and back office
databases on a regular basis. This includes the verification of position data, profit and loss
figures and transaction-by-transaction details. The institution should ensure that the methods
it uses to value its derivatives positions are appropriate and that the assumptions underlying
those methods are reasonable. The pricing procedures and models the institution chooses
should be consistently applied and well-documented. Models and supporting statistical
analyses should be validated prior to use and as market conditions warrant. Management of
the institution should ensure that a mechanism exists whereby derivatives contract
documentation is confirmed, maintained and safeguarded. An institution should establish a
process through which documentation exceptions are monitored and resolved and
appropriately reviewed by senior management and legal counsel. The institution should also
have approved policies that specify documentation requirements for derivatives activities and
formal procedures for saving and safeguarding important documents that are consistent with
legal requirements and internal policies. Although operations risks are difficult to quantify,
they can often be evaluated by examining a series of "worst-case" or "what if" scenarios, such
as a power loss, a doubling of transaction volume or a mistake found in the pricing software
for collateral management. They can also be assessed through periodic reviews of procedures,
documentation requirements, data processing systems, contingency plans and other
operational practices. Such reviews may help to reduce the likelihood of errors and
breakdowns in controls, improve the control of risk and the effectiveness of the limit system
and prevent unsound marketing practices and the premature adoption of new products or lines
of business. Considering the heavy reliance of derivatives activities on computerised systems,
an institution must have plans that take into account potential problems with its normal
processing procedures

Legal risk
Legal risk is the risk that contracts are not legally enforceable or documented correctly. Legal
risks should be limited and managed through policies developed by the institutions legal
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counsel (typically in consultation with officers in the risk management process) that have
been approved by the institutions senior management and board of directors. At a minimum,
there should be guidelines and processes in place to ensure the enforceability of counterparty
agreements. Prior to engaging in derivatives transactions, an institution should reasonably
satisfy itself that its counterparties have the legal and necessary regulatory authority to
engage in those transactions. In addition to determining the authority of a counterparty to
enter into a derivatives transaction, an institution should also reasonably satisfy itself that the
terms of any contract governing its derivatives activities with a counterparty are legally
sound. 30. An institution should adequately evaluate the enforceability of its agreements
before individual transactions are consummated. Participants in the derivatives markets have
experienced significant losses because they were unable to recover losses from a defaulting
counterparty when a court held that the counterparty had acted outside its authority in
entering into such transactions. An institution should ensure that its counterparties have the
power and authority to enter into derivatives transactions and that the counterparties
obligations arising from them are enforceable. Similarly, an institution should also ensure that
its rights with respect to any margin or collateral received from a counterparty are
enforceable and exercisable. The advantages of netting arrangements can include a reduction
in credit and liquidity risks, the potential to do more business with existing counterparties
within existing credit lines and a reduced need for collateral to support counterparty
obligations. The institution should ascertain that its netting agreements are adequately
documented and that they have been executed properly. Only when a netting arrangement is
legally enforceable in all relevant jurisdictions should an institution monitor its credit and
liquidity risks on a net basis. The institution should have knowledge of relevant tax laws and
interpretations governing the use of derivatives instruments. Knowledge of these laws is
necessary, not only for the institutions marketing activities, but also for its own use of these
products.

PRICE RISK
Price arises for the simple reason that the price of the underlying and price of the derivatives
are correlated. If the prices of the underlying increases, the impact is seen in corresponding
prices of derivatives products i.e. their prices also increase. For an investor who is short in a
futures contract or long in a put option or short in a call option, there are potential losses.
Thus, he or she may default in the obligation of the derivative contract. This is price risk
associated with the derivatives. Default due to Price risk is mitigated by imposing some risk
management tools in exchange-traded derivatives, but in case of over-the-counter market,
since it is largely unregulated, default is more due to price risk.
DEFAULT RISK
This may the most popular and hazardous risk associated with the derivatives. As derivatives
are contracts or agreements, they need the obligations to be performed. If any party default
from the contract, then the contract is meaningless. The risk that arises from the default of
any party in derivatives is called as default risk. This is common risk that is found in overthe-counter derivative market, but in exchange-traded market, this type of risk is minimized
by regulating the transactions. Default risk is the risk that losses will be incurred due to
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default by the counterparty. As noted above, part of the confusion in the current debate about
derivatives stems from the profusion of names associated with the default risk. Terms such as
credit risk and counterparty risk are essentially synonyms for default risk. Legal
risk refers to the enforceability of the contract. Terms such as Settlement risk and
Herstatt risk refer to defaults that occur at a specific point in the life of the contract: date of
settlement. These terms do not represent independent risks; they just describe different
occasions or causes of default. Default risk has two components: the expected exposure and
the probability that default will occur. The expected exposure measures how much capital is
likely to be at risk should the counterparty defaults. The probability of default is the measure
of the possibility that the counterparty will default.
SYSTEMATIC RISK
One of the prominent concerns of regulators is systematic risk arising from derivatives.
Although this risk is rarely defined and almost never quantified, the systemic risk associated
with the derivative contracts is often envisioned as a potential domino effect in which default
in one derivative contract spreads to other contracts and markets, ultimately threatening the
entire financial system. For the purpose of this paper, systemic risk can be defined as
widespread default in any set of financial contracts associated with default in derivatives.
If derivative contracts are to cause widespread default in other markets, there first must be
large defaults in derivative markets. In other words, significant derivative default are a
necessary condition for systematic problems. It is argued that widespread corporate risk
management with derivatives increases the correlation of default among financial contracts.
What this argument fails to recognize, is that the adverse effects of stocks on individual firms
should be smaller precisely because the same shocks are spread more widely. Moe important,
to the extent firms use derivatives to hedge their existing exposures, much of impact of stocks
is being transferred from corporations and investors less able to bear them to counterparties
better able to absorb them. It is conceivable that financial markets could be hit by a large
disturbance. The effect of such disturbances depends, in particular, on the duration of the
disturbances and whether firms suffer common or independent shocks. If the disturbance
were large but temporary many outstanding derivatives would be essentially unaffected
because they specify only relative infrequent payment. Therefore, a tempore disturbance
would primarily affect contracts with required settlements during this period. If the shock
were permanent, it would affect the derivatives in a much hazardous way
RISK MANAGEMENT OF DERIVATIVES
Derivatives, which come to light as a hedging instrument against volatility of market and
market related risk, created risk when there is a default. This gave rise to the essence of risk
management of derivatives and derivatives trading. In case of OTC derivatives, as it is not
regulated, it is more risky and there is no risk management at all. But in case of exchange
traded derivatives, several risk management tools are applied to ensure the integrity of the
market. The tools used for risk management of derivatives are described below;
MARGINS
Margins are upfront payment by the participants of the derivatives market to the exchanges.
This upfront payment is collected to ensure that none will default in future in obliging his
obligation. If someone defaults then the clearinghouse settles the contract from this margin
account. Exchanges clearinghouse collects the margin front he clearing member, the clearing
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member collects the margin from the trading member or the brokers and it is the
responsibility of the trading members to collect the same from its clients.
MARK-TO-MARKET MARGIN
In case of futures contracts, the margin is mark-to-market on daily basis i.e. the gain or loss
of a day is settled to the margin account on a daily basis. If the long position gains, then the
amount he gained will be transferred to his account in the end of the day. Similarly, if the
investor losses, the amount that he lost is withdrawn from his account
EXPOSURE LIMITS
If an investor holds quite a large position than his capacity, then the probability that he will
default is more. For this reason, the regulatory body of the derivative market put an exposure
limit for the participants beyond which one cannot take position in the market. This will
ensure the integrity in term that nobody will default.
POSISTION LIMITS
Position limit is more applicable for the high net worth individuals, the FIIs and the mutual
funds. This is because, these people have huge investible cash and they can direct the market
as their wish. This will harm the market and other participants of the market. Thus a position
limit is introduced for this type of risk by the regulators for the sound running of the market.
FINAL SETTLEMENT
Final settlement is the last part of risk management in case of derivatives. The settlement is
done by the clearing house of the exchange. On exercise the settlement is done on the closing
price of the derivative product and final settlement takes place onT+1 basis. If the long
position exercises his right, then the settlement is done by randomly assigning the obligation
on a short position at the end of the day. Frankly speaking risk management of derivatives
comprises of two things i.e. margining requirement and the regulatory requirement. Thus risk
management of derivatives is nothing but, complying the rules and regulation laid down by
the regulator and satisfying the margin requirement

