• Futures Markets • Future Contracts • Futures Exchanges • Clearing and Margin Mechanism • Trading Setup (RM, Traders, Dealers, Clients) • Bonds Dealing • Nomenclature of Bonds • Bond order entry • YTM • Coupon Calculations • Schedules Margins What is it?
Margins Margins are a critical component of futures trading and are used to ensure that traders have the financial resources to fulfill their contractual obligations. They are deposits held with the broker to cover potential losses that may occur during the life of a futures contract.
Why Margins are used?
The use of margin in futures trading serves several essential purposes, and it's a fundamental aspect of maintaining the integrity and stability of futures markets. Here are the key reasons why margin is necessary in futures trading:
1. Risk Mitigation: • Futures contracts are highly leveraged, meaning that a trader can control a large position with a relatively small amount of capital. • This leverage amplifies both potential profits and potential losses. • Margin acts as a safeguard by ensuring that traders have enough funds to cover potential losses. • It helps protect the financial stability of traders and reduces the risk of default on contract obligations. Margins How the is it calculated and updated? Margins What is the need?
Why Margins are used?
2. Market Integrity: • Without margin, traders could potentially take on positions that far exceed their financial capacity, leading to significant market disruptions if they were unable to meet their obligations. • Margin requirements encourage responsible trading practices and discourage excessive speculation.
3. Daily Settlement: • Futures contracts are marked to market daily, which means that the gains and losses on positions are settled daily. • This ensures that traders meet their obligations in real-time as market prices change. • Margin funds are used to cover these daily settlement variations. • This daily settlement process helps prevent the accumulation of large losses that could be difficult to cover if allowed to accumulate over time. Margins What are the types?
1. Initial Margin: • The initial margin, also known as the "performance bond" or "original margin," is the initial amount of money a trader must deposit with their broker to establish a futures position. • It ensures that traders have sufficient capital to meet potential losses and obligations from their positions. Initial margin requirements vary by contract and exchange and are typically set as a percentage of the contract's notional value. • Before initiating a futures position, a trader must deposit the required initial margin with their broker. This margin serves as a "good faith" deposit. 2. Maintenance Margin: • Maintenance margin is the minimum amount of capital that must be maintained in a trading account to keep a futures position open. • It helps ensure that traders can cover ongoing losses that may occur as market prices fluctuate. If the account balance falls below the maintenance margin level, a margin call is issued. • After opening a futures position, traders must maintain their account balance above the maintenance margin requirement. If the account balance falls below this level, a margin call is triggered. 3. Variation Margin: • Variation margin, also known as "daily settlement variation," is the amount of money added to or subtracted from a trader's account on a daily basis to account for price fluctuations. • It ensures that traders meet their obligations in real-time as market prices change. Gains and losses are settled daily. • At the end of each trading day, the exchange calculates the daily profit or loss for each futures position, and the corresponding variation margin is added or subtracted from the trader's account. Clearing House What is it?
Clearing House A clearing house acts as an intermediary in futures transactions. The main task of the clearing house is to keep track of all the transactions that take place during a day, so that it can calculate the net position of each of its members.
• The clearing house member is required to provide to the clearing house initial margin (sometimes referred to as clearing margin) reflecting the total number of contracts that are being cleared. • There is no maintenance margin applicable to the clearing house member. • At the end of each day, the transactions being handled by the clearing house member are settled through the clearing house. • If in total the transactions have lost money, the member is required to provide variation margin to the exchange clearing house (usually by the beginning of the next day) • If there has been a gain on the transactions, the member receives variation margin from the clearing house. • Intraday variation margin payments may also be required by a clearing house from its members in times of significant price volatility or changes in position. Clearing House What is it?
