Chapter 6

Introduction to Futures

• Because futures are so very similar to forwards, be

sure that you have read Section 3.1.
• A futures contract is an agreement to buy (if you are
long) or sell (if you are short) something in the
future, at an agreed upon price (the futures price).
• Futures exist on financial assets (debt instruments,
currencies, stock indexes), and real assets (gold,
crude oil, wheat, cattle, cotton, etc.)

©David Dubofsky and 6-1

Thomas W. Miller, Jr.
 A Comparison of Futures Contracts
and Forward Contracts
• Both types of contracts specify a trade between two
counter-parties:
– There is a commitment to take delivery of an asset (this is
the buyer, or the long)
– There is a commitment to deliver an asset (this is the seller,
or the short)
• Many times, futures contracts and forward contracts
are substitutes.
• However, at specific times, the relative costs, liquidity,
and convenience of using one market versus the
other will differ.
©David Dubofsky and 6-2
Thomas W. Miller, Jr.
Futures and Forwards: A Comparison Table
Futures Forwards
Default Risk: Borne by Clearinghouse Borne by Counter-Parties
What to Trade: Standardized Negotiable
The Forward/Futures Agreed on at Time Agreed on at Time
Price of Trade Then, of Trade. Payment at
Marked-to-Market Contract Termination
Where to Trade: Standardized Negotiable
When to Trade: Standardized Negotiable
Liquidity Risk: Clearinghouse Makes it Cannot Exit as Easily:
Easy to Exit Commitment Must Make an Entire
New Contrtact
How Much to Trade: Standardized Negotiable

What Type to Trade: Standardized Negotiable

Margin Required Collateral is negotiable
Typical Holding Pd. Offset prior to delivery Delivery takes place

©David Dubofsky and 6-3

Thomas W. Miller, Jr.
Other Unique Features of Futures Contracts

• Some futures contracts have daily price limits.

• Some futures contracts (Euro$, T-bills, stock index futures,

currencies) have one specific delivery date; others (T-bonds, crude
oil) give the short the option of choosing which day (usually in the
delivery month) to make delivery.

• Some futures contracts (e.g., T-bonds) let the seller choose the
quality of good to deliver, within a specified quality range.

• Some futures contracts (Euro$, stock index futures, feeder cattle)

are cash settled.

• Note that a futures contract is like a portfolio of forward contracts

(time series).
©David Dubofsky and 6-4
Thomas W. Miller, Jr.
 Futures Contracts
Payoff Profiles
profit Long futures profit Short futures

F(0,T) F(1,T) F(0,T) F(1,T)

The long profits if the next day’s futures The short profits if the next day’s
price, F(1,T), exceeds the original futures price, F(1,T), is below the
futures price, F(0,T). original futures price, F(0,T).

©David Dubofsky and 6-5

Thomas W. Miller, Jr.
 Reading Futures Prices (8/28/02)
Crude Oil, Light Sweet (NYM) - 1,000 bbls.; $ per bbl.
Lifetime Open
Open High Low Settle CHG High Low Int
Oct 28.87 29.00 28.17 28.34 -0.49 29.65 19.50 175667
Nov 28.62 28.75 28.08 28.23 -0.37 29.35 19.55 53739
Dec 28.64 28.64 28.00 28.12 -0.25 28.90 15.50 58227
Ja03 28.04 28.10 27.83 27.84 -0.12 28.40 19.90 27383
Feb 27.51 27.63 27.43 27.51 -0.05 28.05 19.70 11830
Mar 27.12 27.30 27.04 27.16 -0.01 27.45 20.05 15787
Apr 26.70 26.70 26.70 26.82 0.02 27.10 20.55 8424
May 26.50 26.50 26.50 26.49 0.03 26.68 20.70 5319
June 26.15 26.27 26.10 26.18 0.03 26.45 19.82 18205
July 25.75 25.75 25.75 25.91 0.03 26.05 20.76 4950
Dec 25.05 25.05 24.80 24.86 0.09 25.10 15.92 24864
Jn04 24.30 24.30 24.30 24.28 0.11 24.40 20.53 6804
Dec 23.90 23.90 23.85 23.86 0.17 24.00 16.35 14741
Dc08 22.30 22.30 22.30 22.20 0.17 22.30 19.75 6060
Est vol 209,648; vol Tue 221,229; open int 471,059, +5,139.