13 | P a g e

CME Group is the worlds leading and most diverse derivatives marketplace handling 3
billion contracts worth approximately $1 quadrillion annually, on average. The company is a
marketplace for buyers and sellers bringing together individuals, companies and institutions
that need to manage risk or that want to profit by accepting risk. We have a rich history
stemming from the grain merchants who founded the Chicago Board of Trade in 1848, the
dairy merchants who founded the New York Mercantile Exchange in 1872, and the butter and
egg merchants who founded the Chicago Mercantile Exchange in 1898. Through the
combination of these pioneering exchanges, CME Group provides innovative derivatives
products, services and technologies to the global financial marketplace. We bring buyers and
sellers together through our CME Globex electronic trading platform and our trading
facilities in Chicago and New York.
CME Clearing serves as the counterparty to every cleared transaction, becoming the buyer to
each seller and the seller to each buyer, and limiting credit risk by guaranteeing financial
performance of both parties.
CME Clearings integrated clearing function is designed to ensure the safety and soundness
of our markets and serve the risk management needs of our customers. Through our
operational standards and financial safeguards, CME Clearing provides an effective set of
risk management tools and capabilities to benefit market participants.

Major Events
2012 Acquires Kansas City Board of Trade Completes new S&P Dow Jones Indices
Joint Venture 2011 Launches European clearing services via CME Clearing Europe
2008 Completes acquisition of New York Mercantile Exchange
2007 Completes merger with Chicago Board of Trade
1999 Initiates first weather-based futures contracts
1997 Develops and launches first mini-sized, all electronic futures contracts, CME E-mini
S&P 500 futures
1992 Handles first electronic futures trades with launch of CME Globex electronic trading
platform
1987 Ushers in the era of electronic futures trading by initiating development of CME
Globex platform
1982 Develops first successful stock index futures contract, CME S&P 500 Index futures,
and first options on futures contract for U.S. Treasury Bond futures
1975 Offers first interest rate futures contract, on Government National Mortgage
Association futures
1972 Launches the industrys first-ever financial futures contracts on seven foreign
currencies
1969 Launches trading of first non-grain product silver futures contract
14 | P a g e

1964 Launches first agricultural futures based on non-storable commodities live cattle
futures 1961 Launches first futures contract on frozen, stored meats the frozen pork
belly contract 1865 Establishes worlds first futures clearing operation when it begins
requiring performance bonds, called margin, to be posted by buyers and sellers
1851 Offers earliest forward contract ever recorded on 3,000 bushels of corn
1848 Creates worlds first futures exchange, based in Chicago

Mitigate Your Risk

Counterparty credit risk is shared among clearing members

Enhance Your Efficiency

Real-time trade confirmations and straight-through processing once a contract is cleared

Know Your Costs

Offset margin costs by reducing expenses

Cancel on Disconnect
15 | P a g e

Upon an involuntarily dropped iLink user connection, Cancel on Disconnect (COD) cancels
all resting session/day futures and options orders for that user. Customers are responsible for
re-entering any orders cancelled by COD.
CME Globex Credit Controls
The CME Globex Credit Controls (GC2) provide pre-execution risk controls and allow
Clearing Firm Risk Administrators to set real-time credit limits. Clearing Firm Risk
Administrators can define trading limits and select real-time actions if those limits are
exceeded, including:
Email notification
Order blocking
Order cancellation
CME Globex Credit Controls are available in both manual and automated modes.
Manual Mode
Enables risk administrators to maintain manual credit control limits by setting a maximum
order size and the capability to block new orders
Automated Mode
Automated credit control management defined by clearing firm risk administrators
View open and filled orders by executing firm
Auto cancel orders
Risk Management Interface (RMI)
The Risk Management Interface (RMI) is an API and GUI that supports granular, pre-trade
risk management for Clearing Firms. The RMI consists of two components:
RMI Application Programming Interface (API)
Allows Clearing Firms to programmatically send instructions to:
Block/Unblock order entry by Execution Firm and Account and Exchange and Derivative
Type and Side; Product designation optional
Query current block/unblock instructions
Cancel working orders, including Good Til Cancel (GTC) and Good Til Date (GTD) order
types
RMI Graphical User Interface (GUI)
A web-based user interface that allows clearing firms to:
Block/Unblock order entry at the same levels as the API
View current blocks
16 | P a g e

Access to the RMI is limited to clearing firms' certified proprietary and third-party risk
management applications.
Resources
Drop Copy
Drop Copy is available from CME Group, or certified third-party vendors. A monthly fee of
$500 will be charged per Drop Copy group. The Drop Copy fee will be waived for the
customer's first Drop Copy group. Certification via AutoCert+ is required to access Drop
Copy in production.
Drop Copy allows users to:
Monitor orders and activity
Aggregate execution and reject messages

FirmSoft

FirmSoft is a browser-based order management tool that provides real-time access to

information on working and filled CME Globex orders including iLink and CME
Direct across multiple firm IDs. FirmSoft provides important risk mitigation functionality
during system failures.
Users can view:
Current order status
Fill information, including partial fills and fills from mass quotes
History of cancel and replace requests
CME Globex timestamps
If enabled to do so, users can cancel
An individual order
Group of orders
All working orders and mass quotes
Users can call into the GCC to status and/or cancel orders based on their FirmSoft
permissions.
Features
CME Group Login registration and profile management platform
Improved clearing firm administration tools
17 | P a g e

Secure Socket Layer (SSL) Internet connectivity

COMPANY PROFILE

18 | P a g e

Established in 2008, Zephirum is an innovative and dynamic research and analytics business
specialising in global listed derivatives.
Drawing on our global experience for the past 35 years - our offices in Mumbai and
Hyderabad nurture and develop the brightest minds to identify trends and patterns for
sustainable long term results.
Research& Analysis
Our dedicated experts cover global markets 24hours, 5 days a week - providing unique realtime Research, Analysis and Trading data feeds.
Settlements & Back Office
A complete financial back office solution covering:

19 | P a g e

Complete Trade Cycle Processing

Trade Capture

Trade Processing

Reporting (Ominbus and/or Individual Trading)

Reconciliations and Settlements

Break Discovery and Resolution

Commissions, fees and margin level management

Customer activity monitoring

Risk Management

No risk is ever considered routine. Every venture demands the personal attention and
commitment of people at all levels of the firm.
We have a multi-layered, overlapping real time risk control.
Risk mitigation covers every aspect making up Zephirum People, Products and Technology
The People - careful screening and profiling during the recruitment process, to selective
and detailed training, to on going support and continuing education.
The Products - Opportunities are constant but it needs expertise and experience to
evaluate the risk and rewards of any product. Zephirum conducts in depth analysis and
testing to ensure the best outcomes.
The Technology - Critical to our success is the technology deployed. Years of experience
lead us to one conclusion - Keep it Simple with the Best.

