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Futures Markets & Central Counter Parties

Futures Contracts

  • Traded at exchanges
  • Specification
    • What?
    • Where?
    • When? (it) can be delivered

  • Settled daily

  • Futures converge to spot Hull - Futures Markets & Central Counter Parties-1760007394331.webp

  • Margin
    • Cash/Marketable security deposited by investor with the broker
    • Balance adjusted daily to reflect daily settlement
    • to minimize possibility default loss
    • Cashflows
      • Retail Trader has to bring the balance to initial margin when it falls below maintenance margin level**
      • MoE clearing house has to maintain the initial margin in its account everyday (the balance cannot fall below the margin, but can be above it, the surplus can be withdrawn)
      • Daily margin cashflows = variation margin
      • MoE also requires to contribute to default fund.

Futures Trade Example

Long position in two December gold futures contracts on June 5

  • Contract size = 100 oz.
  • Futures price US$1750
  • Init margin: US $6000/contract (US$12000)
  • Maintenance margin: US$4500/contract (US$9000)
  • Note
    • For each oz., $1750 futures price
    • There are 100 oz. in this contract
    • There are two futures
    • On the first day, the trade price = 1750
    • We check the settle price every consecutive day
    • The daily gain = 1741 - 1750 per oz. = -$9 per oz.
      • 100 oz. \(\implies\) -$900
      • 2 contracts \(\implies\) -$1800
    • If the margin balance drops below 9000, a margin call is made to replenish to the initial margin (NOT THE maintenance margin)

Margin Cash Flows

When Futures price increases

  • Short trader \(\to\) Broker \(\to\) Clearing house member \(\to\) Clearing house
  • Clearing house \(\to\) Clearing house member \(\to\) Broker \(\to\) Long trader

When Futures price decreases

  • Long trader \(\to\) Broker \(\to\) Clearing house member \(\to\) Clearing house
  • Clearing house \(\to\) Clearing house member \(\to\) Broker \(\to\) Short trader
  • Price increase, the person who is going to get the asset gets a profit (strike is fixed, price increases… long can buy at a lower (strike) price than the spot price)
  • Price decrease, the person who sold the asset gets the advantage (strike is fixed, price decreases… short can sell at a higher (strike) price than the spot price)

Terminology

  • Open interest
    • total contracts O/S
    • # of long positions = # of short positions
  • Settlement price
    • price just before the final bell each day
    • for the daily settlement process
  • Volume of trading
    • # of trades in one day

Key points about futures

  • settled daily
  • closing out \(\implies\) offsetting trade
  • most contracts closed out before maturity

Delivery

  • If futures not closed out before maturity
    • settled by delivering underlying asset
    • In case of options about what, where & when, the short position chooses.
  • Few contracts are settled in cash
    • e.g. stock indices & Eurodollars

Types of Orders

Actual operations are referred to market order

Limit
  • Order to buy or sell at a specific (or better) price
  • Buy limit order is placed below current market price, executes if price drops to or lower.
  • Sell limit order is placed above current price, executes only if the prices to or above.
  • You get your price (or better) but no guarantee of execution of order.
Stop-loss Order
  • Becomes a market order when a specific "stop price" is reached, to limit losses or protect profits.
  • sell-stop below the current price on a long position.
    • if market price \(\leq\) stop price, trigger sell
  • buy-stop above current price on a short position
  • Execution guaranteed, but price is not (slippage may occur)
Stop-limit Order
  • Hybrid of stop and limit order to give more price control
  • STOP Price when hit, becomes a limit order at specified limit - LIMIT Price
  • Protects from slippage, but order may not get filled at all.
Market-if-touched (MIT) order
  • Becomes market order when price moves in a favorable direction to touch specified price
  • Inverse of stop-order
  • buy MIT below current price
    • hoping to buy on a dip
  • sell MIT above current price
    • hoping to sell on a rally
  • Tool to enter a market at what is more advantageous, can experience slippage

Regulation of Futures

  • Primary responsibility of Commodity Futures & Trading Commission (CFTC)
  • Try to protect public interest and prevent questionable trading practices

Accounting & Tax

  • Ideally, hedging profits should be recognized at the same time as losses on the item being hedged (TIME)
  • Ideally, profits and losses from speculation should be recognized on a margin basis (AMOUNT)

Forwards vs Futures

Forwards Futures
Private contract between 2 parties Exchange traded
Non-standard contract Standard Contract
1 specified delivery date Range of delivery date
Settled at the end of contract Settled daily
Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity
Some credit risk Virtually no credit risk

Foreign Exchange Quotes

  • Futures exchange rates quoted as = number of USD per unit of foreign currency
  • Forward exchange rates quoted same way as spot exchange rates.
    • GBP, EUR, AUD, NZD = \(\dfrac{\text{USD}}{\text{unit of foreign curr.}}\)
    • INR, CAD, JYP = \(\dfrac{\text{unit of foreign curr.}}{\text{USD}}\)

Bilateral Clearing vs Central Clearing

Hull - Futures Markets & Central Counter Parties-1760024135364.webp

Bilaterally Cleared

  • ISDA Master agreement with credit support annex (CSA)