©David Dubofsky and 6-6

Thomas W. Miller, Jr.
 Margin Requirements, I.
• Futures exchanges require good faith money from counter-
parties to futures contracts, to act as a guarantee that each will
abide by the terms of the contract.

• This money is called margin.

• Each futures exchange is responsible for setting the minimum

initial margin requirements for their futures contracts.
– The initial margin is the money a trader must deposit into a trading
account (margin account) when establishing a futures position.
– Many futures exchanges establish initial margin requirements by
using computer algorithms, the most popular of which is called
SPAN (Standard Portfolio ANalysis of risk).

©David Dubofsky and 6-7

Thomas W. Miller, Jr.
 Margin, August 1, 2001

Contract Exch. Init-Spec Init-Spr Maint-Spec Maint-Spr

S&P 500 CME $21,563 $250 $17,250 $250

Nikkei 225 CME 6750 135 5000 135
Japanese Yen CME 2835 68 2100 68
Euro CME 2349 250 1740 250
British Pound CME 1418 68 1050 68
Eurodollar CME 810 450 600 450
TBill CME 540 203 400 150
TBond CBOT 2363 350 1750 350
10 yr. TNote CBOT 1620 350 1200 350
Gold CMX 1350 100 1000 100
Crude Oil NYM 3375 1000 3000 1000*

©David Dubofsky and 6-8

Thomas W. Miller, Jr.
 Margin Requirements, II.

• SPAN uses historical price data to set initial margin to what is

believed to be a worst case one-day price movement.

• An exchange can change the required margin anytime.

• Initial Margin will increase if price volatility increases, or if the

price of the underlying commodity rises substantially.

• The margin required for trading futures differs from the concept
of margin when buying common stock or bonds.
– Margin for Common Stock: The fraction of the asset's cost that
must be financed by the purchaser's own funds. The remainder is
borrowed from the purchaser’s stock broker.
– Margin for Futures: A good faith deposit, or collateral, designed to
insure that the futures trader can pay any losses that may be
incurred. Futures margin is not a partial payment for a purchase.

©David Dubofsky and 6-9

Thomas W. Miller, Jr.
 Margin Requirements, III.
• If the equity in the account falls to, or below, the maintenance margin
level, additional funds must be deposited to restore the account
balance to the initial margin level.
• E.g., suppose the initial margin required to trade one gold futures
contract is $1000, and the maintenance margin level is $750. Then,
an adverse change of $2.60/oz. will result in a margin call.
• Because one gold futures contract covers 100 oz. of gold, a decline of
$2.60/oz. in the futures price will deplete the equity of a long position by
$260. The trader with losses must then deposit sufficient funds to bring
the equity in the account back to the initial margin of $1000.
• The margin that is deposited in order to meet margin calls is called
variation margin. If the trader does not promptly meet the margin call,
his FCM will liquidate the position.

©David Dubofsky and 6-10

Thomas W. Miller, Jr.
 Margin Requirements, IV.
• Note that once a trader receives a margin call, he must meet
that call, even if the price has subsequently moved in his favor.

• For example, suppose the futures price of gold declines to a

level that triggers a margin call on day t.

• On day t+1, the trader who is long a gold futures contract will
receive a margin call, regardless of the futures price of gold on
day t+1.

• Even if the gold futures price has substantially rebounded, the

trader must still deposit variation margin into his account.

©David Dubofsky and 6-11

Thomas W. Miller, Jr.
 Margin Requirements, V.
• FCM's will often set initial and maintenance margin requirements at
higher levels than the minimum requirements specified by the
exchanges.

• Margin requirements also differ for different traders, depending on

whether the position is part of a spread, a hedge or a speculative
trade.

• Margin requirements on spreads and hedges are less than those on

speculative positions. Hedgers must sign a hedge account
agreement, declaring that the trades in the account will in fact be
hedges as defined by the Commodity Exchange Act of 1936, and as
specified by the CFTC.