20 | P a g e

XRISK
Risk Monitoring

XRISK in detail
At the core of XRISK is the Risk Register; a database of all identified risks and their
respective controls. Risks for projects are identified by project execution step, while for
operations; risks are presented by item of equipment and operating activity. Each risk element
is assigned its own mini risk assessment, showing the scope of uncontrolled risk, a cause and
effects analysis (ranging from failure modes and effects analysis to bow-tie analysis for more
complex scenarios), along with possible preventive and control measures.

The cost of controls can be used as the basis for an As Low as Reasonably Practicable
(ALARP) analysis, so that controls can be selected on the basis of a cost / benefit analysis.
Any residual risk is also shown, along with an assessment of justifiable contingency
measures. These risk assessments are often based on multiple factors with multiple
consequences. A risk scenario can have safety, environmental and availability implications,
and all these exposures must be considered in an integrated, coordinated manner.

Because XRISK is a database management system, each control can be switched on or off
allowing reviewers to assess their impact immediately. This provides useful decision-making
support in the event of performance degradation or completes breakdowns. The database
back-end also means the system can be tailored to individual customer requirements. Another
advantage is that many key fields can be populated relatively easily, giving managers and
engineers more time to focus on areas where risk identification is not as complete (such as
environmental and availability elements), or where risk assessments are lacking (often the
case for controls optimisation or ALARP evaluations). Xodus has designed the database as a
live tool, which steadily improves as knowledge grows. The more accurately risks are
categorised and controlled; the easier it is to focus on less clearly defined elements.

XRISK in action

21 | P a g e

Hosted by Xodus, XRISK helps our clients to manage their risk registers on a project related
as well as overall strategic level. With support for clients own risk matrices and internal
management roles, the clarity and accessibility of XRISK is set to revolutionise efficient risk
management.

SPECIFICATION OF A FUTURES CONTRACT

when developing a new contract, the exchange must specify in some detail the exact nature of
the agreement between the two parties. In particular, it must specify the asset, the contract
size (exactly how much of the asset will be delivered under one contract), where delivery will
be made, and when delivery will be made. Sometimes alternatives are specified for the grade
of the asset that will be delivered or for the delivery locations. 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.
The Asset
When the asset is a commodity, there may be quite a variation in the quality of what is
available in the marketplace. When the asset is specified, it is therefore important that the
exchange stipulate the grade or grades of the commodity that are acceptable. The
Intercontinental Exchange (ICE) has specified the asset in its orange juice futures contract as
frozen concentrates that are US Grade A with Brix value of not less than 62.5 degrees. For
some commodities a range of grades can be delivered, but the price received depends on the
grade chosen. For example, in the CME Groups corn futures contract, the standard grade is
No. 2 Yellow, but substitutions are allowed with the price being adjusted in a way
established by the exchange. No. 1 Yellow is deliverable for 1.5 cents per bushel more than
No. 2 Yellow. No. 3 Yellow is deliverable for 1.5 cents per bushel less than No. 2 Yellow.
The Contract Size
The contract size specifies the amount of the asset that has to be delivered less than 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 or who wish to take relatively small
speculative positions will be unable to use the exchange. On the other hand, if the contract
size is too small, trading may be expensive as there is a cost associated with each contract
traded. The correct size for a contract clearly depends on the likely user. Whereas the value of
what is delivered under a futures contract on an agricultural product might be $10,000 to
$20,000, it is much higher for some financial futures. For example, under the Treasury bond
futures contract traded by the CME Group, instruments with a face value of $100,000 are
delivered
22 | P a g e

Delivery Arrangements
The place where delivery will be made must be specified by the exchange. This is particularly
important for commodities that involve significant transportation costs. In the case of the ICE
frozen concentrate orange juice contract, delivery is to exchange licensed warehouses in
Florida, New Jersey, or Delaware. 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. The price tends to be higher for delivery locations that are relatively far
from the main sources of the commodity.

Delivery Months
A 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. For example, corn futures traded by
the CME Group have delivery months of March, May, July, September, and December. At
any given time, contracts trade for the closest delivery month and a number of subsequent
delivery months. The exchange specifies when trading in a particular months contract will
begin. The exchange also specifies the last day on which trading can take place for a given
contract. Trading generally ceases a few days before the last day on which delivery can be
made.
Price Quotes
The exchange defines how prices will be quoted. For example, in the US, crude oil futures
prices are quoted in dollars and cents. Treasury bond and Treasury note futures prices are
quoted in dollars and thirty-seconds of a dollar.

Price Limits and Position Limits For most contracts, daily price movement limits are
specified by the exchange. If in a day the price moves down from the previous days close by
an amount equal to the daily price limit, the contract is said to be limit down. 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. Normally, trading ceases for the day once the contract is limit up or limit
down. However, in some instances the exchange has the authority to step in and change the
limits. The purpose of daily price limits is to prevent large price movements from occurring
because of speculative excesses. However, limits can become an artificial barrier to trading
23 | P a g e

