Download Mechanics of Futures Markets

Mechanics of Futures
Markets
Chapter 2
Options, Futures, and Other Derivatives, 7th International Edition,
Copyright © John C. Hull 2008
1
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
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
2
Opening and Closing Futures
Position
An investor could instruct a broker to buy for exp. one
October oil futures contract. There is period of time
during the delivery month when delivery can be
made. Trading usually ends some time during the
delivery period. The party with the short position
chooses when delivery is made.
However majorty of the futures contracts that are
initiated do not lead to delivery. The reason is that
most investors choose to close out their positions
perior to the delivery period.
Closing a position is entering into an opposite trade.
Most contracts are closed out before maturity
Specification of Futures Contracts
The Asset
Contract size
Delivery arrangements
Delivery months
Price Quotes
Price limits & position limits
Convergence of Futures to Spot
(Figure 2.1, page 26)
Futures
Price
Spot Price
Futures
Price
Spot Price
Time
(a)
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
Time
(b)
5
The Operation of 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
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
6
Example of a Futures Trade (page
26-28)
An investor takes a long position in 2
December gold futures contracts on
June 5
contract size is 100 oz.
futures price is US$600 per oz
margin requirement is US$2,000/contract
(US$4,000 in total)
maintenance margin is US$1,500/contract
(US$3,000 in total)
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
7
A Possible Outcome
Day
Futures
Price
(US$)
Daily
Gain
(Loss)
(US$)
Cumulative
Gain
(Loss)
(US$)
600.00
Table 2.1, Page 28
Margin
Account Margin
Balance
Call
(US$)
(US$)
4,000
5-Jun 597.00
.
.
.
.
.
.
(600)
.
.
.
(600)
.
.
.
3,400
.
.
.
13-Jun 593.30
.
.
.
.
.
.
(420)
.
.
.
(1,340)
.
.
.
2,660 + 1,340 = 4,000
.
.
.
.
.
< 3,000
19-Jun 587.00
.
.
.
.
.
.
(1,140)
.
.
.
(2,600)
.
.
.
2,740 + 1,260 = 4,000
.
.
.
.
.
.
26-Jun 592.30
260
(1,540)
5,060
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
0
.
.
.
0
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Other Key Points About Futures
They are settled daily.
Min. Levels of initial and
maintenance margin are set by the
exchange.
Margin requirements may depend
on the objective of the trader.
Day trades and spread transaction
often give rise to lower margin
requirement.
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
9
The clearing house and clearing
margins
The clearing house acts as an intermediary.
It guarantees the performance of the two
parties.
It has a number of members who must post
funds with the exchange.
The main task of it is to keep track of all the
transactions and calculate the net positions of
its members.
A clearing house member is required to
maintain a margin with the clearing house
(clearing margin).
The main purpose of the margining system is
to reduce default (credit) risk.
Credit risk is a feature of the OTC market.
Collateralization in OTC Markets
A collateralization agreement btw two parties
require them to value the contract each day.
It is becoming increasingly common for
contracts to be collateralized in OTC markets
They are then similar to futures contracts in
that they are settled regularly (e.g. every day
or every week)
They were used by a hedge fund (LTCM) in
1990s.
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
12
The credit crisis and the use of
Clearing houses in OTC markets
Credit crisis causes a systemic risk. Failure by
a large fin. inst. will lead to failures by other
large fin. insts.
So that politiciants and regulators have
looked at ways of making the OTC market
more like the futures market.
Newspaper Quotes
Settlement price: the price just before the final
bell each day.
Open interest: the total number of contracts
outstanding
equal to number of long positions or number of short
positions
used for the daily settlement process
Volume of trading: the number of trades in 1
day
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
14
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.
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
15
Futures Price ($ per oz)
Futures Prices for Gold on Jan 8, 2007: Prices
Increase with Maturity (Figure 2.2a, page 33)
650
640
630
620
Contract Maturity Month
610
600
Jan-07
Apr-07
Jul-07
Oct-07
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
Jan-08
16
Futures Price (cents per lb)
Futures Prices for Orange Juice on January 8, 2007:
Prices Decrease with Maturity (Figure 2.2b, page 33)
210
205
200
195
190
185
180
175
170
Jan-07
Contract Maturity Month
Mar-07
May-07
Jul-07
Sep-07
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
Nov-07
17
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
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
18
Types of Traders
Traders:
Futures Commission merchants
Locals
Traders:
Speculators
• Scalpers: Hold positions for a few minutes
• Day traders: Hold positions for less than one day.
• Position traders: Hold positions for longer periods
Hedgers
Arbitrageurs
Types of Orders
Market Order: A trade be carried out immediately at
the best price available in the market.
Limit order: Specifies a particular price. If the limit
price is $30 for an investor wanting to buy, the order
will be executed at a price of $30 or less.
Stop order (Stop loss order): Suppose a stop order to
sell at $30 is issued when the market price is $35. It
becomes an order to sell when and if the price falls
to $30.
Orders cont.
Stop limit order: Two prices must be
specified. Suppose that at a price of $35,
a stop limit order to buy is issued with a
stop price of $40 and a limit price of $41.
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
21
Regulation of Futures
Regulation is designed to protect the
public interest
Regulators try to prevent
questionable trading practices by
either individuals on the floor of the
exchange or outside groups
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
22
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 attempts to achieve
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
23
Forward Contracts vs Futures Contracts
TABLE 2.3 (p. 39)
FORWARDS
FUTURES
Private contract between 2 parties
Exchange traded
Non-standard contract
Standard contract
Usually 1 specified delivery date
Settled at end of contract
Delivery or final cash
settlement usually occurs
Some credit risk
Range of delivery dates
Settled daily
Contract usually closed out
prior to maturity
Virtually no credit risk
Options, Futures, and Other Derivatives, 7th International
Edition, Copyright © John C. Hull 2008
24