Futures Contract
Futures Contract
Futures Contract
Margin [edit]
Main article: Margin (finance)
To minimize credit risk to the exchange, traders must post a margin or a performance bond,
typically 5%-15% of the contract's value. Unlike use of the term margin in equities, this
performance bond is not a partial payment used to purchase a security, but simply a good-faith
deposit held to cover the day-to-day obligations of maintaining the position.[10]
To minimize counterparty risk to traders, trades executed on regulated futures exchanges are
guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the
seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of
loss. This enables traders to transact without performing due diligence on their counterparty.
Margin requirements are waived or reduced in some cases for hedgers who have physical
ownership of the covered commodity or spread traders who have offsetting contracts balancing
the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on
their customers' open futures and options contracts. Clearing margins are distinct from customer
margins that individual buyers and sellers of futures and options contracts are required to deposit
with brokers.
Customer margin Within the futures industry, financial guarantees required of both buyers and
sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract
obligations. Futures Commission Merchants are responsible for overseeing customer margin
accounts. Margins are determined on the basis of market risk and contract value. Also referred to
as performance bond margin.
Initial margin is the equity required to initiate a futures position. This is a type of performance
bond. The maximum exposure is not limited to the amount of the initial margin, however the initial
margin requirement is calculated based on the maximum estimated change in contract value
within a trading day. Initial margin is set by the exchange.
If a position involves an exchange-traded product, the amount or percentage of initial margin is
set by the exchange concerned.
In case of loss or if the value of the initial margin is being eroded, the broker will make a margin
call in order to restore the amount of initial margin available. Often referred to as “variation
margin”, margin called for this reason is usually done on a daily basis, however, in times of high
volatility a broker can make a margin call or calls intra-day.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker
has the right to close sufficient positions to meet the amount called by way of margin. After the
position is closed-out the client is liable for any resulting deficit in the client’s account.
Some U.S. exchanges also use the term “maintenance margin”, which in effect defines by how
much the value of the initial margin can reduce before a margin call is made. However, most
non-US brokers only use the term “initial margin” and “variation margin”.
The Initial Margin requirement is established by the Futures exchange, in contrast to other
securities' Initial Margin (which is set by the Federal Reserve in the U.S. Markets).
A futures account is marked to market daily. If the margin drops below the margin maintenance
requirement established by the exchange listing the futures, a margin call will be issued to bring
the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer
must maintain in their margin account.
Margin-equity ratio is a term used by speculators, representing the amount of their trading
capital that is being held as margin at any particular time. The low margin requirements of futures
results in substantial leverage of the investment. However, the exchanges require a minimum
amount that varies depending on the contract and the trader. The broker may set the
requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does
not want to be subject to margin calls.
Performance bond margin The amount of money deposited by both a buyer and seller of a
futures contract or an options seller to ensure performance of the term of the contract. Margin in
commodities is not a payment of equity or down payment on the commodity itself, but rather it is
a security deposit.
Return on margin (ROM) is often used to judge performance because it represents the gain or
loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be
calculated (realized return) / (initial margin). The Annualized ROM is equal to
(ROM+1)(year/trade_duration)-1. For example, if a trader earns 10% on margin in two months, that would
be about 77% annualized.
Physical delivery − the amount specified of the underlying asset of the contract is delivered
by the seller of the contract to the exchange, and by the exchange to the buyers of the
contract. Physical delivery is common with commodities and bonds. In practice, it occurs only
on a minority of contracts. Most are cancelled out by purchasing a covering position—that is,
buying a contract to cancel out an earlier sale (covering a short), or selling a contract to
liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this
method of settlement upon expiration
Cash settlement − a cash payment is made based on the underlying reference rate, such
as a short-term interest rate index such as 90 Day T-Bills, or the closing value of a stock
market index. The parties settle by paying/receiving the loss/gain related to the contract in
cash when the contract expires.[11] Cash settled futures are those that, as a practical matter,
could not be settled by delivery of the referenced item—for example, it would be impossible
to deliver an index. A futures contract might also opt to settle against an index based on
trade in a related spot market. ICE Brent futures use this method.
