CHAPTER%201%20Futures%20Markets%20Introduction

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CHAPTER 1Futures Markets Introduction

• In this chapter, we introduce futures markets and
  their key players. This chapter is organized into
  the following sections
• Forward Contracts Versus Futures Contracts
• Institutions Facilitating Futures Trading
• Structure of Futures Exchanges
• Clearinghouses Role in Futures Markets
• Types of Futures Contracts
• The Social Function of Futures Markets
• Futures Markets Regulatory Framework and
  Taxation

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Forward Contracts

• A forward contract is an agreement between two
  parties (counterparties) for the delivery of a
  physical asset (e.g., oil or gold) at a certain
  time in the future for a certain price that is
  fixed at the inception of the contract.
• Forward contracts can be customized to
  accommodate any commodity, in any quantity, for
  delivery at any point in the future, at any place.

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EXAMPLE St. Bernard Puppy

• Counterparties Buyers and Seller
• Asset/Commodity St. Bernard Pup
• Delivery/Payment Time 6 weeks
• Priced Fixed 400
• Buyer Dog Fancier has a long position
• Seller Breeder has a short position
• Trading Volume Occurs when one trader buys
  another sells
• Open Interest Number of open contracts
  obligated for delivery
• If the dog owner had completed similar contracts
  for six different dogs, the open interest would
  be 6.

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Future Contracts

• Futures contracts are highly uniform and
  well-specified commitments for a carefully
  described good (quantity and quality of the good)
  to be delivered at a certain time and place
  (acceptable delivery date) and in a certain
  manner (method for closing the contract) and the
  permissible price fluctuations are specified
  (minimum and maximum daily price changes).

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Forward Versus Futures
COMPARISON FORWARD FUTURES
Trade on organized exchanges No Yes
Use standardized contract terms No Yes
Use associate clearinghouses to guarantee contract fulfillment No Yes
Require margin payments and daily settlements No Yes
Close easily No Yes
Regulated by identifiable agencies No Yes
Any quantity Yes No
Any product Yes No
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Futures Contract Standardized Terms

• Quantity
• Quality
• Expiration months
• Delivery terms
• Delivery differentials
• Delivery dates
• Minimum price fluctuation
• Daily price limits
• Trading days and hours

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CBOT Wheat Futures Contract

• Quantity 5,000 bushels per contract.
• Quality No. 2 Soft Red, No. 2 Hard Red Winter
  No. 2 Dark Northern Spring, or No. 1
  Northern Spring.
• Expiration July, September, December, March,
  May.
• Delivery Terms Wheat must be delivered at a
  regular or approved warehouse (e.g.,
  warehouses located Chicago Switching
  District).
• Delivery Any business days in the delivery
  month.
• Payment Seller received payment and delivers a
  warehouse receipt to the buyer.
• Price Fluctuation 1/4 cent per bushel.
• Daily Price Limit Trading price on a given day
  cannot differ from the preceding
  day's closing price by more
  than 30 cents/bushel (1,500/contract).
• Trading Days Wheat trades from 930 a.m. to
  115 p.m. Chicago time.

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Institutions Facilitating Futures Contract Trading

• There are two types of organizations that
  facilitate futures trading
• Exchange
• Exchanges are non-profit or for-profit
  organizations that offer standardized futures
  contracts for physical commodities, foreign
  currency and financial products.
• Clearinghouse
• A clearinghouse is agency associated with an
  exchange, which settles trades and regulates
  delivery. Clearinghouses guarantee the
  fulfillment of futures contract obligations by
  all parties involved.

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The Organized Exchange

• Not-for-Profit Organization Structure
• Members hold exchange memberships or seats that
  allow them to
• Trade on the exchange
• Have a voice in the exchanges operation
• For-Profit Organization Structure
• Members receive shares or stocks.
• DemutualizeConversion of an exchange from
  not-for-profit to for-profit.

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Organized Exchange Trading Systems

• Futures contracts trade by two systems
• Open Outcry
• Open outcry is a trading room where traders
  literally cry out their bids to locate another
  trader who is willing to trade with them.
• Electronic Trading PlatformsContracts are
  traded through electronic computer networks.
  Electronic trading represents over 50 of futures
  contracts trading.