©David Dubofsky and 6-12

Thomas W. Miller, Jr.
 Margin Requirements, VI.
• In a spread, a trader will be long one contract, and also be short
another related contract.

• The two contracts may be on the same good, but for different
delivery months (called a calendar spread, or an intermonth
spread), or be on two similar goods for delivery in the same
month (called an intercommodity spread, or an intermarket
spread).

©David Dubofsky and 6-13

Thomas W. Miller, Jr.
 Marking to Market, Example.
• The entire daily resettlement process is illustrated with the
following example.
• On November 6, 2001, you sell one gold futures contract for
delivery in December 2001.
• You sell the contract at 10 AM, when the futures price is
$285/oz.
• The initial margin requirement is $1000, and that sum of money
is transferred from your cash account to your margin account.
• The settlement price at the close on November 6 is $286.40/oz.
• Your account is marked to market, and your equity at the close
is $860.
• The futures price rose by $1.40/oz, and one contract covers 100
oz of gold; therefore, you have lost $140 on the short position.

©David Dubofsky and 6-14

Thomas W. Miller, Jr.
 Marking to Market, Table.
On all subsequent days, the account is marked to market. If the
futures price falls, your equity rises. If the futures price rises, your
equity declines. Maintenance margin calls will have to be met if
your account equity falls to a level equal to or below $750.

Maint.
Gold Cash Begin. Margin Ending
Date Price Flow Equity Call Equity
11/6 285.00 1000
11/6 (end) 286.40 (140) 860 0 860
11/7 288.80 (240) 620 380 1000
11/10 289.00 (20) 980 0 980
11/11 288.60 40 1020 0 1020
11/12 290.70 (210) 810 0 810
11/13 292.80 (210) 600 400 1000
11/14 292.80 0 1000 0 1000

©David Dubofsky and 6-15

Thomas W. Miller, Jr.
 Basis

• Understanding the basis is a key to hedging.

• Basis = futures price - spot price (financial futures)
• Basis = spot price - futures price (agricultural futures)
• Basis = “net cost of carry” (see chapter 5)
– F = S(1 + r) = S + rS = S + carry costs
– F - S = carry costs
– For stock index futures, F = S(1 + r) - FV(divs).
– If we define the dividend yield over the life of the contract as d:
F = S + rS - dS = S(1 + r - d)
F - S = S(r - d) = net cost of carry

©David Dubofsky and 6-16

Thomas W. Miller, Jr.
 Convergence
• On the delivery date, ST = FT

• That is, at delivery (expiration) the basis equals zero.

• Question: What if ST did not equal FT?

• BTW, this is not the last time we will ask one of these ‘arbitrage’
questions.

©David Dubofsky and 6-17

Thomas W. Miller, Jr.
 Types of Futures Contract Orders

• Every order must include:

– Whether the trader wants to buy or sell
– The name of the commodity
– The delivery month and year of the contract
– The number of contracts
– The exchange on which they trade
– Day order or “good-til-canceled” order
– Market or limit order; if a limit order, then specify a limit price
– There are other order types; see section 6.10.

©David Dubofsky and 6-18

Thomas W. Miller, Jr.
 Should Futures Prices Equal
Forward Prices?
• Assume perfect markets.

• If interest rates are non-stochastic (i.e., known), then

futures prices = forward prices. This is because futures
can be transformed into forwards and the impact of the
daily resettlement in futures contracts can be eliminated.

• If corr(DF, Dr) > 0, then futures prices > forward prices

• If corr(DF, Dr) < 0, then futures prices < forward prices

©David Dubofsky and 6-19

Thomas W. Miller, Jr.
 For More Information

• The major futures exchanges have websites. For links to some

of them, see: http://www.numa.com/ref/exchange.htm.

• The exchanges offer many free brochures, booklets and

information. Call them (or go to their websites) to get catalogs.
For example:
– CBOT: 1-800-843-2268 (1-800-THE-CBOT)
– CME: 1-800-331-3332

©David Dubofsky and 6-20

Thomas W. Miller, Jr.