Expiry (or Expiration in the U.S.) is the time and the day that a particular delivery month of a
futures contract stops trading, as well as the final settlement price for that contract. For many
equity index and Interest rate future contracts (as well as for most equity options), this happens
on the third Friday of certain trading months. On this day the t+1 futures contract becomes
the t futures contract. For example, for most CME and CBOT contracts, at the expiration of the
December contract, the March futures become the nearest contract. This is an exciting time for
arbitrage desks, which try to make quick profits during the short period (perhaps 30 minutes)
during which the underlying cash price and the futures price sometimes struggle to converge. At
this moment the futures and the underlying assets are extremely liquid and any disparity between
an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the
increase in volume is caused by traders rolling over positions to the next contract or, in the case
of equity index futures, purchasing underlying components of those indexes to hedge against
current index positions. On the expiry date, a European equity arbitrage trading desk in London
or Frankfurt will see positions expire in as many as eight major markets almost every half an
hour.
Pricing[edit]
When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a
futures contract is determined via arbitrage arguments. This is typical for stock index
futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g.
agricultural crops after the harvest). However, when the deliverable commodity is not in plentiful
supply or when it does not yet exist — for example on crops before the harvest or
on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument
is to be created upon the delivery date) — the futures price cannot be fixed by arbitrage. In this
scenario there is only one force setting the price, which is simple supply and demand for the
asset in the future, as expressed by supply and demand for the futures contract.
Arbitrage arguments[edit]
Arbitrage arguments ("rational pricing") apply when the deliverable asset exists in plentiful
supply, or may be freely created. Here, the forward price represents the expected future value of
the underlying discounted at the risk free rate—as any deviation from the theoretical price will
afford investors a riskless profit opportunity and should be arbitraged away. We define the
forward price to be the strike K such that the contract has 0 value at the present time. Assuming
interest rates are constant the forward price of the futures is equal to the forward price of the
forward contract with the same strike and maturity. It is also the same if the underlying asset is
uncorrelated with interest rates. Otherwise the difference between the forward price on the
futures (futures price) and forward price on the asset, is proportional to the covariance between
the underlying asset price and interest rates. For example, a futures on a zero coupon bond will
have a futures price lower than the forward price. This is called the futures "convexity correction."
Thus, assuming constant rates, for a simple, non-dividend paying asset, the value of the
futures/forward price, F(t,T), will be found by compounding the present value S(t) at time t to
maturity T by the rate of risk-free return r.
This relationship may be modified for storage costs, dividends, dividend yields, and
convenience yields.
In a perfect market the relationship between futures and spot prices depends only on the
above variables; in practice there are various market imperfections (transaction costs,
differential borrowing and lending rates, restrictions on short selling) that prevent
complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries
around the theoretical price.
Exchanges[edit]
Contracts on financial instruments were introduced in the 1970s by the Chicago
Mercantile Exchange (CME) and these instruments became hugely successful and
quickly overtook commodities futures in terms of trading volume and global
accessibility to the markets. This innovation led to the introduction of many new
futures exchanges worldwide, such as the London International Financial Futures
Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and
the Tokyo Commodity Exchange (TOCOM). Today, there are more than 90 futures
and futures options exchanges worldwide trading to include:
CME Group (formerly CBOT and CME) -- Currencies, Various Interest Rate
derivatives (including US Bonds); Agriculture (Corn, Soybeans, Soy Products,
Wheat, Pork, Cattle, Butter, Milk); Indices (Dow Jones Industrial Average,
NASDAQ Composite, S&P 500, etc.); Metals (Gold, Silver)
Intercontinental Exchange (ICE Futures Europe) - formerly the International
Petroleum Exchange trades energy including crude oil, heating oil, gas oil
(diesel), refined petroleum products, electric power, coal, natural gas, and
emissions
NYSE Euronext - which absorbed Euronext into which London International
Financial Futures and Options Exchange or LIFFE (pronounced 'LIFE') was
merged. (LIFFE had taken over London Commodities Exchange ("LCE") in
1996)- softs: grains and meats. Inactive market in Baltic Exchange shipping.
Index futures include EURIBOR, FTSE 100, CAC 40, AEX index.