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Organized Exchange Trading Players

• Speculator
• A trader who enters the futures market in pursuit
  of profit, accepting risk in the endeavor.
• Hedger
• A Trader who enters the futures market to reduce
  some pre-existing risk exposure.
• Broker
• An Individual or firm acting as an intermediary
  by conveying customers trade instructions.
  Account executives or floor brokers are examples
  of brokers.

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Major Futures Exchange
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Clearinghouses

• Guarantee that the traders will honor their
  obligations (solves issues of trust).
• Each trader has obligations only to the
  clearinghouse, not to other traders.
• Each exchange uses a futures clearinghouse.
• Clearinghouses may be part of a futures exchange
  (division), or a separate entity.
• Due to 2000 CFMA, clearing arrangements vary
  across industries.
• Clearinghouses are perfectly hedged by
  maintaining no futures market position of their
  own.

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The Function of Clearinghouses in Futures Markets

• Obligations without a clearinghouse

Buyer
Seller
Obligations with a clearinghouse
Seller
Buyer
Clearing- house
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Major Futures Clearing Organizations
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Margin and Daily Settlement

• Margin A good-faith deposit (or performance
  bond) made by a prospective trader with a broker.
  Margin can be posted in cash, bank letter of
  credit or short-term U.S. Treasury instruments.
• Daily Settlement
• Process by which traders are required to realize
  any losses in cash immediately (marked-to-the-mark
  et). The losses are usually deducted from the
  margin deposit.

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TYPES OF MARGIN

• There are 3 types of margin
• Initial MarginDeposit that a trader must make
  before trading any futures.
• Maintenance MarginWhen margin reaches a minimum
  maintenance level, the trader is required to
  bring the margin back to its initial level. The
  maintenance margin is generally about 75 of the
  initial margin.
• Variation MarginAdditional margin required to
  bring an account up to the required level.

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Futures Market Obligations
Table 1.2 shows a typical trading situation.
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Futures Market Obligations

• Based on Table 1.2, a trader purchases an oat
  Contract at 171 cents/ bushel at the close of day
  0. The initial margin is 1,400.
• DAY 1
• Contract closed _at_ 168 cents/bushel.
• Loss 3 cents/bushel or 150 .
• Required maintenance margin 1,100.
• Initial Margin 1,400(-) Daily Settlement
  150New Margin Balance 1,250
• DAY 2
• Loss 4 cents/bushel or 200
• Margin Balance 1,250(-) Daily Settlement
  200New Margin Balance 1,050
• Traders margin is below the maintenance margin.
  Margin call occurs.
• Variation Margin needed 350

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Account Equity Margin Requirements

• Figure 1.3 illustrates the account equity and
  margin requirements at different price levels.

• Insert figure 1.3 here

Notice that the trader would have received two
margin calls.
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Margin Cash Flows

Trader A
Clearingmember
Clearinghouse
Non-clearingmember
Trader B
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Closing a Futures Position

• There are 3 ways to close a futures position
• Delivery or cash settlement
• Offset or reversing trade
• Exchange-for-physicals (EFP) or ex-pit
  transaction

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Closing a Futures Position Delivery or Cash
Settlement

• DeliveryMost commodity futures contracts are
  written for completion of the futures contract
  through the physical delivery of a particular
  good.
• Cash settlementMost financial futures contracts
  allow completion through cash settlement.
• In cash settlement, traders make payments at the
  expiration of the contract to settle any gains or
  losses, instead of making physical delivery.

