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1
INTRODUCTION TO FUTURES
Lakshmi Ananthanarayan
NOV 2013
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2 Basic Concepts
Futures are exchange traded contracts to sell or buy financial
instruments or physical commodities for future delivery at an agreed
price on designated contract markets
Agreement to buy or sell a specified quantity of financial instrument/
commodity in a designated future month at a price agreed upon by the
buyer and seller
Contracts have certain standardized specifications
Futures exchanges use clearinghouses to guarantee that the terms of the
futures contracts are fulfilled
The clearinghouse is the actual buyer of the contract from the short
seller. And the clearinghouse is the actual seller of the long contract. If
either party defaults on the contract the clearinghouse steps in and
becomes the seller or buyer of last resort
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3 Types of futures
Classification based on the underlying asset:
A foreign currency
An interest-earning asset (debenture or time deposit)
An index (stock index)
A physical commodity (wheat, corn etc.)
Futures on individual stock
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4 Characteristics of futures contract specified by exchange
Asset (includes quality)
Price
Contract size
Amount of asset to be delivered under one contract
Delivery arrangements
Location important when transportation costs are significant
Delivery Month
Contracts are referred to by the month in which delivery is to take place
Tick size
Exchange specifies minimum price fluctuation for the contract
Daily price limits
Exchange sets the maximum price movement for a contract during a day
Limit up, Limit down
Position limits
Exchange sets a maximum number of contracts that a speculator may hold in order to
prevent speculators from having an undue influence on the market
Such limits do not apply to hedgers
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5 Clearing House Mechanism
Each contract is substituted by two contracts in such a way that the clearing house becomes the buyer
to every seller and seller to every buyer
This mechanism effectively removes counterparty risk from the futures transaction
Clearing house will never have open positions in the market
Important functions of a clearing house – ensuring adherence to system & procedures for smooth
trading; minimizing credit risk by being a counterparty to all trades; accounting for all gains / losses
on daily basis; monitoring the speculation margins; ensuring delivery of payment for the assets on the
maturity date for all the outstanding contracts
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6 Margins
Minimization of credit risk of the clearing house – imposition of margins
Margins are amounts that the buyers and sellers of futures contracts have to deposit as
collateral for their positions – upfront posting of collaterals that can be seized should the other
party default – akin to performance bonds
Marking to market – daily procedure of adjusting the margin account balance for daily
movements in the futures price – involves settlement of gains and losses on the contract
everyday – avoids accumulation of large losses over time, potentially leading to an expensive
default
Initial margin - Amount required to open a futures contract
Maintenance margin – minimum margin account balance required to retain the futures
position
Variation margin – When the margin account balance falls below the maintenance margin, the
investor gets a margin call, and he or she must bring the margin account back to the initial
margin amount. This amount is the variation margin
The level of margin called is set by the clearing house and is usually a function of the volatility
of the underlying cash market. It is calculated to cover the maximum expected move in the cash
market in one day (i.e. the highest probable loss incurred on a contract between daily margin
calls)
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7 Example 1
An investor instructs a broker to buy a futures contract
on gold for USD 293.60 per ounce with an April
delivery date. Each gold contract represents 100 troy
ounces and is quoted on a per ounce basis. Assume
that the initial margin is $2,500, the maintenance
margin is $2,000 and the futures price drops to $ 291
at the end of the first day and $ 285 at the end of the
second day. Compute the amount in the margin
account at the end of each day for the long position
and any variation margin needed.
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8 Example 2
An investor buys 5 futures contracts on gold at MCX of India.
Each contract is for 100 gm of gold. The price quotation is Rs
15,550 per 10 gm. The tick size is Re 1. Initial margin is set at
4%, while minimum margin is 90% of the initial margin. Find
out the following:
a) What is the minimum change in the value of a contract?
b) What is the amount of initial margin the investor has to
deposit with the exchange?
c) At what price level would the investor get the margin call?
d) If the investor had sold the contracts, what price level
would trigger a margin call?
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9 Example 3
A US firm enters into 6 long Japanese yen futures contract on September 22nd, at a
price of $0.00892/¥. Subsequently, the settlement prices of the contract are:
The standard size of a contract is 1,25,00,000 yen.
a. Compute the cash flows incurred by the firm at the end of each day because of
the marking to market.
b. If the initial margin is $ 3,000/contract, and the maintenance margin is $
1750/contract, show the firm margin account and amount of additional
deposits to be made (assuming no withdrawals).