South African Futures Exchange - SAFEX
Sydney Futures Exchange
Tokyo Stock Exchange TSE (JGB Futures, TOPIX Futures)
Tokyo Commodity Exchange TOCOM
Tokyo Financial Exchange - TFX - (Euroyen Futures, OverNight CallRate
Futures, SpotNext RepoRate Futures)
Osaka Securities Exchange OSE (Nikkei Futures, RNP Futures)
London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel, tin and
steel
Intercontinental Exchange (ICE Futures U.S.) - formerly New York Board of
Trade - softs: cocoa, coffee, cotton, orange juice, sugar
New York Mercantile Exchange (CME Group)- energy and metals: crude
oil, gasoline, heating oil, natural
gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium
Dubai Mercantile Exchange
JFX Jakarta Futures Exchange
Montreal Exchange (MX) (owned by the TMX Group) also known in French as
Bourse De Montreal: Interest Rate and Cash Derivatives: Canadian 90
Days Bankers' AcceptanceFutures, Canadian government
bond futures, S&P/TSX 60 Index Futures, and various other Index Futures
Korea Exchange - KRX
Singapore Exchange - SGX - into which merged Singapore International
Monetary Exchange (SIMEX)
ROFEX - Rosario (Argentina) Futures Exchange
NCDEX - National Commodity and Derivatives Exchange, India
EverMarkets Exchange (EMX) - slated for launch in late 2018 -
global currencies, equities, commodities and cryptocurrencies
FEX Global - Financial and Energy Exchange of Australia
Codes[edit]
Most futures contracts codes are five characters. The first two characters identify the
contract type, the third character identifies the month and the last two characters
identify the year.
Third (month) futures contract codes are
January = F
February = G
March = H
April = J
May = K
June = M
July = N
August = Q
September = U
October = V
November = X
December = Z
Example: CLX14 is a Crude Oil (CL), November (X) 2014 (14) contract.[12]
Futures traders[edit]
Futures traders are traditionally placed in one of two groups: hedgers, who have an
interest in the underlying asset (which could include an intangible such as an index
or interest rate) and are seeking to hedge out the risk of price changes;
and speculators, who seek to make a profit by predicting market moves and opening
a derivative contract related to the asset "on paper", while they have no practical use
for or intent to actually take or make delivery of the underlying asset. In other words,
the investor is seeking exposure to the asset in a long futures or the opposite effect
via a short futures contract.
Hedgers[edit]
Hedgers typically include producers and consumers of a commodity or the owner of
an asset or assets subject to certain influences such as an interest rate.
For example, in traditional commodity markets, farmers often sell futures contracts
for the crops and livestock they produce to guarantee a certain price, making it
easier for them to plan. Similarly, livestock producers often purchase futures to cover
their feed costs, so that they can plan on a fixed cost for feed. In modern (financial)
markets, "producers" of interest rate swaps or equity derivative products will use
financial futures or equity index futures to reduce or remove the risk on the swap.
The utility of futures markets for this specific purpose is considered to be mainly in
the transfer of risk. [1]
Those that buy or sell commodity futures need to be careful. If a company buys
contracts hedging against price increases, but in fact the market price of the
commodity is substantially lower at time of delivery, they could find themselves
disastrously non-competitive (for example see: VeraSun Energy).
Speculators[edit]
Speculators typically fall into three categories: position traders, day traders, and
swing traders (swing trading), though many hybrid types and unique styles exist.
With many investors pouring into the futures markets in recent years controversy
has risen about whether speculators are responsible for increased volatility in
commodities like oil, and experts are divided on the matter. [13]
An example that has both hedge and speculative notions involves a mutual
fund or separately managed account whose investment objective is to track the
performance of a stock index such as the S&P 500 stock index. The Portfolio
manager often "equitizes" cash inflows in an easy and cost effective manner by
investing in (opening long) S&P 500 stock index futures. This gains the portfolio
exposure to the index which is consistent with the fund or account investment
objective without having to buy an appropriate proportion of each of the individual
500 stocks just yet. This also preserves balanced diversification, maintains a higher
degree of the percent of assets invested in the market and helps reduce tracking
errorin the performance of the fund/account. When it is economically feasible (an
efficient amount of shares of every individual position within the fund or account can
be purchased), the portfolio manager can close the contract and make purchases of
each individual stock.
Options on futures[edit]
In many cases, options are traded on futures, sometimes called simply "futures
options". A put is the option to sell a futures contract, and a call is the option to buy a
futures contract. For both, the option strike price is the specified futures price at
which the future is traded if the option is exercised. Futures are often used since
they are delta one instruments. Calls and options on futures may be priced similarly
to those on traded assets by using an extension of the Black-Scholes formula,
namely the Black–Scholes model for futures. For options on futures, where the
premium is not due until unwound, the positions are commonly referred to as
a fution, as they act like options, however, they settle like futures.
Investors can either take on the role of option seller (or "writer") or the option buyer.