when the price of the underlying commodity is advancing or declining rapidly. Whether price
limits are, on balance, good for futures markets is controversial. 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.
Daily Settlement To illustrate how margins work, we consider an investor who contacts his or
her broker to buy two December gold futures contracts on the COMEX division of the New
York Mercantile Exchange (NYMEX), which is part of the CME Group. We suppose that the
current futures price is $1,250 per ounce. Because the contract size is 100 ounces, the
investor has contracted to buy a total of 200 ounces at this price. The broker will require the
investor to deposit funds in a margin account. The amount that must be deposited at the time
the contract is entered into is known as the initial margin. We suppose this is $6,000 per
contract, or $12,000 in total. At the end of each trading day, the margin account is adjusted to
reflect the investors gain or loss. This practice is referred to as daily settlement or marking to
market. Suppose, for example, that by the end of the first day the futures price has dropped by
$9 from $1,250 to $1,241. The investor has a loss of $1,800 ( 200 $9), because the 200
ounces of December gold, which the investor contracted to buy at $1,250, can now be sold
for only $1,241. The balance in the margin account would therefore be reduced by $1,800 to
$10,200. Similarly, if the price of December gold rose to $1,259 by the end of the first day,
the balance in the margin account would be increased by $1,800 to $13,800. A trade is first
settled at the close of the day on which it takes place. It is then settled at the close of trading
on each subsequent day. Time (a) (b) Futures price Spot price Time Futures price Spot price
Figure 2.1 Relationship between futures price and spot price as the delivery period is
approached: (a) Futures price above spot price; (b) futures price below spot price. Mechanics
of Futures Markets 27 Note that daily settlement is not merely an arrangement between
broker and client. When there is a decrease in the futures price so that the margin account of
an investor with a long position is reduced by $1,800, the investors broker has to pay the
exchange $1,800 and the exchange passes the money on to the broker of an investor with a
short position. Similarly, when there is an increase in the futures price, brokers for parties
with short positions pay money to the exchange and brokers for parties with long positions
receive money from the exchange. Later we will examine in more detail the mechanism by
which this happens. The investor is entitled to withdraw any balance in the margin account in
excess of the initial margin. To ensure that the balance in the margin account never becomes
negative a maintenance margin, which is somewhat lower than the initial margin, is set. If the
balance in the margin account falls below the maintenance margin, the investor receives a
margin call and is expected to top up the margin account to the initial margin level by the end
of the next day. The extra funds deposited are known as a variation margin. If the investor
does not provide the variation margin, the broker closes out the position. In the case of the
investor considered earlier, closing out the position would involve neutralizing the existing
contract by selling 200 ounces of gold for delivery in December.
The Clearing House and Clearing Margins A clearing house acts as an intermediary in futures
transactions. It guarantees the performance of the parties to each transaction. The clearing
house has a number of Mechanics of Futures Markets 29 members, who must post funds with
the clearing house. Brokers who are not members themselves must channel their business
through a member. The main task of the clearing house is to keep track of all the transactions
that take place during a day, so that it can calculate the net position of each of its members.
Just as an investor is required to maintain a margin account with a broker, the broker is
required to maintain a margin account with a clearing house member and the clearing house
member is required to maintain a margin account with the clearing house. The latter is known
24 | P a g e

as a clearing margin. The margin accounts for clearing house members are adjusted for gains
and losses at the end of each trading day in the same way as are the margin accounts of
investors. However, in the case of the clearing house member, there is an original margin, but
no maintenance margin. Every day the account balance for each contract must be maintained
at an amount equal to the original margin times the number of contracts outstanding. Thus,
depending on transactions during the day and price movements, the clearing house member
may have to add funds to its margin account at the end of the day or it may find it can remove
funds from the account at this time. Brokers who are not clearing house members must
maintain a margin account with a clearing house member. In determining clearing margins,
the exchange clearing house calculates the number of contracts outstanding on either a gross
or a net basis. When the gross basis is used, the number of contracts equals the sum of the
long and short positions. When the net basis is used, these are offset against each other.
Suppose a clearing house member has two clients: one with a long position in 20 contracts,
the other with a short position in 15 contracts. Gross margining would calculate the clearing
margin on the basis of 35 contracts; net margining would calculate the clearing margin on the
basis of 5 contracts. Most exchanges currently use net margining.
OTC MARKETS Credit risk has traditionally been a feature of the over-the-counter markets.
There is always a chance that the party on the other side of an over-the-counter trade will
default. It is interesting that, in an attempt to reduce credit risk, the over-the-counter market
has adopted, or has been compelled to adopt, some of the procedures used by exchanges.
PRODUCTS

EURO DOLLARS
CME Eurodollar futures have achieved remarkable success since their debut in December
1981. Much of this growth may directly be attributed to the fact that Eurodollar futures
represent fundamental building blocks of the interest rate marketplace. Indeed, they may be
deployed in any number of ways to achieve diverse objectives
Eurodollar futures are based on a $1 million face value, 3-month maturity Eurodollar Time
Deposit. They are settled in cash on the 2nd London bank business day prior to the 3rd
Wednesday of the contract month by reference to the ICE Benchmark Administration Limited
(ICE) Interest Settlement Rate for three-month Eurodollar Interbank Time Deposits.
These contracts mature during the months of March, June, September, or December,
extending outward 10 years into the future. However, the exchange also offers serial
contract months in the four nearby months that do not fall into the March quarterly cycle.
CRUDE OIL
The crude oil market is the largest commodity market in the world, with global demand
amounting to about 80 million barrels daily. Ten-year fixed-price supply contracts have been
commonplace in the over-the-counter market for many years. These are swaps where oil at a
fixed price is exchanged for oil at a floating price. There are many grades of crude oil,
reflecting variations in the gravity and the sulphur content. Two important benchmarks for
pricing are Brent crude oil (which is sourced from the North Sea) and West Texas
Intermediate (WTI) crude oil. Crude oil is refined into products such as gasoline, heating oil,
fuel oil, and kerosene. In the over-the-counter market, virtually any derivative that is
25 | P a g e

available on common stocks or stock indices is now available with oil as the underlying asset.
Swaps, forward contracts, and options are popular. Contracts sometimes require settlement in
cash and sometimes require settlement by physical delivery (i.e., by delivery of oil).
Exchange-traded contracts are also popular. The CME Group and Intercontinental Exchange
(ICE) trade a number of oil futures and oil futures options contracts. Some of the futures
contracts are settled in cash; others are settled by physical delivery. For example, the Brent
crude oil futures traded on ICE have a cash settlement option; the light sweet crude oil futures
traded on CME Group require physical delivery. In both cases, the amount of oil underlying
one contract is 1,000 barrels. The CME Group also trades popular contracts on two refined
products: heating oil and gasoline. In both cases, one contract is for the delivery of 42,000
gallons.
NATURAL GAS
The natural gas industry throughout the world went through a period of deregulation and the
elimination of government monopolies in the 1980s and 1990s. The supplier of natural gas is
now not necessarily the same company as the producer of the gas. Suppliers are faced with
the problem of meeting daily demand. 750 CHAPTER 33 A typical over-the-counter contract
is for the delivery of a specified amount of natural gas at a roughly uniform rate over a 1month period. Forward contracts, options, and swaps are available in the over-the-counter
market. The seller of natural gas is usually responsible for moving the gas through pipelines
to the specified location. The CME Group trades a contract for the delivery of 10,000 million
British thermal units of natural gas. The contract, if not closed out, requires physical delivery
to be made during the delivery month at a roughly uniform rate to a particular hub in
Louisiana. ICE trades a similar contract in London. Natural gas is a popular source of energy
for heating buildings. It is also used to produce electricity, which in turn is used for airconditioning. As a result, demand for natural gas is seasonal and dependent on the weather.

CORN
Corn futures are standardized, exchange-traded contracts in which the contract buyer agrees
to take delivery, from the seller, a specific quantity of corn (eg. 50 tonnes) at a predetermined
price on a future delivery date.

Corn Futures Exchanges

You can trade Corn futures at Chicago Board of Trade (CBOT), NYSE Euronext (Euronext)
and Tokyo Grain Exchange (TGE).
CBOT Corn futures prices are quoted in dollars and cents per bushel and are traded in lot
sizes of 5000 bushels (127 metric tons).
Euronext Corn futures are traded in units of 50 tonnes and contract prices are quoted in
dollars and cents per metric ton.
TGE Corn futures prices are quoted in yen per metric ton and are traded in lot sizes of 50
tonnes .

