Derivative Markets

The FUTURE is uncertain and the end is

always near-Jim Morrison , The Doors.
Sessions 3&4, June 16 , SIBM-B

Agenda
Quick , very quick take on markets
Fundamentals of Forwards, Futures
Clearing House
Daily Settlement
Margins

Derivatives and Markets

Derivative securities
Financial instrument that offers a return
based on the return of some underlying
asset

Markets
Exchange traded: standardization, traded
on organized exchanges (CME, LIFFE,Eurex)
OTC: non-standardized, negotiated, traded
anywhere else

Uses
Hedging, speculation, or arbitrage

Forward Commitments
Agreement between two parties in which
one party, the buyer, agrees to buy from
the other party, the seller, an underlying
asset at a future date at a price
established at the contract initiation.
Main characterization: obligation by
BOTH parties
Types: forward contracts, futures
contracts, swaps

Forward Contracts
Purchase and sale of underlying asset
(stocks, fixed income instruments and
rates, currencies, commodities, etc.) at a
later date at a price agreed upon today
(maintenance?)
Non-standardized, customizable, OTC
transactions between large financial
institutions and/or corporations
Private and largely unregulated market

Future - Definition
A Legally binding agreement
To take or make delivery
Of a given quantity and quality of a
commodity
At an agreed price
On a specific date or dates in the future

Mnemonic
A futures contract fixes the price and
conditions
NOW
For a transaction that will take place in the

FUTURE

Clearing House
After the trade
Buyer
+1

-1
Member
firm
+1

Seller
-1

+1
Member Firm
-1

Clearing House
After Clearing
Buyer
+1

-1
Member
firm
+1

Seller
-1

-1
CLEARING
HOUSE
+1

+1
Member Firm
-1

Counterparty Risk
Always only ONE counterparty.
Forward: Two OFFSETTING positions!
Once a futures position is closed out, ALL
profits or losses to date are realised and
NOTHING remains on the customers books.
This feature adds to liquidity and makes it
very easy to reverse any position in futures
This is in sharp contrast to the OTC market

Futures Markets
Variation on a forward contract
Public, standardized transaction that occurs on a
futures exchange
Exchange determines expiration dates, underlying
assets, size of the contracts, etc.
Default risk and the clearinghouse
Exchange is the counterparty in futures transactions

Marking-to-market
Daily settlement where profits and losses are charged
and credited to the short and long position each day

Offsetting transactions
Ability to unwind positions prior to expiration
Take an opposite position to the original contract

Review of Futures
Public, standardized transactions on
organized exchanges
Underlying asset, quality of asset, expiration
dates (months and maturities), size of
contract, price and position limits
Homogenization and liquidity = active secondary
market
Ability to take offsetting positions
Clearinghouse

Marking to market: daily settlement of gains

and losses between long and short positions
Long profits from price increases, short profits from
price decreases

Margin and Marking to

Market
To open a position in the futures market, a party must
deposit monies into a margin account with the
clearinghouse
Futures margin = good faith or collateral (not borrowed)
Required by long and short positions
Set by clearinghouse and varies per futures contract
Gains and losses are charged or credited daily to the margin
accounts by marking to market

Initial margin: amount deposited at beginning of the

contract (usually less than 10% of contract value)
Maintenance margin: minimum margin balance that
traders can hold before margin call
(1) deposit additional funds (variation margin) or (2) close out
position

Settlement price: price at which marking to market occurs

Marking to Market
Example
Long Position
Day Beg. Funds
Settlement Price
Bal. Deposited Price
Chg

Gain

Revaluation

50

100

50

50

99.20

-0.80

-8

42

42

96.00

-3.20

-32

10

10

40

101.00

5.00

50

100

100

103.50

2.50

25

125

125

103.00

-0.50

-5

120

A note on margin calls: a price change exceeding the difference between

the initial and maintenance margin will trigger a margin call.
Marking to market occurs to identify losses and gains in such a
manner that losses are paid before becoming large enough to run the risk
of default.

E-mini S&P500 future,

CME
Value per basis point = $50 ( worth $75,000
@1500)
Initial Margin=$5,625 per contract
Maintenance Margin=$4,500
Fin17 buys ONE contract @ $1,275 on Monday.
Settlement Prices from Mon-Thurs were
1280,1260,1250 and 1255

Position was squared on Friday at a price of 1265.

Day

Closin Change
g
in Price
Price

Margin
Margin
Account Flow

Explanation

Monday

1280

+5

5,625

-5,375

Profit of $250

Tuesday

1260

-20

4,625

Position -1000 but

Margin above the
maintenance
level

Wednesday 1250

-10

5,625

-1,500

Loss of $500
depletes the
Margin a/c to
4,125. Margin
Call restores
the a/c to the
initial margin
level

Thursday

1255

+5

5,875

Fin17 leaves the

+250profit in the
margin a/c

Friday

n/a

+10

+6,375

Previous days
margin a/c +
todays profit

Useful side effect

All profits and losses are realised on a DAILY basis and

IN CASH.

