MECHANICS OF FUTURES MARKETS

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• A futures market, like any market, is a place where
buyers and sellers meet in order to transact. For every
buyer, there is a seller and for every seller, there is a
buyer.

Futures Market
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• The central player of a futures market is a futures
exchange. A futures exchange is a meeting place where
futures contracts are bought and sold.
• Trading occurs under the background of regulatory
surveillance and guidelines from the exchange itself and
from the regulatory bodies like Commodity Futures
Trading Commission (CFTC) and Forward Markets
Commission.

Futures Exchange
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• Each exchange has its own list of products that it trades, and
each product is traded in a designated futures trading pit. A
trading pit is an area of floor, usually round with concentric
steps leading down into the center.
• In addition to providing the market place for trading futures
and regulating trading within its pits, futures exchanges also
design and specify their futures contracts. Futures contracts are
very specific in terms of the quality and quantity of goods
underlying the contract.

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• A futures broker acts as a communication link between
the trading pit and the trader, taking orders from the
customer, and executing them in the futures pit. By law,
futures brokers do not have the authority to take customer
funds and hold them in deposit. Only an FCM can do
this. For this reason, a futures broker needs to team up
with an FCM in order to provide order execution services
to its customers.

Futures Broker
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• The Futures Commission Merchant (FCM) is responsible
for holding customer funds of the margin account,
clearing the futures trade, and performing all back-office
recording functions such as marking-to-market a
customer's futures account, sending trade confirmations
and account summaries, and year-end tax forms.

The Futures Commission Merchant

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• The clearing corporation guarantees the performance of
every buyer and seller of a futures or options contract.
• It stands as a buyer to every seller and a seller to every
buyer. That means that a futures trader does not have to
worry about any default of a futures counterparty.

The Clearing Corporation

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• In finance, a futures contract (more colloquially, futures) is a
standardized contract between two parties to buy or sell a
specified asset of standardized quantity and quality for a price
agreed upon today (the futures price) with delivery and
payment occurring at a specified future date, the delivery date.

Definition
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• The contracts are negotiated at a futures exchange,
which acts as an intermediary between the two parties.
The party agreeing to buy the underlying asset in the
future, the "buyer" of the contract, is said to be "long",
and the party agreeing to sell the asset in the future, the
"seller" of the contract, is said to be "short".

Cont.
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I. EQUITY INDEX FUTURES
II. SINGLE STOCK FUTURES
III. INTEREST RATE FUTURES
IV. COMMODITY FUTURES
V. CURRENCY FUTURES

FUTURES PRODUCTS
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• EQUITY INDEX: Agreements to buy or sell a standardized value of
a stock index, on a future date at a specified price, such
as trading New York Stock Exchange composite index on the New
York Futures Exchange (NYFE). As an investment instrument it
combines features of securities trading based on stock indices with
the features of commodity futures trading. It
allows investors to speculate on the entire stock
market's performance, short sell an index with a futures contract,
or to hedge a long position against a decline in value.

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• There are two main types of traders executing trades: Brokers and
Locals.
• Commission Brokers are following the instructions of their clients
and charge a commission for doing so.
• Locals are trading on their own account.
• Individuals taking position, whether locals or the clients of
commission brokers, can be categorized as hedgers, speculators
and arbitrageurs.

TRADERS
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• Speculators can be classified as scalpers, day traders, or position
traders.
• Scalpers are watching for very short term trends and attempt to
profit from small changes in the contract price. They usually hold
their positions for only a few minutes.
• Day traders hold their positions for less than one trading day. They
are unwilling to take the risk that adverse news will occur overnight.
• Position traders hold their positions for much longer periods of
time. They hope to make significant profits from major movements
in the markets.

Speculators
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• A futures contract with an underlying instrument that pays
interest. An interest rate future is a contract between the buyer
and seller agreeing to the future delivery of any interest-bearing
asset. The interest rate future allows the buyer and seller to lock
in the price of the interest-bearing asset for a future date.

Interest Rate Futures

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• Short term interest rate futures

• A short term interest rate future is a future (obligation to

buy or sell an underlying in the future) whose
underlying reference is determined by the level of a
specific short term interest rate. A short term interest
rate corresponds to an original term to maturity equal to
or lower than 12 months (treasury bills, deposits etc.)

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• Long term interest rate futures

• A long term interest rate future is a future (obligation to

buy or sell an underlying in the future) whose underlying
reference is determined by the level of a specific long
term interest rate. A long term interest rate corresponds to
an original term to maturity greater than 12 months
(treasury bonds, corporate bonds, Eurobonds etc.)