26 | P a g e

Exchange & Product Name

Symbol

Contract Size

Initial Margin

CBOT Corn Futures

(Price Quotes)

5000 bushels
(Full Contract Spec)

USD 2,025 (appro

(Latest Margin In

Euronext Corn Futures

(Price Quotes)

EMA

50 tonnes
(Full Contract Spec)

EUR 700 (approx

(Latest Margin In

TGE Corn Futures

(Price Quotes)

50 tonnes
(Full Contract Spec)

JPY 75,000 (appr

(Latest Margin In

Corn Futures Trading Basics

Consumers and producers of corn can manage corn price risk by purchasing and selling corn
futures. Corn producers can employ a short hedge to lock in a selling price for the corn they
produce while businesses that require corn can utilize a long hedge to secure a purchase price
for the commodity they need.
Corn futures are also traded by speculators who assume the price risk that hedgers try to
avoid in return for a chance to profit from favorable corn price movement. Speculators buy
corn futures when they believe that corn prices will go up. Conversely, they will sell corn
futures when they think that corn prices will fall.
LIVE CATTLE
Live cattle futures are standardized, exchange-traded contracts in which the contract buyer
agrees to take delivery, from the seller, a specific quantity of live cattle (eg. 40000 pounds) at
a predetermined price on a future delivery date

Live Cattle Futures Exchanges

You can trade Live Cattle futures at Chicago Mercantile Exchange (CME).
CME Live Cattle futures prices are quoted in dollars and cents per pound and are traded in lot
sizes of 40000 pounds (18 metric tons).

Exchange & Product Name

Symbol

Contract Size

Initial Margin

27 | P a g e

CME Live Cattle Futures

(Price Quotes)

LC

40000 pounds
(Full Contract Spec)

USD 1,620 (app

(Latest Margin I

Live Cattle Futures Trading Basics

Consumers and producers of live cattle can manage live cattle price risk by purchasing and
selling live cattle futures. Live Cattle producers can employ a short hedge to lock in a selling
price for the live cattle they produce while businesses that require live cattle can utilize a long
hedge to secure a purchase price for the commodity they need.
Live Cattle futures are also traded by speculators who assume the price risk that hedgers try
to avoid in return for a chance to profit from favorable live cattle price movement.
Speculators buy live cattle futures when they believe that live cattle prices will go up.
Conversely, they will sell live cattle futures when they think that live cattle prices will fall.

LEAN HOGS futures are standardized, exchange-traded contracts in which the contract
buyer agrees to take delivery, from the seller, a specific quantity of lean hogs (eg. 40000
pounds) at a predetermined price on a future delivery date.

Lean Hogs Futures Exchanges

You can trade Lean Hogs futures at Chicago Mercantile Exchange (CME).
CME Lean Hogs futures prices are quoted in dollars and cents per pound and are traded in lot
sizes of 40000 pounds (18 metric tons).

Exchange & Product Name

Symbol

Contract Size

Initial Margin

CME Lean Hogs Futures

(Price Quotes)

LH

40000 pounds
(Full Contract Spec)

USD 1,350 (app

(Latest Margin I

28 | P a g e

Lean Hogs Futures Trading Basics

Consumers and producers of lean hogs can manage lean hogs price risk by purchasing and
selling lean hogs futures. Lean Hogs producers can employ a short hedge to lock in a selling
price for the lean hogs they produce while businesses that require lean hogs can utilize a long
hedge to secure a purchase price for the commodity they need.
Lean Hogs futures are also traded by speculators who assume the price risk that hedgers try to
avoid in return for a chance to profit from favorable lean hogs price movement. Speculators
buy lean hogs futures when they believe that lean hogs prices will go up. Conversely, they
will sell lean hogs futures when they think that lean hogs prices will fall.

What Are Futures?

In the United States, trading futures began in the mid-19th century with the
establishment of central grain markets where farmers could sell their products
either for immediate delivery, also called the spot or cash market, or for forward
delivery. These forward contracts were private contracts between buyers and
sellers and became the forerunner of todays exchange-traded futures contracts.
Both forward contracts and futures contracts are legal agreements to buy or sell
an asset on a specific date or during a specific month. Where forward contracts
are negotiated directly between a buyer and a seller and settlement terms may
vary from contract to contract, a futures contract is facilitated through a futures
exchange and is standardized according to quality, quantity, delivery time and
place. The only remaining variable is price, which is discovered through an
auction-like process that occurs on the Exchange trading floor or via CME Globex,
Although trading began with floor trading of traditional agricultural commodities such as
grains and livestock,
exchange-traded futures have expanded to include metals, energy, currencies, equity indexes
and interest rate
products, all of which are also traded electronically

AGRICULTURE

29 | P a g e

INTEREST RATES

ENERGY

METALS

EQUITY
30 | P a g e

FX

Who Trades Futures?

Conventionally, traders are divided into two main categories, hedgers and speculators.
Hedgers use the futures market to manage price risk. Speculators on the other hand accept
that risk in an attempt to profit from favorable price movement. While futures help hedgers
manage their exposure to price risk, the market would not be possible without the
participation of speculators. They provide the bulk of market liquidity, which allows the
hedger to enter and exit the market in an efficient manner. Speculators may be full-time
professional traders or individuals who occasionally trade. Some hold positions for months,
while others rarely hold onto a trade more than a few seconds.
Regardless of their approach, each market participant plays an important role in
making the futures market an efficient place to conduct business.
How Does a Trade Work?
Contract Size
By definition, each futures contract has a standardized size that does not change. For
example, one contract of corn represents 5,000 bushels of a very specific type and quality of
corn. If you are trading British pound futures, the contract size is always 62,500 British
pounds. The E-mini S&P 500 futures contract size is always $50 times the price of S&P 500
index.
Contract Value
31 | P a g e

Contract value, also known as a contracts notional value, is calculated by multiplying the
size of the contract by the current price. For example, the E-mini S&P 500 contract is $50
times the price of the index. If the index is trading at $1,425, the value of one
E-mini contract would be $71,250.
Tick Size
The minimum price change in a futures or options contract is measured in ticks. A tick is the
smallest amount that the price of a particular contract can fluctuate. Tick sizevaries from
contract to contract. A tick in the E-mini S&P 500 futures contract is equal to one-quarter of
an index point. Since an index point is valued at $50 in the E-mini, one tick is equivalent to
$12.50.