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Completion of Futures Contracts
Notice that very few contracts are delivered or
settled in cash.
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Delivery Differential

• Sometimes the quantity and quality do not exactly
  match the quantity and quality specified in the
  contract. In these cases, shorts are given the
  option of delivering non-standard commodities at
  non-standard delivery points. However, they may
  have to pay a surcharge or delivery
  differential relative to standard terms of the
  futures contracts.
• There are 2 types of delivery differential
• Quality Differentials
• Location Differential

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Delivery Differential

• Example CBOT Corn Contract Quality
  differentialGrade differential based on the
  standard par delivery grade.
• Premium grade No. 1 YellowPremium grade
  price differential 1.5cents/bushelPrice
  3.015/bushel
• Par grade No. 2 YellowPar grade price
  3/bushel
• Lower grade No. 3 YellowLower grade Price
  differential 1.5 cents/bushel or Price
  2.985/bushel
• Location differential Based relative to the
  standard delivery point or points specified in
  the futures contracts.
• Premium Location 2 cents/bushel for
  delivery at terminals between Lockport
  Seneca, Illinois
• Par Location Terminals between
  Chicago Burns Harbor, Indiana

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Closing a Futures Position Offset or Reversing
Trade

• If you previously sold a futures contract, you
  can close out your position by purchasing an
  identical futures contract. The exchange will
  cancel out your two positions. Table 1.4
  illustrates a reversing trade.

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Closing a Futures Position Exchange-for-Physicals
(EFP)

• Two traders agree to a simultaneous exchange of a
  cash commodity and futures contracts based on
  that cash commodity. Table 1.5 illustrates a EFP
  transaction.

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Types of Futures Contracts

• In this section, we will examine the following
  types of futures contracts
• Physical Commodity
• Foreign Currency
• Interest-Earning Asset
• Index (Stock Index)
• Individual Stocks

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Future Contracts Physical Commodity

• Contracts on physical commodities include
• Agricultural contracts
• Metallurgical contracts
• Energy contracts
• These commodities, excluding electricity, are
  physically settled and are highly storable.
• Trading varies from commodity to commodity.

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Future Contracts Physical Commodity
AGRICULTURAL METALLURGICAL ENERGY
Grains - corn, oats, rice, wheat Livestock - live hogs, cattle Forest - lumber and plywood Textiles - cotton Foodstuffs - rice cocoa, coffee, orange juice, sugar Gold Silver Aluminum Platinum Heating oil Crude oil Natural gas Unleaded gasoline Coal, propane Electricity
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Futures Contracts Foreign Currency and
Interest-Earning Asset
Foreign Currency Interest-Earning Assets
Australian dollar Brazilian Real Russian Ruble New Zealand dollar Swedish Krona South African Rand Norwegian Krone British pound Canadian dollar Japanese yen Swiss franc Mexican peso Euro Treasury bills Notes Bonds Eurodollar deposits Interest rate swaps Fed funds Municipal bonds
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Futures Contracts Index Based

• Traders must fulfill their obligation by
  reversing trade or cash settlement at the end of
  trading.

EXAMPLE OF INDEX BASED CONTRACTS EXAMPLE OF INDEX BASED CONTRACTS
US Exchanges Foreign Exchanges
Broad-Based stock indexes SP 500 Dow Jones Industrial Average Russell 2000 NASDAQ 100 Style-Based Indexes SP Barra Growth SP Barra Value Foreign Stock Indexes British FTSE 100 French CAC 40 Dow Jones Euro Stoxx 50 German DAX Brazillian Bovespa stock Japanese Nikkei 225 Korean KOSPI 200
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Future Contracts on Individual Stocks

• Permitted for trade in United States after the
  passage of the Commodity Futures Modernization
  Act of 2000 (CFMA).
• Also called single stock futures in the United
  States and universal futures in Great Britain.

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Relative Importance of Commodity Types

• INSERT FIGURE 1.5 HERE

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Changing Commodity Trading Volume

• INSERT FIGURE 1.6 HERE

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Social Function of Futures Markets

• Futures markets meet the needs of three groups of
  users
• Those who wish to discover information about
  future prices of commodities
• Those who wish to speculate
• Those who wish to hedge
• There are two main social functions of futures
  markets
• Price discovery
• Hedging
• Speculation is not regarded as a social function
  by itself, but it may have socially useful
  by-products.