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• Foreign Currency Futures :Standardized and
easily transferable obligation between two parties to
exchange currencies at a specified rate during a
specified delivery month; standardized contract on
specified underlying currencies, in multiples of
standard amounts. Purchased and traded on
a regulated exchange on which margins are posted.

FCF
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• An agreement to buy or sell a set amount of a
commodity at a predetermined price and date.
Buyers use these to avoid the risks associated with
the price fluctuations of the product or raw
material, while sellers try to lock in a price for their
products. Like in all financial markets, others use
such contracts to gamble on price movements. 

Commodity Futures
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• To minimize credit risk to the exchange, traders must post

a margin or a performance bond, typically 5%-15% of the

contract's value.

Margins
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• Before trading a futures contract, the prospective trader must deposit funds with
an FCM (Futures Commission Merchants) – the deposit serves as a
performance bond and is referred to as initial margin.
• The requirements are not set as a percentage of contract value. Instead they are
a function of the price volatility of the commodity. A common method is to set
IPF (Initial Performance Fund) equal to μ + 3σ
• An initial margin is a deposit to cover losses the trader may incur on a
futures contract as it is marked-to-market.
• A maintenance margin is a minimum amount of money that must be
maintained on deposit in a trader’s account. Maintenance margin is a lesser
amount than the initial margin - typically 75% of the initial margin
• A margin call is a demand for an additional deposit to bring a trader’s
account up to the initial performance bond level.
• Traders post the funds for performance bond with their FCMs

Margin
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 • Each Gold futures contract is for 100 ounces of gold
• Assume that the current market price of gold is $400 an ounce
• The average daily absolute price change over the last 4 weeks is $10 an
ounce
• μ = $10 × 100 = $1,000
• The standard deviation of the last 4 weeks’ daily absolute price change
is $2 an ounce
• σ = $2 × 100 = $200
• Thus, the initial margin for 1 gold futures contract will be
• μ + 3σ = $1,000 + 3 × $200 = $1,600
• For most futures contracts, the initial margin may be 5 percent or less of
the contract’s face value.

Example
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• Maintenance Margin- An Example
• In general, maintenance margin is a lesser amount than the
initial margin - typically 75% of the initial margin
• For example, the initial margin and maintenance margin for
CBT Corn futures are $1,000 and $800 per contract.
• The maintenance margin is used as a threshold for the
trader’s account with her/his FCM.
• Whenever the deposit in trader’s account reaches or falls
below the maintenance margin, the trader is required to
replenish the account, bringing it back to its initial level
(initial margin).
• The demand (from the FCM) for additional funds to
replenish the trader’s account is known as margin call.

CTSK 06/02/2020
• Margin Call - An Example
• Suppose that the initial margin and maintenance
margin for CBT Corn futures are $1,000 and $800 per
contract.
• Now suppose that, due to an adverse price change, the
trader’s account incurs a loss of $250 after marking-
to-market.
• The trader will receive a margin call from her/his
FCM to deposit additional $250 to her/his account that
brings the account to its initial deposit level.
• However, as long as the deposit level is above the
maintenance margin after marking-to-market (e.g.,
above $800), the trader will not receive the margin
call.

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• Mr. X, who went long in a contract for 100 units of the
asset at a price of $ 75 unit, and deposited $ 1,000 as
collateral for the same. The maintenance margin fixed by
the broker is $ 750 for the contract. The contract lasts for
five days. The future’s prices in the subsequent days are
78.5, 73.5, 71.0, 79.5 and 82.5. Draw the table of
Changes in the Margin Account over the course of time.

Example
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 Changes in the Margin Account Over the Course of Time
Day Future’s Daily Cumulative Account Margin
Price Gain/Loss Gain/Loss Balance Call

0 75.00 1,000
1 78.50 350 350 1,350
2 73.50 (500) (150) 850
3 71.00 (250) (400) 600 400
4 79.50 850 450 1,850
5 82.50 300 750 2,150

Example
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• Suppose that you enter into a short futures contract to sell
July silver for $17.20 per ounce. The size of the contract is
5,000 ounces. The initial margin is $4,000 and the
maintenance margin is $3,000. What change in the futures
price will lead to a margin call? What happens if you do not
meet the margin call?

Example
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• There will be a margin call when $1,000 has been lost
from the margin account. This will occur when the price
of silver increases by 1,000/5,000 = $0.20. The price of
silver must therefore rise to $17.40 per ounce for there to
be a margin call. If the margin call is not met, your broker
closes out your position.