Option sellers are generally seen as taking on more risk because they are
contractually obligated to take the opposite futures position if the options buyer
exercises their right to the futures position specified in the option. The price of an
option is determined by supply and demand principles and consists of the option
premium, or the price paid to the option seller for offering the option and taking on
risk.[14]
During any time interval , the holder receives the amount . (this
reflects instantaneous marking to market)
At time T, the holder pays F(T,T) and is entitled to receive J. Note
that F(T,T) should be the spot price of J at time T.
Forward contracts[edit]
A closely related contract is a forward contract. A forward is like a futures in that it
specifies the exchange of goods for a specified price at a specified future date.
However, a forward is not traded on an exchange and thus does not have the interim
partial payments due to marking to market. Nor is the contract standardized, as on
the exchange.
Unlike an option, both parties of a futures contract must fulfill the contract on the
delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-
settled futures contract, then cash is transferred from the futures trader who
sustained a loss to the one who made a profit. To exit the commitment prior to the
settlement date, the holder of a futures position can close out its contract obligations
by taking the opposite position on another futures contract on the same asset and
settlement date. The difference in futures prices is then a profit or loss.
A futures contract is an agreement between two parties – a buyer and a seller – wherein the former agrees to
purchase from the latter, a fixed number of shares or an index at a specific time in the future for a pre-determined
price. These details are agreed upon when the transaction takes place. As futures contracts are standardized in
terms of expiry dates and contract sizes, they can be freely traded on exchanges. A buyer may not know the
identity of the seller and vice versa. Further, every contract is guaranteed and honored by the stock exchange, or
more precisely, the clearing house or the clearing corporation of the stock exchange, which is an agency
designated to settle trades of investors on the stock exchanges.
Futures contracts are available on different kinds of assets – stocks, indices, commodities, currency pairs and so
on. Here we will look at the two most common futures contracts – stock futures and index futures.
A stock index is used to measure changes in the prices of a group stocks over a period of time. It is constructed
by selecting stocks of similar companies in terms of an industry or size. Some indices represent a certain
segment or the overall market, thus helping track price movements. For instance, the BSE Sensex is comprised
of 30 liquid and fundamentally strong companies. Since these stocks are market leaders, any change in the
fundamentals of the economy or industries will be reflected in this index through movements in the prices of
these stocks on the BSE. Similarly, there are other popular indices like the CNX Nifty 50, S&P 500, etc, which
represent price movements on different exchanges or in different segments.
Futures contracts are also available on these indices. This helps traders make money on the performance of the
index.
Here are some features of index futures:
Contract size: Just like stock futures, these contracts are also dealt in lots. But how is that possible when the
index is simply a non-physical number. No, you do not purchase futures of the stocks belonging to the index.
Instead, stock indices points – the value of the index – are converted into rupees.
For example, suppose the CNX Nifty value was 6500 points. The exchange stipulates that each point is
equivalent to Rs 1 , then you have to pay 100 times the index value – Rs 6,50,000 i.e. 1x6500x100. This also
means each contract has a lot size of 100.
Expiry: Since indices are abstract market concepts, the transaction cannot be settled by actually buying or
selling the underlying asset. Physical settlement is only possible in case of stock futures. Hence, an open position
in index futures can be settled by conducting an opposing transaction on or before the day of expiry.
Duration: As in the case of stock futures, index futures too have three contract series open for trading at any
point in time – the near-month (1 month), middle-month (2 months) and far-month (3 months) index futures
contracts.
Illustration of an index futures contract: If the index stands at 3550 points in the cash market today and you
decide to purchase one Nifty 50 July future, you would have to purchase it at the price prevailing in the futures
market.
This price of one July futures contract could be anywhere above, below or at Rs 3.55 lakh (i.e., 3550*100),
depending on the prevailing market conditions. Investors and traders try to profit from the opportunity arising from
this difference in prices
The existence and the utility of a futures market benefits a lot of market participants:
It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be.
Based on the current future price, it helps in determining the future demand and supply of the shares.
Since it is based on margin trading, it allows small speculators to participate and trade in the futures market by
paying a small margin instead of the entire value of physical holdings.
However, you must be aware of the risks involved too. The main risk stems from the temptation to speculate
excessively due to a high leverage factor, which could amplify losses in the same way as it multiplies profits.
Further, as derivative products are slightly more complicated than stocks or tracking an index, lack of knowledge
among market participants could lead to losses.