Date Futures Price ($/¥)
Sep 22nd 0.008854
Sep 25th 0.008665
Sep 26th 0.008456
Sep 27th 0.008704
Sep 28th 0.008548
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10 Differences between forwards and futures
Futures contracts always trade on an organized exchange; Forwards OTC
Futures contracts have standardized terms; Forwards customized terms
Futures – more liquid; Forwards – less liquid
Futures exchanges use clearinghouses to guarantee that the terms of the futures
contract is fulfilled
Futures – follows daily settlement; Forwards – settlement happens at the end of
the period
Margins and daily settlement are required with futures trading; Forwards –
margins not required
Futures positions can easily be closed. The trader has the option of taking physical
delivery. Placing an offsetting trade. And arranging an exchange-for-physicals
transaction. The futures exchange makes exiting a contract relatively easy
Forward contract markets are self regulating and futures markets are regulated by
certain agencies dedicated to this responsibility
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11 Open Interest
Open Interest (OI) measures the number of contracts held at
the conclusion of a trading session
It is a description of participation - traders show their
conviction to the market participation by taking their positions
“home” with them, at least overnight
Important as many transactions may take place during the day
without initiating new contracts
Open interest is calculated by adding all of the contracts that
are associated with opening trades and
subtracting all of the contracts that are associated with closing
trades
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12
An example
TradeOpen
Interest
No. of
Contracts
Traded
Day 1 A sells 10 contracts which are bought by B 10 10
Day 2 C sells 5 contracts which are bought by D 15 5
Day 3B exits his position of 10 contracts which are bought by
E15 10
Day 4D exits his position of 5 contracts which are bought by
A to partially close his position10 5
Day 5E sells his 10 contracts bought by A and C, 5 each to
fully close their position0 10
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13 Example 4
The following is an extract from futures price quotations in a financial newspaper as
they appeared on August 11, 1989. The quotations are as of the close of trading on
August 10, 1989. Explain the various terms and numbers given below.
Japanese Yen (IMM): 12.5 million yen; $ per yen(.00)
Est vol 16,065; vol Wed 22,580; open int 59,486
Open High Low Settle Change High Low
Open
Interest
Sept 0.6682 0.6692 0.6673 0.6677 +0.0002 0.7410 0.6268 54,991
Dec 0.6684 0.6690 0.6676 0.6677 +0.0002 0.7165 0.6290 3,182
Mar-90 0.6685 0.6685 0.6685 0.6676 ………….. 0.6850 0.6315 1,313
Lifetime
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14 Closing a futures position
Three common ways of liquidating a futures position:
Physical delivery or cash settlement
Offsetting
Exchange of Futures for Physicals (EFP)
Physical delivery
Traders have an obligation either to take delivery (a long position) or to
make delivery (a short position) of the underlying commodity
Usually the most cumbersome way to fulfill contractual obligations
Cash settlement
Substitute for physical delivery
Available only for futures contracts that specifically designate cash
delivery as the settlement procedure
Traders make the payments at the expiration of the contract to settle any
gains or losses
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15 Closing a futures position
Offsetting
Most common way of liquidating an open futures position
Reverse the initial transaction that established the futures position – net
position becomes zero
Initial buyer (long) liquidates his position by selling (going short) an
identical futures contract (same commodity and same delivery month)
Initial seller (short) liquidates his position by buying (going long) an
identical futures contract (same commodity and same delivery month)
Exchange of Futures for Physicals (EFP)
A form of physical delivery
Involves the sale of a commodity off the exchange by the holder of short
contracts to the holder of long contracts, at mutually agreed-upon terms
and at a mutually agreed-upon price
Also referred to as ex-pit transaction
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16 Types of orders
June 89 crude oil futures contracts, during May 16, 1989
Market Order
“BUY 1 June 89 Crude MKT”
Order to be executed immediately at the best possible price after it reaches the trading floor
Limit Order
“BUY 1 June 89 Crude 20.90” “SELL 1 June 89 Crude 20.96”
Customer wants to buy (sell) at a specified price below (above) the current market price
Order to be filled either at the price specified on the order or at a better price
Market-If-Touched (MIT)
“SELL 1 June 89 Crude 21.05 MIT”
When the market reaches the specified limit price, an MIT order becomes an order for
immediate execution
Market-On-Close (MOC)
“BUY 3 June 89 Crude MOC”
Instruction to the broker to execute the order during the official closing period for the contract
Actual execution price need not be the last sale price which occurred, but it must fall within
the range of closing prices for the month for the said contract
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17 Types of orders
Stop-Loss Order
“BUY 2 June 89 Crude 21.15 stop” “SELL 2 June 89 Crude 20.95 stop”
Order to buy or sell when the price reaches a specified level
Buy-stop market order is placed at a price above the present market price.
Typically used to limit a loss (or to protect an existing profit) on a short
sale. For example, if an trader sells a stock short hoping the stock price
goes down in order to book profits at a lower price, the trader may use a
buy stop order to protect himself against losses if the price goes too high
Sell-stop market order is placed at a price below the present market price.
Order to sell at the best available price after the price goes below the stop
price. For example, if an trader holds a stock currently valued at Rs.100
and is worried that the value may drop, he/she can place a sell stop order
at Rs.90. If the share price drops to Rs.90, the exchange will sell the order
at the next available price. This can limit the traders losses (if the stop
price is at or below the purchase price) or lock in some of the profits
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18 Types of orders
Exchange for Physical (EFP) Order
“SELL 2 June 89 Crude 21.10 EFP to XYZ Co.”