Price Limits
Some futures markets impose limits on daily price fluctuations. A price limit is themaximum
amount the price of a contract can move in one day based on the previous days settlement
price. These limits are set by the Exchange and help to regulate dramatic price swings. When
a futures contract settles at its limit bid or offer, the limit may be expanded to facilitate
transactions on the next trading day. This may help futures prices return to a level reflective
of the current market environment.
Mark-to-Market
Futures contracts follow a practice known as mark-to-market. At the end of each trading day,
the Exchange sets a settlement price based on the days closing price range for each contract.
Each trading account is credited or debited based on that days profits or losses and checked
to ensure that the trading account maintains the appropriate margin for all open positions. As
described in the Why Trade Futures? your position in the market is secured by a
performance bond. A performance bond is an amount of money that must be deposited with
your broker to open or maintain a position in a futures account. This good-faith money helps
to ensure that all market participants are able to meet their obligations. It helps maintain
confidence in the financial integrity of the Exchange as a whole. The practice of marking
accounts to market helps ensure that your account maintains sufficient capital to meet margin
requirements on a daily basis
AGRICULTURE FUTURES
We all know that grains and livestock have sustained us for thousands of years, but did you
know that they are the foundational products upon which the first futures exchanges were
established? Today, agricultural markets are highly complex. They involve farmers, ranchers,
processors, distributors, packagers, wholesalers and retailers all working to help lock in fair
and predictable prices for the food we buy at the store.
Who hedges?
Lets say that a cattle rancher is concerned about lower prices at the time his animals will be
ready to bring to market. He uses the futures market to hedge, or attempt to minimize, his
price risk. He can calculate the cash price he needs for his livestock, and then sell live cattle
futures at the futures exchange to lock in that price. This will ensure his profitability, despite
any declines in the market price for his herd.

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hedge:
To buy or sell a futures contract in order to lock in the price of the underlying commodity at a
later date.
View in Glossary
And who speculates?
Now, on the other side of the transaction are the individual and institutional traders who are
willing to absorb the risk being transferred by the cattle rancher. They speculate, or invest
with intent to profit, by buying and selling cattle contracts.
How do real grocery stores use futures?
Linda Whiteside is responsible for dairy and frozen food products at Associated Wholesale
Grocers (AWG), a member-owned co-op serving more than 2,900 stores in 24 states.
Our concern is controlling our costs, Whiteside says. Our goal is to keep our stores very
competitive in their markets.
To control costs, AWG works with vendors to ensure price points. For example, she works
with cheese vendors to hedge their needs over a certain period of time, generally via CME
Group Class III milk futures or cheese futures contracts.
Where we can, we will work with vendors to establish a hedge that they might choose, she
says, but every vendor is different, and we work with multiple vendors to ensure consistent
supply.

FUTURES TRADE

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All kinds of people come to futures exchanges, to buy and sell futures and options contracts.
They may work for banks, corporations or governments. They may be livestock ranchers,
investment managers, construction planners, farmers or food manufacturers. Really, futures
trading involves just about anyone in the world who wants either to manage the risk of
fluctuating prices or profit from those fluctuations. But whoever they are, and wherever they
came from, these traders are interested in two types of trading: hedging and speculating.
Hedgers and speculators go hand in hand if you took one away, there simply would be no
market. Hedgers transfer risk, and speculators absorb that risk. It takes both types of traders
to bring balance to the market and keep trades moving back and forth.
futures exchange:
A central marketplace where buyers and sellers come together to trade futures and options
contracts.
View in Glossary
Meet the hedger
The hedger buys futures contracts because he wants to protect himself from price swings in
the future. By using futures to lock in a future price for a product, he makes his costs and
his profits more predictable. In other words, he trades futures to drive risk out of his
business.
But that risk doesnt just disappear into thin air it gets transferred to the speculator.
Meet the speculator
The speculator accepts price risk in pursuit of profit. Speculators have no interest in owning
the product being traded, but they are interested in the contracts for those products. Think of
it like investing buying and selling futures contracts in order to make a profit when prices
move in the right direction.
Hedger or Speculator
People who trade futures contracts come to an exchange to hedge and speculate on the future
prices of a wide range of products. Outside the exchanges, people hedge and speculate on all
sorts of everyday financial matters. To better understand what these practices look like in the
real world, take the quiz below.

The Exchange: How It Works

Traders from all over the world come to a futures exchange for a stable, regulated, transparent
and liquid venue on which to buy and sell futures contracts. These exchanges were born on
the streets of Chicago, eventually moving indoors to the bustling open-outcry pits weve
come to associate with the concept of trading. But todays exchanges are almost entirely
electronic, executing millions of trades per second and offering market participants aroundthe-clock access to the global markets.
trader:
A member of the exchange who buys and sells futures and options through electronic trading
platforms and/or on the floor of the exchange.
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View in Glossary
The ingredients of a futures exchange
In the broadest sense, there are four key components that make a futures exchange tick.
1. FUTURES TRADERS: HEDGERS AND SPECULATORS
These two types of traders go hand in hand, ensuring the flow of trades back and forth and
bringing balance to the market.
2. TRADING TECHNOLOGY: THE NERVE CENTER
Electronic trading platforms enable exchanges to operate on a global scale, providing a steady
level of speed, access and transparency for everyone.
3. CLEARING: THE INTEGRITY BEHIND EVERY TRADE
Clearing houses stand at the center of every trade, acting as the buyer for every seller and the
seller for every buyer, ensuring that each side can make good on the terms of the trade and
protecting the integrity of the market.
4. LIQUIDITY: THE MORE, THE BETTER
Liquidity is the ability for every buyer to find a seller, and every seller to find a buyer, so that
trading activity can remain consistent and reliable.
Learn How to Trade
If you're curious about what it's like to trade futures and options, now's your chance to try in a
practice trading environment. But before you start buying and selling, lets look at an
example. Over the next four pages, well walk through the steps of a sample corn trade. From
research and analysis to reading market conditions and placing a trade, this tutorial will help
you understand what to expect when you try your hand at trading using our simulator.
Were not going to lie this is complicated. Theres a lot to consider when making a trade.
But when you focus on the different pieces, you can more easily make sense of the whole
electronic trading process. First you need to get a sense of the current market.

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Most traders use a variety of tools to inform their decision making. Broadly speaking, there
are two kinds of analytical tools that can help you make the most of your trades: technical
analysis and fundamental analysis. Let's start with technical analysis.

Place a Trade
Youve done your research, evaluated trends and assessed the marketplace. Now its time to
place a trade.
After clicking the TRADE button within the corn section of the heatmap, youll be given a
breakdown of current market information. Then, you put your analysis to work.
Step 1. Order Types
In the simulator, you'll be limited to trading the contracts that expire next, often referred to as
the front month. In this instance, that's December. There are four order types to choose from:
market, limit, stop and stop-limit. For this example, we'll focus on a market order, an order
placed at any time during the trading session with the intention of immediately executing the
entire order at the best available offer price (for buy orders) or bid price (for sell orders).
Step 2. Quantity
Select the number of units you want to buy or sell.
UNDERSTANDING QUANTITIES