Answer
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• Suppose that in September 2015 a Company takes a long
position in a contract on May 2016 crude oil futures. It closes
out its position in March 2016. The futures price (per barrel) is
$68.30 when it enters into the contract, $70.50 when it closes
out its position and $69.10 at the end of December 2015. One
contract is for the delivery of 1,000 barrels. What is the
company’s total profit? When is it realised? How is it taxed if it
is (a) a hedger and (b) a speculator?
• Assume that the company has a December 31 year end.
Example
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• The total profit is ($70.50 - $68.30)*1000 = $2200. Of this
($69.10 - $68.30) * 1000 or $ 800 is realised on a day-by-day
basis between September 2015 and December 31, 2015. A
further ($70.50 - $69.10) * 1000 = $1400 is realised on a day-
by-day basis between January 1, 2016 and March 2016. The
hedger would be taxed on the whole profit of $2200 in 2016. A
speculator would be taxed on $800 in 2015 and $1400 in 2016.

Answer:
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• An investor enters into a short forward contract to sell
£100,000 for US $ at an exchange rate of $1.4000 per
GBP. How much does the investor gain or lose if the
exchange rate at the end of the contract is (i) $1.3900 and
(ii) $1.4200?

Example
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• a) The investor is obligated to sell £ when they are
worth 1.3900. The gain is (1.400 – 1.3900) * 100000 =
$1000
• b) The investor is obligated to sell £ for 1.400 when they
are worth 1.4200. The loss is (1.4200- 1.400) * 100000 =
$ 2000

Answer
CTSK 06/02/2020
• i) The trader sells for 50 cents per pound something that
is worth 48.20 cents per pound. Gain = ($0.5000 - $
0.4820)* 50,000 = $900
• ii) The trader sells for 50 cents per pound something that
is worth 51.30 cents per pound. Loss = ($0.51.30 -
$0.5000)* 50,000 = $650

Answer
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• A trader enters into a short cotton futures contract when
the futures price is 50 cents per pound. The contract is for
the delivery of 50,000 pounds. How much does the trader
gain or lose if the cotton price at the end of the contract
is;
• i) 48.20 cents per pound?

• ii) 51.30 cents per pound?

Example
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• Assume today’s settlement price on a CME EUR futures
contract is $1.3140/EUR. You have a short position in one
contract. Your performance bond account currently has a
balance of $1,700. The next three days’ settlement prices are
$1.3126, $1.3133, and $1.3049. Calculate the changes in the
performance bond account from daily marking-to-market and
the balance of the performance bond account after the third day.
• where EUR125,000 is the contractual size of one EUR contract.

Example
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• $1,700 + [($1.3140 - $1.3126) + ($1.3126 - $1.3133)

+ ($1.3133 - $1.3049)] x EUR125,000 = $2,837.50

Answer
CTSK 06/02/2020
• Assume today’s settlement price on a CME EUR futures
contract is $1.3140/EUR. You have a long position in one
contract. Your performance bond account currently has a
balance of $1,700. The next three days’ settlement prices are
$1.3126, $1.3133, and $1.3049. Calculate the changes in the
performance bond account from daily marking-to-market and
the balance of the performance bond account after the third day.
• where EUR125,000 is the contractual size of one EUR contract.

Example
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 $1,700 + [($1.3126 - $1.3140) + ($1.3133 - $1.3126) +
($1.3049 - $1.3133)] x EUR125,000 = $562.50

Example
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• Value at Risk measures the potential loss in value of a risky asset or

portfolio over a defined period for a given confidence interval. Thus,

if the VaR on an asset is $ 100 million at a one-week, 95%

confidence level, there is a only a 5% chance that the value of the

asset will drop more than $ 100 million over any given week.

• Value at Risk is measured in three variables: the amount of potential

loss, the probability of that amount of loss, and the time frame.
VALUE AT RISK (VaR)
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• There are three methods of calculating VAR: the
historical method, the variance-covariance method and
the Monte Carlo simulation. 

Methods of VAR
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• The historical method simply re-organizes actual historical
returns, putting them in order from worst to best. It then assumes
that history will repeat itself, from a risk perspective. 

Historical Method 
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• This method assumes that stock returns are normally distributed.
In other words, it requires that we estimate only two factors -
an expected (or average) return and a standard deviation - which
allow us to plot a normal distribution curve.
• The idea behind the variance-covariance is similar to the ideas
behind the historical method - except that we use the familiar
curve instead of actual data.

The Variance-Covariance Method 

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• The third method involves developing a model for future stock
price returns and running multiple hypothetical trials through the
model. A Monte Carlo simulation refers to any method that
randomly generates trials, but by itself does not tell us anything
about the underlying methodology. 

Monte Carlo Simulation 

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