Mechanics of Futures Market

Mechanics of Futures Markets

1. 2. 3. 4. Transaction at a Futures Exchange Specifications of a Futures Contract Convergence of Futures Price to Spot Price Safeguards in the Futures Market Clearing House Margin Requirements Daily Settlement (Mark-to-Market) 5. Closing a Futures Position 6. Open Interest 7. Pay-offs from a Futures Contract
Mechanics of Futures Market 2

Transaction on a Futures Exchange

3 2

Buyer

1 5

Buyers Broker
6 Buyers Brokers Clearing Firm

Futures Exchange
4

Sellers Broker
6

Seller
5

Futures Clearinghouse

Sellers Brokers Clearing Firm

1: Buyer places a BUY order with his Broker who in turn places it with the Futures Exchange. 2: Seller places a SELL order with his Broker who in turn places it with the Futures Exchange. 3: Futures Exchange matches the trade through a computerised system. 4: Information about the trade is reported to the Clearinghouse 5: Buyer and Seller deposit margin with their respective brokers 6: Buyers and Sellers Brokers deposit the margins with their respective clearing firms 7: Clearing firms deposit the margins with the Clearinghouse
Mechanics of Futures Market 3

Specifications of a Futures Contract

A futures contract is a standardised contract, it is defined (specified) in terms of: 1. Underlying Asset 2. Contract Size 3. Delivery Arrangements 4. Delivery Month 5. Price Quotes 6. Daily Price Movement Limits

Mechanics of Futures Market

The Underlying Asset

In case of Commodity Futures, the Exchange stipulates the grade(s) of the commodity. E.g.: Lumber Futures - standard length of 8by 20. Juice Futures in terms of Brix value A range of grades may be delivered with adjustment in price based on the grade delivered. In case of Financial assets - Futures contracts are well defined & unambiguous. E.g.: Enough to say Futures on BSE Sensex or Futures on Infosys.
Mechanics of Futures Market 5

Contract Size
Contract size specifies the amount of the asset that has to be delivered under a Futures contract. If the Contract size is set too high, it will keep away many investors, while if set too small, it will make trading expensive as transaction cost are linked to no. of contracts traded. E.g.: Futures on Reliance Industries has a lot size of 150 shares. i.e. 1 RIL Futures = 150 shares of RIL.
Mechanics of Futures Market 6

Delivery Arrangements
Place where the delivery will be made, is specified by the exchange, especially in case of Commodity Futures. Delivery may be made at alternative site with due adjustments in the delivery prices. Prices tend to be higher for delivery locations that are relatively far from the main centres.

Mechanics of Futures Market

Delivery Month
Futures contract is referred to by its Delivery month. The exchange must specify the precise period during the month delivery can be made. Vary from contract to contract Specified by exchange. At any given time, contracts trade for the closest delivery month & a number of subsequent months. NSE Futures 1, 2, 3 month futures. Exchange also specifies the last day on which trading can take place for a given contract
Mechanics of Futures Market 8

Price Quotes
The exchange defines how prices will be quoted. In a way that is convenient and easy to understand. E.g.: Crude Oil NYMEX - $/per barrel Minimum price movement that can occur in trading is also set by the exchange tick size E.g.: Crude Oil ($0.01 or 1 cent per barrel)

Mechanics of Futures Market

Daily Price Movement Limits

Maximum movement in prices during a day (in either direction) so as to prevent large price movements due to speculative trading. Exchange may change the limits to counter excessive speculation.

Mechanics of Futures Market

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Convergence of Futures to Spot Price As the delivery month approaches, the Futures price converges to the Spot price of the underlying asset. At the delivery date, the Futures price equals (or is very close to) the Spot price. If the prices differ substantially, arbitrageur shall take appropriate position to drive away any benefits. Eventually the two prices will converge.

