Futures : A Primer

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Futures A Primer

• By A.V. Vedpuriswar

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Introduction

• Futures contracts are very much like forward
  contacts .
• They are similar in that both
• -- Can lock us into definite rates
• Can be either deliverable or cash settlement
  contracts.
• Have right and obligation

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Futures and forwards

• Futures contracts differ from forward contracts
  in the following ways
• Futures contracts trade on organized exchanges.
• Forwards are private contracts and do not trade.
• Futures contracts are highly standardized.
• Forwards are customized contacts satisfying the
  needs of the parties involved.
• A single clearinghouse is the counterparty to all
  futures contracts.
• Forwards are contracts with the originating
  counterparty.
• The government regulates futures markets.
• Forward contracts are usually not regulated.

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Standardisation

• A major difference between forwards and futures
  is that futures contracts have standardized
  contract terms.
• Futures contracts specify the quality and
  quantity of goods that can be delivered, the
  delivery time, and the manner of delivery.
• Standardization tells traders exactly what is
  being traded and the conditions of the
  transaction.
• Uniformity promotes market liquidity.
• The purchaser of a futures contract is said to
  have gone long or taken a long position.
• The seller of a futures contact is said to have
  gone short or taken a short position.

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Clearing house

• Each futures exchange has a clearinghouse.
• The clearing house guarantees that traders in the
  futures market will honor their obligations.
• The clearing house splits each trade and acts as
  the opposite side of each position.
• The clearing house acts as the buyer to every
  seller and the seller to every buyer.
• Either side of the trade can reverse positions at
  a future date without having to contact the other
  side of the initial trade.

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Margin

• Initial margin is the money that must be
  deposited in a futures account before any trading
  takes place.
• It is set for each type of underlying asset.
• Initial margin per contract is relatively low
  and equals about one days maximum price
  fluctuation on the total value of the contracts
  underlying asset.
• Maintenance margin is the amount of margin that
  must be maintained in a futures account.

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Margin

• If the margin balance in the account falls below
  the maintenance margin , additional funds must be
  deposited to bring the margin balance back up to
  the initial margin requirements.
• Variation margin is the funds that must be
  deposited into the account to bring it back to
  the initial margin amount.
• If account margin exceeds the initial margin
  requirement, funds can be withdrawn or used as
  initial margin for additional positions.

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Settlement price

• The settlement price is used to make margin
  calculations at the end of each trading day.
• The settlement price is analogous to the closing
  price for a stock but is not simply the price of
  the last trade.
• It is an average of the prices of the trades
  during the last period of trading, called the
  closing period, which is set by the exchange.
• This prevents manipulation by traders.
• Marking to market is the process of adjusting the
  margin balance in a futures account each day,
  based on the new settlement price.

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Termination

• There are four ways to terminate a futures
  contract
• Delivery A short can terminate the contract by
  delivering the goods, a long by accepting
  delivery and paying the contract price to the
  short. This is called delivery.
• Cash-settlement
• A reverse, or offsetting, trade
• Exchange for physicals. Here you find a trader
  with an opposite position to your own and deliver
  the goods and settle up between yourselves, off
  the floor of the exchange (called an ex-pit
  transaction.)

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Delivery options

• Some futures contracts grant delivery options to
  the short options on what, where and when to
  deliver.
• Some Treasury bond contracts give the short a
  choice of several bonds that are acceptable to
  deliver and options as to when to deliver during
  the expiration month.
• Physical assets, such as gold or corn, may offer
  a choice of delivery locations to the short.
• These options can be of significant value to the
  holder of the short position in a futures
  contact.

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Futures Contracts

• Treasury bill futures contacts are based on a 1
  million face value 90-day (13-week) T-bill and
  settle in cash.
• The price quotes are 100 minus the annualized
  discount in percent on the T-bills.
• Eurodollar futures are based on 90-day LIBOR,
  which is an add-on yield, rather than a discount
  yield.
• By convention, however, the price quotes follow
  the same convention as T-bills and are calculated
  as (100 annualized LIBOR in percent).
• Futures contracts covering several popular stock
  indices are traded.
• The multiplier can vary from contract to contract.

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Problem
Suppose I have a long position in wheat futures
contracts. Each contract consists of 5000
bushels with initial margin 250 and
maintenance margin 200. What will be the
margin position if the price falls by 0.01 on
the first day and 0.02 on the second day.
Solution Initial margin 250 Day 1
Decrease in contract value (5000) (.01)
50 Margin account falls to 200. Day 2 Decrease
in contract value (5000) (.02) 100 Margin
account falls to 100 So Margin call 150 to
bring the amount in the account back to the
initial margin.
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Problem
Four 150,000 Euro futures contracts are sold at a
price of 1.0334. The next day the price settles
at 1.0280. By how much will the margin account
change?
Solution There is a fall in price. This is a
short position. So there will be a gain in the
margin account. (1.0334 1.0280) (150,000)
(4) 3240.00
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Problem
A 90 day T Bill future is quoting at 98.42. What
is the delivery price? Assume face value is
1,000,000.
Solution 98.42 means annualised discount of
1.58. This in turn means discount of 1.58/100 x
90/360 for 90 days .00395 Delivery price (1
- .00395) (1,000,000) 996,050
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Problem
A stock index has a multiplier of 250. If the
index future changes from 1041 to 1048, what is
the gain for a long position?
Solution (1048 1041) (250) 1750
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Problem
I take a long position in Eurodollar interest
rate futures contracts (1 million face value) at
98.24 and close out at a price of 98.37. What is
my gain or loss?
Solution Higher the price, lower the
discount. Lower the discount, higher the value of
the bond. So as price of futures increases, I
make a gain. Gain 98.37 98.24 / 100 X
90/360 x (1,000,000) 325
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Futures trading in India

• NSE commenced trading in index futures on June
  12, 2000.
• The index futures contracts are based on the
  popular market benchmark SP CNX Nifty index.
• NSE defines the characteristics of the futures
  contract such as the underlying index, market
  lot, and the maturity date of the contract.
• The futures contracts are available for trading
  from introduction to the expiry date.
• .

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• Contracts have a maximum of 3-month trading cycle
  - the near month (one), the next month (two) and
  the far month (three).
• A new 3 month contract is introduced on the
  trading day following the expiry of the near
  month contract.
• This way, at any point in time, there will be 3
  contracts available for trading in the market
  i.e., one near month, one mid month and one far
  month duration respectively.
• Contracts expire on the last Thursday of the
  expiry month. If the last Thursday is a trading
  holiday, the contracts expire on the previous
  trading day.

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• The value of the futures contracts on Nifty may
  not be less than Rs. 2 lakhs at the time of
  introduction.
• The permitted lot size for futures contracts
  options contracts shall be the same for a given
  underlying or such lot size as may be stipulated
  by the Exchange from time to time.
• The price step in respect of SP CNX Nifty
  futures contracts is Re.0.05.
• Base price of SP CNX Nifty futures contracts on
  the first day of trading would be theoretical
  futures price..
• The base price of the contracts on subsequent
  trading days would be the daily settlement price
  of the futures contracts.