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Social Function of Futures Markets

• PRICE DISCOVERY
• Futures market information helps people make
  better estimates of future prices.
• Futures market information helps people with
  their production or consumption decisions.
• Example silver Mine
• HEDGING
• Hedging is the prime social rationale for futures
  trading.
• Hedgers have a pre-existing risk exposure that
  leads them to use futures transactions as a
  substitute for a cash market transaction. By
  doing so, they are able to reduce or eliminate
  their risk.
• Example wheat Farmer

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Regulation of Futures Markets

• CEA
• Grain Futures Act of 1922, superseded by the
  Commodity Exchange Act (CEA) of 1936.
• The CEA was last amended by the Commodity Futures
  Modernization Act of 2000 (CFMA).
• CFMA
• Promotes competition and innovation in futures
  markets.
• Provides a predictable and calibrated regulatory
  structure tailored to the product, the
  participant, and the trading platform (the three
  Ps).

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The CFMAs Three Tiers of Regulation

• First Tier- Agricultural Commodities
• Futures on commodities (agricultural commodities)
  that Congress judged to be potentially
  susceptible to manipulation and that are offered
  to members of the public.
• Second Tier- Exempt Futures Contracts
• Futures contracts on metals and energy that are
  judged to be less susceptible to manipulation.
• Third Tier- Trade Principal to Principal Basis
• Contracts on financial products (swaps) that are
  privately-negotiated between large, sophisticated
  contract counterparties.

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Futures Markets Levels of Regulation (Market
Regulators)

• Brokers
• Exchanges and clearinghouses
• National Futures Association (NFA), industry
  self-regulatory body
• Commodity Futures Trading Commission (CFTC),
  federal governmental agency

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Market Regulators Brokers

• The Broker is responsible for
• Knowing the customer's position and intentions.
• Ensuring that the customer does not disrupt the
  market or place the system in jeopardy.
• Keeping the customer's trading activity in line
  with industry regulations and legal restrictions.

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Market Regulators Exchange Clearinghouses

• Futures exchanges and clearinghouses formulate
  and enforce rules to
• Prohibit fraud
• Prohibit dishonorable conduct
• Prevent defaulting on contract obligations

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Abusive Trading Practices
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Market Regulators National Futures Association
(NFA)

• The NFA seeks to prevent fraudulent and
  manipulative acts by
• Screening and test applicants for registration.
• Requiring members who handle customer funds to
  maintain adequate capital.
• Requiring members to keep accurate trading
  records.

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Market Regulators Commodity Futures Trading
Commission (CFTC)

• CFTC protects market participants from
  manipulation, abusive trading practices, and
  fraud by enforcing regulatory oversight of
• Futures exchanges
• Futures clearinghouses
• NFA
• The heart of the CFTCs market surveillance is
  its large-trader electronic reporting system.
  This reporting system helps identify potential
  concentrations of market power within a market
  and to enforce speculative position limits.

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Insert figure 1.7 here

• Figure 1.7 shows the place of the CFTC in the
  regulatory structure of the futures industry in
  the United States.

• Insert Figure 1.7 here

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Recent Regulatory Initiatives

• FASB ACCOUNTING RULES
• In 1998, The FASB adopted new rules for
  disclosure of risk positions in firms
  derivatives positions.
• CFMA 2000
• Allows futures trading on individual stocks and
  narrow-based stock indexes.
• Clarifies the legal status of privately-negotiated
  swap transactions.
• Provides a predictable and calibrated regulatory
  structure tailored to the product, the
  participant, and the trading platform.
• Allows exchanges to bring new contracts to market
  without prior regulatory approval.
• Establishes a set of standards, that permit
  futures exchanges and clearinghouses to use
  different methods to achieve federal
  requirements.
• Gives the CFTC clear authority to stop certain
  illegal, foreign exchange transactions aimed at
  defrauding small investors.
• Gives the CFTC separate oversight authority with
  respect to clearinghouse organizations.

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Recent Regulatory Initiatives

• TAXATION OF FUTURES TRADING
• 1981 LAWFutures positions must be
  marked-to-market at the end of the year.
• ACT of 1986Stipulates that short-term and
  long-term capital gains will be taxed at one
  rate.