Mechanics of Futures Market

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Convergence of Futures to Spot Price

Futures Price

Spot Price

Price

Spot Price

Price

Futures Price

Time

Time

Mechanics of Futures Market

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Clearing House
To ensure smooth functioning, each Futures Market has a Clearing House (CH) associated. CH guarantees ALL trades on the Exchange. This is achieved by CH adopting a position of a Buyer for every Seller & that of a Seller for every Buyer. Every trader has obligations only to the CH & hopes that CH will execute its side of the trade as well. CH substitutes its own credibility for the promise of each trader. CH, however, does not take ACTIVE position but interposes itself between all parties to every transactions.

Mechanics of Futures Market

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Clearing House (Contd.) Obligations without Clearing House

Funds

Buyer
Goods

Seller

Obligations with Clearing House

Funds Funds

Buyer
Goods

Clearing House

Seller
Goods

Mechanics of Futures Market

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Clearing House (Contd.)

Without CH, both parties would deal with each other-direct obligation to each other. With CH, each party has obligation to the CH which ensures that both parties perform. Because of the CH, the two parties need not trust or know each other. They need to be concerned about the reliability of the CH. Hence, CH is a large, well-capitalised Institution. US Futures trading history, CH have never faulted. Default Risk of CH is very small.
Mechanics of Futures Market 15

Operation of Margins
Futures trading is guided by the need to eliminate the payments crises- Default Risk or Credit Risk Besides the role of the Clearing House, the system of Margins protects from a payments problem. Different types of margins are maintained: Initial Margin (IM) Maintenance Margin (MM) Variation Margin (VM)

Mechanics of Futures Market

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Operation of Margins (Contd.)

Initial Margin (IM):Good faith deposit paid by the trader at the time of entering the contract to ensure performance. IM may vary from contract to contract & from trader to trader. Typically set at 5% of the contract value. Trader retains title to the deposit. Usually equal to Maximum Daily Price fluctuation limit. IM is returned upon proper completion of all the obligations. At the end of each day, the margin account is adjusted to reflect gain/loss. This is called Mark to market
Mechanics of Futures Market 17

Operation of Margins (Contd.)

Maintenance Margin (MM) :(% of the Initial Margin) is the Minimum amount of margin below which margin account should NOT fall. MM is used to calculate the third margin Variation Margin. If the margin account falls below the MM, trader is required to replenish ( top-up) the margin, bringing the margin amount back to the Initial Margin. This additional amount paid by the trader is called VM. Any amount in excess of the IM can be withdrawn by the investor. Initial margin covers 1 days price fluctuations, any additional losses is covered by the VM. Failure to pay VM leads to the futures position being closed out. Mechanics of Futures Market

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Operation of Margins - An Example

X buys 2 Gold Futures @ Rs 400 per ounce. Contract size = 100 ounces. Initial Margin (IM) = Rs 2000 per contract = 2000 x 2 = Rs 4000 Maintenance = Rs 1500 per contract

Margin (MM) = 1500 x 2 = Rs 3000

Mechanics of Futures Market

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Operation of Margins
Day Futures Price Daily Gain/(Loss) Cumulative Gain/(loss) Margin Account Balance 4000.00 3400.00 3220.00 3640.00 3420.00 3340.00 3080.00 2660.00 4060.00 3700.00 3880.00 2740.00 4000.00 4220.00 4340.00 4800.00 5060.00 Margin Call

0 400.00 1 397.00 (600.00) 2 396.10 (180.00) 3 398.20 420.00 4 397.10 (220.00) 5 396.70 (80.00) 6 395.40 (260.00) 7 393.30 (420.00) 8 393.60 60.00 9 391.80 (360.00) 10 392.70 180.00 11 387.00 (1140.00) 12 387.00 0.00 13 388.10 220.00 14 388.70 120.00 15 391.00 460.00 16 Mechanics 392.30 Market 260.00 of Futures

(600.00) (780.00) (360.00) (580.00) (660.00) (920.00) (1340.00) (1280.00) (1640.00) (1460.00) (2600.00) (2600.00) (2380.00) (2260.00) (1800.00) (1540.00)

3080-420+x=4000

1340.00

1260.00 3880-1140+x=4000

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Closing a Futures Position

1. Delivery: Delivery of the goods under the contract will automatically close the position. Physical Settlement: Physical delivery of the asset at a certain location at a specified time as per the Exchange rules. Cash Settlement: Traders make payment at expiry of contract to settle any gains or losses.