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To purchase one unit or futures contract does not mean you are purchasing a single cob or
even stalk of corn. In fact, one futures contract of corn is equal to 5,000 bushels.
Step 3. Buying vs. Selling
Unlike stocks, you can sell futures without making a previous purchase. However, you cannot
realize a profit in futures trading until you flatten your position placing an order for the
same quantity on the opposite side of the market.
If that rainfall has you thinking that prices in the corn market will spike, you'll purchase one
corn futures contract in anticipation of that potential rise.
On the other hand, if that bumper crop came through and supply is set to exceed demand,
youll sell in anticipation of a downward trend in prices.
Step 4. Confirm
Once you place your order, the confirmation screen gives you a summary of the transaction.
One key piece of information: the notional value of your order, which is the number of
contracts multiplied by the price of the last trade. The confirmation screen also shows the
margin requirement for buyers or sellers to commit in order to hold a position for the future.
Step 5. Position Summary
Having decided to buy, you have a trading position that is now long one unit of corn. (Selling
would result in a short position.) Your position is reflected below the trading chart in the
position summary. You'll notice that prices as well as your unrealized profit and loss
update in real time in the summary. That way, if the market moves in your favor, you can
simply click flatten to even your position and realize a profit.
The Role of Technology in Futures Markets
Electronic trading has achieved much more than enabling the open-outcry traders of
yesterday to do business in the comfort of their own home. Because it frees futures trading
from the confines of a physical exchange, electronic trading enables futures exchanges to
operate on a global scale, with 24/7 access to markets around the world.
Todays electronic futures trading platforms are some of the most advanced technologies in
the world of finance. The speed and constant activity they enable adds ever-greater liquidity
to the markets so the worlds economies can move more quickly, more decisively and more
confidently.
Protecting the Futures Markets
A futures exchange is a highly complex organization that directly impacts the worlds markets
and helps foster global commerce. As you might expect, its activities are watched very
closely. Extensive processes, monitoring, standardization, rules and regulations work in
concert to protect everyone both inside and outside the exchange. These measures ensure that
these futures exchanges that exist to create stable markets continue to do just that.
This section explores the two key mechanisms that keep futures markets under watch and
running smoothly for everyone.
futures exchange:

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A central marketplace where buyers and sellers come together to trade futures and options
contracts.
View in Glossary
Clearing houses: protecting trading partners
Clearing houses act as a neutral counterparty for every single trade that crosses a futures
exchange, assuming responsibility for ensuring buyer and seller performance on each
contract.
Market regulation: protecting market integrity
Futures exchanges are closely monitored and regulated by governmental agencies, as well as
by regulatory group functions within each exchange.
The Clearing House: The Integrity Behind Every Trade
The ClearingClearing is a fundamental benefit in the futures markets. Long before a trade is
cleared through a clearing house, clearing firms check the financial strength of both parties to
the trade, whether theyre a big institution or an individual trader. They also provide access to
trading platforms, where the buyer and seller agree on the price, quantity and maturity of the
contract. Then, when the contract is cleared by matching these offsetting (one buy, one sell)
positions together, the clearing house guarantees that both buyer and seller get paid. This
offsetting or netting process takes risk out of the financial system as a whole.
clearing:
The procedure through which a clearing house becomes the buyer to each seller of a futures
contract and the seller to each buyer, and assumes the responsibility of ensuring that each
buyer and seller performs on each contract.
View in Glossary
How clearing works
Clearing houses provide clearing and settlement services for futures traded at an exchange.
They act as the neutral counterparty between every buyer and seller, ensuring the soundness
and integrity of every trade.
How to Clear a Trade
Clearing involves a number of protections that take place instantaneously from the time an
order is placed to the time it is settled. And by enabling traders to submit their orders through
a central clearing function, the process enables the market to run more smoothly and
efficiently.
The market protections of an electronic trade
Futures exchanges process millions of trades each day. With so many orders coming at once,
you need a lot of checkpoints to make sure everything goes smoothly.
Heres a look at a few of the risk protections that every order must pass in order to make it
through an electronic trading engine. These protections help maintain the integrity of the
overall futures market.
The Regulatory Measures
As with any other financial business responsible for handling peoples money, futures
exchanges operate within very strict, very closely watched guidelines. This regulation comes

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from both outside and inside the exchange, ensuring that everything that happens at an
exchange follows the letter and spirit of the law.
Outside the exchange
In the United States, the Commodity Futures Trading Commission (CFTC) regulates the
nations futures and options markets. Its oversight protects market participants from fraud,
manipulation and market abuse, and ensures the financial integrity of an exchange.
Inside the exchange
Futures exchanges are self-regulatory organizations, or SROs, meaning that they create and
enforce rules and standards that comply with CFTC principles, protect market participants
and promote integrity and equality throughout the industry. Typically, there is a formalized
department that works within the exchange, running constant surveillance and compliance
measures on each and every activity performed at an exchange.
Over-the-Counter vs. Over-the-Exchange
Its hard to talk about futures without mentioning options over-the-counter contracts,
particularly those in the interest rate, foreign exchange and commodities markets. Over-thecounter, or OTC, trades are those that take place between a buyer and a seller outside of a
formal exchange.
OTC derivatives let traders go beyond standardized futures products and customize the terms
of the contracts they trade. Usually, the traders work through a network of dealers who
negotiate these agreements on a one-to-one basis. Though it offers greater freedom and
potentially lower trading costs, OTC trading may leave both parties at risk for counterparty
default if they are not using the services of a clearing house.
TRADING STRATEGIES
CALENDAR SPREADS are done by simultaneously buying and selling two contracts for
the same commodity or option with different delivery months. These spreads can be just the
mechanical process of maintaining a long or short position through a roll period when the
front month or spot contract goes off the board or putting on a position designed to benefit
from a change in the differential. The further out you go in time, the more volatility you buy
in the spread. CME Group offers calendar spread options in corn, wheat, soybeans, soybean
oil and soybean meal (see Knowing your options). Calendar spreads are popular in the
grain markets due to seasonality in planting and harvest. For example, for corn, in a July-Dec
calendar spread, you are selling the old crop (July contract based mainly on carryover from
the previous growing season) and buying the new crop (December contract based on the
current growing season)
Alternatively, you can execute a Dec-July spread, selling the new crop and buying the old
crop. You also can trade a year- round spread, trading Dec-Dec. For wheat, you can do a
spread trade for Dec-July, July-Dec, or July-July; and for soybeans July-Nov (old crop/new
crop), Jan-May, Nov-July, and year-round Nov-Nov.
BUTTERFLY
The Butterfly Futures Spread will combine a near term bull spread and a longer term bear
spread (or vice versa if bearish). We will buy two different months, and then sell one month
twice. The month we will sell twice is referred as the whipping post because we believe it
will underperform the other two months that we buy individually. This spread is popular
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because it offers cheaper margins rather than outright directional trades. In my opinion, many
perceive this strategy as less risky because you are long and short the same commodity, just
in different months.
In a market like corn, the term structure will offer many opportunities to gain profit from the
changes in prices in different months. Because of the fundamentals of the grain markets and
the fact that new supply will be on the market only a few times a year, the term structure can
change drastically depending on supply/demand and fund movement. In the case of our
example below, we will sell the September contract twice, making it our whipping post. Note:
you always want to make your sale in what you perceive to be the weakest month. How to
determine which month will be the weakest will take some homework.
Here are the prices as we look to enter the trade, with our purchases in green and our sales in
red:
July Corn: 626-0
September Corn: 559-0
December Corn: 544-0
The way we will track the spreads will be to follow the July-Sep leg and the Sep-Dec leg
separately. Even though I look at this butterfly spread as one big trade, I will still use stops
and targets on each leg to make the execution smoother and easier to follow. Below, you can
see the risk/reward plan for the trade. If the trade goes to plan, I expect the July to get back
over a 1.00 inverse to the September and the December to get to a 15 cent carry (right now
its is inverted) over the September for a profit of 28 cents on the July-Sep leg and a 30 cent
profit on the Dec-Sep leg, making the total profit for the trade 58 cents, or $2900 dollars.