Off-the-exchange transaction
Exchange of futures position for a physical position
Discretionary Order
“BUY 2 June 89 Crude 20.92 with 1 Point Disc”
Broker is given some discretion to buy or sell when the market is
falling very steeply or rising very fast to avoid losses
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19 Types of orders
Not Held Order
“BUY 2 June 89 Crude 20.92 Not Held”
Broker is given the discretion to wait to buy if he feels that the prices will go
further down or wait to sell if he feels that the prices may go further up
Spread Order
“Spread BUY 2 June 89 Crude SELL 2 July 89 Crude, 90 cents premium”
Entitles the broker to buy and sell two different contracts at the same time
with a spread premium
Time Order
Day Orders
Good Till Cancelled (GTC)
Good This Week (GTW)
Good This Month (GTM)
Good Through Date (GTD)
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20
FUTURES PRICES
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21 Cost-of-Carry Relationship
The extent to which the futures price exceeds the cash price at any moment is
determined by the “cost-of-carry”
Costs associated with purchasing and carrying (or holding) a commodity for a specified
period of time
Carrying charges can be further classified into storage, insurance, transportation and
financing costs
Futures Price = Cash price + financing costs per unit + storage costs per unit
Ft,T = Ct + Ct * St,T * T-t + Gt,T
365
Where,
Ft,T = Futures Price at time t, which is to be delivered at time period T
Ct = Cash Price at time t
St,T = Annualised interest rate on borrowings
Gt,T = Storage costs
T-t = Time period
Futures price arrived at with cost-of-carry is referred to as “full carry futures price”
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22 Cost-of-Carry Relationship
The formula assumes the following:
Simple interest financing cost
No information or transaction costs associated with buying or selling either
futures or the physical commodity
Unlimited ability to borrow or lend money
All borrowing and lending is done at the same interest rate
No credit risk associated with buying or selling either the futures contract or
the physical commodity (assumes no margins required on futures contracts)
Commodities can be stored indefinitely without any change in the
characteristics of the commodity (such as its quality)
No taxes
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23 Cost-of-Carry Relationship
On April 11, 1989, the cash price of silver was 582.5 cents. AT the close of
trading on April 11, the settlement price of the December 89 silver futures contract
was 624.1 cents. The time from April 11 to mid-December is approximately 8
months. The annualized borrowing rate on April 11, 1989 was about 10.70.
Finally, the cost of storing silver is negligible and assumed to be zero.
582.5+582.5*0.1070*8/12+0 = 624.05
Another way of looking at the cost-of-carry relationship is that the difference
between the futures price and the cash price should equal the cost of carry
Carry = Ft,T - Ct
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24 Relationship between Cash Price and Futures Price
Cash-futures arbitrage
Cash and near-month futures price should differ only by the
transaction costs associated with doing a cash-futures
arbitrage
Assuming no transaction costs, taxes etc., actual futures
price should be exactly equal to cash price plus the cost-of-
carry
If actual futures prices were not equal to these constructed
full-carry prices, there would exist profitable, no risk
cash/futures arbitrage opportunities
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25 Examples - Cash-futures arbitrage
5. In the month of April 1989, silver was trading in the
cash market at 582.5 cents per ounce. The prevailing
interest rate was 10.7% p.a. December 1989 futures
were trading at 628 cents. Identify the arbitrage
opportunity and the net gain / loss from the arbitrage
activity.
6. In the above example, if the futures were trading at
620 cents, then what would be the arbitrage
opportunity and the gain / loss from the said activity?
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26 Basis, Contango and Backwardation
Basis is the difference between cash and futures prices
Basis = Current Cash Price – Futures Price
When the futures contract is at expiration, the futures price and the spot price of
the commodity should be the same, hence the basis must be zero. This behaviour
pattern of the basis over a period of time is referred to as convergence
If the futures prices are accurately described by a full-carry relationship, the basis
is negative, since futures prices are higher than cash prices. This condition is
referred to as a contango market, meaning that the relationship between futures
and cash prices is determined solely by the cost-of-carry
If futures prices are lower than cash prices, the basis is positive. This is referred to
as Backwardation. This condition prevails only if the futures prices are
determined by some factors other than the cost-of-carry
A contango market is characterized by progressively rising futures prices as the
time to delivery becomes more distant, and a backwardation market by
progressively lower futures prices as the time to delivery becomes more distant
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27 Basis
Perfect and Imperfect hedge
Loss in the physical market is fully offset by the gains in
the position in the futures market and vice versa –
perfect hedge
Reasons for imperfect hedge:
Mismatch of asset and Quality
Mismatch of quantities
Mismatch of period of hedging
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28 Example 7
Today is 24th March. A refinery needs 1,050 barrels of crude oil in the
month of September. The current price of crude oil is Rs 3,000 per
barrel. September futures contract at MCX is trading at Rs 3,200. The
firm expects the price to go up further and beyond Rs 3,200 in
September. It has the option of buying the stock now. Alternatively, it
can hedge through futures contract.
If the cost of capital, insurance and storage is 15% per annum,
examine if it is beneficial for the firm to buy now? (Use continuous
compounding)
If the firm decides to hedge through futures, find out the effective
price it would pay for crude oil, if at the time of lifting the hedge (1)
the spot and futures price are Rs 2,900 and Rs 2,910 respectively, (2)
the spot and futures price are Rs 3,300 and Rs 3,315 respectively.