Mechanics of Futures Market

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Closing a Futures Position

2. Offset: Most Futures contracts are settled by Offsets, by entering into a exactly reverse trade which shall cancel the original trade. The trader, in order to close the contract, should enter into an exactly reverse contract in terms of the underlying assets, No. of contracts & expiry date. If it does not, then the trader shall undertakes a new obligation instead of cancelling the old obligation.

Mechanics of Futures Market

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Offset Trades An Example

May 1 Party As Initial Position: Bought 1 September Wheat Futures Contract @ Rs 2200/-. Party As Reversing Trade: Sold 1 September Wheat Futures Contract @ Rs 2300/-. Party B : Sold 1 September Wheat Futures Contract @ Rs 2200/-.

May 15

Party C: Bought 1 September Wheat Futures Contract @ Rs 2300/-.

Mechanics of Futures Market

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Closing a Futures Position (Contd.)

3. Exchange for Physicals: Two traders simultaneously exchange for cash, commodity & Futures contract based on that commodity. EFP vs. Offset: Under both, the traders have completed their obligations & are now out of the market. Differs from Offsets: Traders actually exchange the physical goods. Futures is not closed by a transaction through the Exchange. Traders privately negotiate the terms, hence also called ex-pit
Mechanics of Futures Market 24

Exchange for Physicals An Example

Before the EFP Party A Long 1 Wheat Futures Wants to acquire Actual Wheat Party A Agrees with B to purchase wheat & cancels Futures Receives wheat & pays B Reports EFP to the Exchange Exchange adjusts to show A is out of the Market. Party B Short 1 Wheat Futures Owns Wheat & wishes to sell

EFP Transaction Party B Agrees with A to sell wheat & cancels Futures Delivers wheat & receives payment from A Reports EFP to the Exchange Exchange adjusts to show B is out of the Market.

Mechanics of Futures Market

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Open Interest
Open Interest refers to the number of futures contracts outstanding. It is the total no. of open positions waiting to be liquidated before the contracts maturity. Todays newspaper carry yesterdays trading data and day before yesterdays Open Interest data. Three rules regarding open interest Any trade (long or short) initiated afresh raises OI Any trade (long or short) that squares up existing position lowers OI Every trade needs a buyer & a seller

Mechanics of Futures Market

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Open Interest : An Example

Trader 1 Trader 2 Trader 3 Trader 4 Trader 5 Long Short Long Short Long Long Short Short Long Short Open Interest 20 20 40 20 0

Mechanics of Futures Market

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Pay-off from a Forward Contract

Consider a trader who has entered into a 3-month Long position to buy 100 kg. of Silver @ Rs 2000/per kg. At the end of 3-months, if the price is Rs 2500/- per kg, then the trader has made a profit of Rs. 500/per kg. At the end of 3-months, if the price is Rs 1900/- per kg, then the trader has made a loss of Rs. 100/per kg. In general, the pay-off from a long position in the Forward/Futures Contract is: Spot Price on Maturity (ST) less Delivery Price(K)
Mechanics of Futures Market 28

Pay-off from a Forward Contract

Pay-off from a Short position in the Forward/Futures Contract is: Delivery Price (K) less Spot Price on Maturity (ST) These pay-offs represents total profit/loss from the contract, as it costs nothing to enter into a Forward/Futures contract
K Profit Profit ST
Pay-off : Long Position
Mechanics of Futures Market

K ST
Pay-off : Short Position
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