LONG FUTURES

When to use: When you are bullish on the market and uncertain about volatility. You will not
be affected by volatility changing. However, if you have an opinion on volatility and that
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opinion turn out to be correct, one of the other strategies may have greater profit potential
and/or less risk.
Profit characteristics: Profit increases as market rises. Profit is based strictly on the difference
between the exit price and the entry price.
Loss characteristics: Loss increases as market falls. Loss is based strictly on the difference
between the exit price and the entry price.

Example

Scenario:
This trader feels that Live Cattle futures are poised for a rally. The implied volatility of the
options is relatively high, but the trader does not expect it to come down soon. Therefore, he
decides to buy one futures contract.
Specifics:
Underlying Futures Contract: April Live Cattle
Futures Price Level: 73.00
Days to Futures Expiration: 75
Days to Options Expiration: 55
Option Implied Volatility: 16.2%
Position: Long 1 Future
At Expiration:
Breakeven: 73.00 (original futures price)
Loss Risk: Unlimited; losses increase as futures fall.
Potential Gain: Unlimited; profits increase as futures rise.
Things to Watch:

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Changes in implied volatility have no effect on this position. If the trader has an opinion on
volatility, he may consider another strategy. Another strategy may increase potential profits
and/or reduce potential losses. Check the next page for suggested follow-up strategies.

BULL SPREAD

BULL SPREAD
Overview
Pattern evolution:

When to use: If you think the market will go up, but with limited upside. Good position if
you want to be in the market but are less confident of bullish expectations. Youre in good
company. This is the most popular bullish trade.
Profit characteristics: Profit limited, reaching maximum if market ends at or above strike
price B at expiration. If call-vs.- call version (most common) used, break-even is at A + net
cost
of spread. If put-vs.-put version used, break-even is at B net premium collected.
Loss characteristics: What is gained by limiting profit potential is mainly a limit to loss if
you guessed wrong on market. Maximum loss if market at expiration is at or below A. With
call-vs.-call version, maximum loss is net cost of spread.
Decay characteristics: If market is midway between A and B, little if any time decay effect.
If market is closer to B, time decay is generally a benefit. If market is closer to A, time decay
is generally detrimental to profitability.
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CATEGORY: Directional
Long call A, short call B
Long put A, short put B

Example

Scenario:
The trader feels bullish on Lumber, but volatility is in question. He could try futures as an
alternative, but wants the comfort of a limited loss position. He decides on a bull spread with
the higher strike written at the top of his expected trading range of 210.
Specifics:
Underlying Futures Contract: November Lumber
Futures Price Level: 193.00
Days to Futures Expiration: 60
Days to Options Expiration: 40
Option Implied Volatility: 18.6%
Option Position:
Long 1 Nov 200 Call
Short 1 Nov 210 Call

At Expiration:
Breakeven: 201.60 (200.00 strike + 1.60 debit)
Loss Risk: Limited to premium paid. Losses increase below 201.60 to a maximum loss below
200.00 of 1.60 ($240).
Potential Gain: Limited to difference between strikes less debit paid (10.00 1.60) 8.40
($12,600). Gains mount above 201.60 with maximum profit at 210.00.
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BEAR SPREAD

When to use: If you think the market will go down, but with limited downside. Good
position if you want to be in the market but are less confident of bearish expectations. The
most popular position among bears because it may be entered as a conservative trade when
uncertain about bearish stance.
Profit characteristics: Profit limited, reaching maximum at expiration if market is at or
below strike price A. If put-vs.-put version (most common) used, break-even is at B net cost
of spread. If call-vs.-call version, break-even is at A + net premium collected.
Loss characteristics: By accepting a limit on profits, you also achieve a limit on losses.
Losses, at expiration, increase as market rises to B, where they are at a maximum. With putvs.- put version, maximum loss is net cost of spread.
Decay characteristics: If market is midway between A and B, little if any time decay effect.
If market is closer to A, time decay is generally a benefit. If market is closer to B, time decay
is generally detrimental to profitability.
CATEGORY: Directional
Short put A, long put B
Short call A, long call B

LONG BUTTERFLY

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When to use: One of the few positions which may be entered advantageously in a long-term
options series. Enter when, with one month or more to go, cost of the spread is 10 percent or
less of B A (20 percent if a strike exists between A and B). This is a rule of thumb; check
theoretical values.
Profit characteristics: Maximum profit occurs if a market is at B at expiration. That profit
would be B A net cost of spread. This profit develops, almost totally, in the last month.
Loss characteristics: Maximum loss, in either direction, is cost of spread. A very
conservative trade, break-evens are at A + cost of spread and at C cost of spread.
Decay characteristics: Decay negligible until final month, during which distinctive pattern
of butterfly forms. Maximum profit growth is at B. If you are away from (A-C) range
entering the last month, you may wish to liquidate position.
CATEGORY: Precision
Long call A, short 2 calls B, long call C
Long put A, short 2 puts B, long put C

Example

Scenario:
The trader currently has a #17 Ratio Call Spread. He thinks this is still a good position.
However, he is worried that the futures may increase dramatically on the upside, leaving him
with a substantial loss. He adds a long call and converts the position into a long butterfly.
Specifics:
Underlying Futures Contract: December Lean Hogs
Futures Price Level: 52.50
Days to Futures Expiration: 74
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Days to Option Expiration: 45

Option Implied Volatility: 21.5%
Option Position:
Long 1 Dec 52.00 Call
Short 2 Dec 54.00 Calls
Long 1 Dec 56.00 Call

At Expiration:
Breakeven: Downside: 52.375 (52.00 strike + 0.375 debit). Upside: 55.625 (56.00 strike
0.375 debit).
Loss Risk: Losses start above 55.625, or below 52.375, but limited to the debit paid.
Maximum loss above 56.00 strikes or below 52.00 strike.
Potential Gain: Gains peak at strike of written calls. Maximum profit of 1.625 ($487.50).
Things to Watch :
There is not much risk in this position. Volatility has little effect. Avoid follow-up strategies
unless you are quite certain of a particular move. Nearly every follow-up to this strategy
requires more than one tradepossibly incurring large transaction costs.
SHORT BUTTERFLY

When to use: When the market is either below A or above C and position is overpriced with
a month or so left. Or when only a few weeks are left, market is near B, and you expect an
imminent move in either direction.
Profit characteristics: Maximum profit equals the credit at which spread is established.
Occurs when market, at expiration, is below A or above C, thus making all options in-themoney or all options out-of-the-money.
Loss characteristics: Maximum loss occurs if market is at B at expiration. Amount of that
loss is B A credit received when setting up position. Break-evens are at A + initial credit
and C initial credit.
Decay characteristics: Decay negligible until final month, during which distinctive pattern
of butterfly forms. Maximum loss acceleration is at B.

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CATEGORY: Precision
Short call A, long 2 calls B, short call C
Short put A, long 2 puts B, short put C

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