This differs from the cash markets where MtM losses ,

though real are only in paper!

A losing position in cash markets can accumulate losses

which may not be acknowledged until it is TOO LATE.

In contrast , a losing position in the Futures markets

results in a steady stream of Margin Calls and ensures
Financial Discipline on everyone using Futures

Liquidation by the Exchange in case of member default

Price Limits

Some contracts impose limits on price

changes that can occur from day to day: SP
price limit

Limit move: if transaction exceeds a price

limit, price freezes at the limit
Limit up: price stuck at upper limit
Limit down: price stuck at lower limit
Locked limit: transaction cannot occur

because price is beyond the limits

Closing Out the Position

Three options:

Offsetting position: take identical, but opposite contract

to existing position (>90% of all contracts)
Delivery: holder of oldest long contract to accept
delivery

Accepts delivery and pays the previous days settlement

price to the short

Cash settlement: Let position expire and margin

accounts are settled for final marking to market

Complications: high transactions cost for physical

delivery, short can often determine when, what and
where to deliver

Exchange for physicals: arrangement of alternative

delivery procedure acceptable to the exchange

Futures vs Forwards
Markets
Futures Markets

Forwards or OTC market

Contract specifications are

standardised

Every aspect of the deal is

negotiated

Clearing house guarantees

No counterparty risk mitigant
against default of any specific
counterparty
Positions easily reversed with
anyone at anytime

Positions can only be offset at

the discretion of deal
counterparty

Requirement to meet daily

margin requirements

Nil

Profits and losses realised in

CASH daily

Mark to Market profits or

losses realised only on paper

Most contracts are reversed

or cash settled; delivery of
underlying is rare

Physical delivery is usual

STIR

Transaction is a notional Fixed Deposit and the

price is the fixed rate of interest that will apply
during the term of that deposit, which covers a
particular period of the future.

Buying a future is equivalent to making a deposit

Selling a future is equivalent to selling a deposit i.e.

taking a loan

No actual depositing or borrowing takes place

The STIR merely secures the interest rate for the

future

V.Ravi Kumar

17/01/17

Eurodollar Contracts
CME contracts on 90-day, $1M notional

principal of Eurodollars

Prices are quoted in the same manner as

T-bills

Cash settled
One of the most widely traded contracts
because of use of LIBOR in swaps, FRAs and
interest rate options
Unlike Eurodollar deposits, which have addon interest, Eurodollar futures are quoted on
a discount basis, like T-bills
V.Ravi Kumar

17/01/17

CME Eurodollar Contract

details

http://www.cmegroup.com/trading/interest-ra
tes/stir/eurodollar_contract_specifications
.html

V.Ravi Kumar

17/01/17

Contract Details

Underlying Instrument: Eurodollar interbank

deposit having approximately $1 million principal
value,

for three-month term to maturity,

for spot settlement on the 3rd Wednesday of the

contract month.

Tick Value: 0.0025% (nearest expiring contract

0.0050%( all other contracts)

V.Ravi Kumar

17/01/17

How are they quoted?

Buying a futures contract = placing a deposit

Selling a futures contract= taking a loan

You would look to place deposits at a HIGH

interest rate and borrow at a LOW interest rate

This means BUY high and SELL low!

When I rises , price falls , when rates fall ,

prices rise

BLASH

Price Quote
100 points minus the three-month London

interbank offered rate for spot settlement on

the 3rd Wednesday of contract month.
E.g., a price quote of 97.45 signifies a

deposit rate of 2.55 percent per annum. One

interest rate basis point = 0.01 price points =
$25 per contract. (?)

V.Ravi Kumar

17/01/17

Tick Size

The minimum price movement of a trading

instrument.

The price movements of different trading

instruments varies.

The tick size of a trading instrument is its

minimum price movement; in other words, it is
the minimum increment in which prices can
change.

The tick value is what each price movement is

worth in terms of dollars.
V.Ravi Kumar

17/01/17

Tick Value

Futures markets typically have a tick size

that is specific to the instrument.

Eurodollar Future :One quarter of one

interest rate basis point = 0.0025 price
points = $6.25 per contract( TICK VALUE)

the tick value changes $25( $6.25x4),

either up or down depending on the
direction of the price movement.

V.Ravi Kumar

17/01/17

CME Tick Size

Minimum Price
Fluctuation

One interest rate basis point = 0.01 price

points = $25 per contract.

Logic : $1,000,000 x ( 0.01%) x ( 3/12)

V.Ravi Kumar

17/01/17