Chapter 2

Mechanics of Futures
Markets

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Futures Contracts
Available on a wide range of assets
Exchange traded
Specifications need to be defined:
What can be delivered,
Where it can be delivered, &
When it can be delivered
Settled daily

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Specification of a future contract
Assets
Contract size
Delivery arrangements
Delivery months
Price Quotes
Price limits and position limits

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FUTURES PRODUCTS AVAILABLE IN INDIA

Single stock futures

Equity index futures
Interest rate futures
Commodity futures
Currency futures
Volatility futures

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Contract details- Equity Market
Product: Index and individual securities(206 approved
by NSE)
Index futures: (6) nifty 50, Indices of Bank
(12),Infrastructure (25), IT(20) Midcap 50,PSE(20),
CPSE (10)
Trading cycle : 3 months, Price step Rs0.05
Lot size: index 50, individual varies
Expiry date: Last Thursday of the expiry month
Price band: Operating range of 10% of base price for
index and 20% for individual securities
Qty freez: based on Index level
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CURRENCY FUTURES
4 pairs i.e USD-INR, GBP-INR,
EUR-INR,JPY-INR
Lot size: 1000 for USD,BPB,EUR and
100000 for JPY
Tick size: Re 0.0025 0.25 paise

Trading cycle: 12 months

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CURRENCY FUTURES.. Contd
Operating Range: 3% of base price upto 6
month and 5% beyond 6 months
Position Limit : 15% of OI
Margin: ( based on SPAN)
1% of the MTM value of OI for USD/INR
0.3% for EUR/INR
0.5% for GBP/INR
0.7% for JPY/INR
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INTREST RATE FUTURES
6 years,10 years and 13 years GOI securities
91days Treasury Bill
Tick Size Re 0.01
Value of each contract Rs 2,00,000
Lot size 2000
Operating range +/- 2%
Settlement price as stipulated by NSCCL
from time to time and settled in cash
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Commodity futures
Traded on NCDEX, NMCX and MCX
Bullion, Base Metal, Energy and agricultural
commodities.
GOLD
Price: Ex Ahamedabad
Tick size : Re 1 per 10gm
Trading unit 1 Kg. Maximum : 10 Kg. OI 5 ton
Price limit : 3% further enhancement 6%
Cooling period :15 Minutes,
Initial Margin :4 % of SPAN
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Convergence of Futures to Spot (Figure
2.1, page 29)

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)

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Margins
A margin is cash or marketable securities
deposited by an investor with his or her
broker
The balance in the margin account is
adjusted to reflect daily settlement
Margins minimize the possibility of a loss
through a default on a contract

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Margin Cash Flows
A trader has to bring the balance in the margin
account up to the initial margin when it falls below the
maintenance margin level
A member of the exchange clearing house only has
an initial margin and is required to bring the balance
in its account up to that level every day.
These daily margin cash flows are referred to as
variation margin
A member is also required to contribute to a default
fund
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Example of a Futures Trade
An investor takes a long position in 2
December gold futures contracts on June
5
contract size is 100 oz.
futures price is US$1,450
initial margin requirement is
US$6,000/contract (US$12,000 in total)
maintenance margin is US$4,500/contract
(US$9,000 in total)

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A Possible Outcome
Day Trade Settle Daily Cumul. Margin Margin
Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,450.00 12,000
1 1,441.00 −1,800 − 1,800 10,200
2 1,438.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,436.20 −780 −2,760 9,240
7 1,429.90 −1,260 −4,020 7,980 4,020
8 1,430.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,426.90 780 −4,620 15,180

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Margin Cash Flows When Futures
Price Increases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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Margin Cash Flows When Futures Price
Decreases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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Some Terminology
Open interest: the total number of contracts
outstanding
equal to number of long positions or number of short
positions
Settlement price: the price just before the final
bell each day
used for the daily settlement process
Volume of trading: the number of trades in one
day
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Key Points About Futures
They are settled daily
Closing out a futures position involves
entering into an offsetting trade
Most contracts are closed out before
maturity

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Crude Oil Trading on May 14,
2013 (Table 2.2, page 36)
Open High Low Prior Last Change Volume
Settle Trade

Jun 2013 94.93 95.66 94.50 95.17 94.72 −0.45 162,901

Aug 2013 95.24 95.92 94.81 95.43 95.01 −0.42 37,830

Dec 2013 93.77 94.37 93.39 93.89 93.60 −0.29 27,179

Dec 2014 89.98 90.09 89.40 89.71 89.62 −0.09 9,606

Dec 2015 86.99 87.33 86.94 86.99 86.94 −0.05 2,181

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Collateralization in OTC Markets
It is becoming increasingly common for transactions
to be collateralized in OTC markets
Consider transactions between companies A and B
These might be governed by an ISDA Master
agreement with a credit support annex (CSA)
The CSA might require A to post collateral with B
equal to the value to B of its outstanding transactions
with B when this value is positive.

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Collateralization in OTC
Markets continued
If A defaults, B is entitled to take possession
of the collateral
The transactions are not settled daily and
interest is paid on cash collateral
See Business Snapshot 2.2 for how
collateralization affected Long Term Capital
Management when there was a “flight to
quality” in 1998.
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Clearing Houses and OTC
Markets
Traditionally most transactions have been cleared
bilaterally in OTC markets
Following the 2007-2009 crisis, the has been a
requirement for most standardized OTC derivatives
transactions between dealers to be cleared through
central counterparties (CCPs)
CCPs require initial margin, variation margin, and
default fund contributions from members similarly to
exchange clearing houses

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Bilateral Clearing vs Central
Clearing House

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New Regulations
New regulations for trades between dealers
that are not cleared centrally require dealers
to post both initial margin and daily variation
margin
The initial margin is posted with a third party

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

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Questions
When a new trade is completed what are
the possible effects on the open interest?
Can the volume of trading in a day be
greater than the open interest?

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

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Regulation of Futures

In the US, the regulation of futures

markets is primarily the responsibility of
the Commodity Futures and Trading
Commission (CFTC)
Regulators try to protect the public
interest and prevent questionable trading
practices

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 Accounting & Tax
Ideally hedging profits (losses) should be
recognized at the same time as the losses
(profits) on the item being hedged
Ideally profits and losses from speculation
should be recognized on a mark-to-market
basis
Roughly speaking, this is what the accounting
and tax treatment of futures in the U.S. and
many other countries attempt to achieve

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Forward Contracts vs Futures Contracts (Table
2.3, page 43)

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

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

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