Clearing House • In determining margin requirements, the number of contracts outstanding is usually calculated on a net basis rather than a gross basis. This means that short positions the clearing house member is handling for clients are netted against long positions. • The calculation of the margin requirement is usually designed to ensure that the clearing house is about 99% certain that the margin will be sufficient to cover any losses in the event that the member defaults and has to be closed out. • Clearing house members are required to contribute to a guaranty fund. This may be used by the clearing house in the event that a member defaults and the member’s margin proves insufficient to cover losses. Hedging using Futures How the Futures is used?
Short Hedge Involves short position in Futures Market
When it should be done:
You already have an asset Not owned right now but will be owned and ready to sale at same time in future.
Example: Contract says, After three months commodity will be sold at the Spot rate Spot rate today - $100 (Buy)Future price of 3M delivery - $99
Spot Rate on 09-Jan - $90 Spot Rate on 09-Jan - $110
Sell of an asset = $90 Sell of an asset = $110
Shorting of an Forward contract = $99 - $90 = $9 Shorting of an Forward contract = $99 - $110 = ($11)
Total Gain = $9 Total Gain = ($11)
Hedging using Futures How the Futures is used?
Long Hedge Involves long position in Futures Market
When it should be done:
You have to buy an asset and wants to lock in prices.
Example: Contract says, After three months commodity have to buy at Spot Rate Spot rate today - $50 Future price of 3M delivery - $49
Spot Rate on 09-Jan - $55 Spot Rate on 09-Jan - $45
Buy the asset = $55 Buy the asset = $45
Sell of an Forward contract = $55 - $49 = $6 Sell of an Forward contract = $45 - $49 = ($4)
Net Profit = 6$ Net profit = ($4)
Hedging using Futures When is problem with Hedging?
Will hedging always have a positive outcome ?
How every hedge can’t be a perfect hedge ?
The hedger was then able to use futures contracts to remove almost all the risk arising from the price of the asset on that date. In practice, hedging is often not quite as straightforward as this.
Some of the reasons are as follows:
1. The asset whose price is to be hedged may not be exactly the same as the asset underlying the futures contract. 2. There may be uncertainty as to the exact date when the asset will be bought or sold. 3. The hedge may require the futures contract to be closed out before its delivery month. Basis Risk What is it?
Basis Risk
The basis in a hedging situation is as follows
Basis = Spot price of asset to be hedged Futures price of contract used
S1 : Spot price at time t1
S2 : Spot price at time t2 F1 : Futures price at time t1 F2 : Futures price at time t2 b1 : Basis at time t1 b2 : Basis at time t2.
b1 = S1 - F1 and b2 = S2 - F2
The effective price that is obtained
S2 + F1 - F2 = F1 + b2
This “b2” is the Basis risk
Basis Risk What is it?
Effect of Basis
Basis changes can lead to an improvement or a worsening of a hedger’s position.
Consider a company that uses a short hedge because it plans to sell the underlying asset. • If the basis strengthens (i.e., increases) unexpectedly, the company’s position improves because it will get a higher price for the asset after futures gains or losses are considered; • if the basis weakens (i.e., decreases) unexpectedly, the company’s position worsens. For a company using a long hedge because it plans to buy the asset, the reverse holds. • If the basis strengthens unexpectedly, the company’s position worsens because it will pay a higher price for the asset after futures gains or losses are considered; • if the basis weakens unexpectedly, the company’s position improves. Hedging using Futures How the Futures is used?
Cross Hedging
The asset that gives rise to the hedger’s exposure is sometimes different from the asset underlying the futures contract that is used for hedging. This is known as Cross Hedging.
Define S2* as the price of the asset underlying the futures contract at time t2. As before, S2 is the price of the asset being hedged at time t2. By hedging, a company ensures that the price that will be paid (or received) for the asset is S2 + F1 - F2 This can be written as F1 + (S2* - F2) + (S2 – S2*)
The terms (S2* - F2) and (S2 – S2*) represent the two components of the basis. The first term is the basis that would exist if the asset being hedged were the same as the asset underlying the futures contract. The second term is the basis arising from the difference between the two assets Thank You
