Futures Contract Specifications

Closing Out Positions

• Most futures contracts are closed out before the delivery period through an offsetting trade.
• Closing out a position involves entering into the opposite trade of the original one.
• A trader's gain or loss is determined by the change in the futures price between the initial trade and the closing trade.
• Delivery is unusual, but the possibility of delivery ties the futures price to the spot price.

Specification of a Futures Contract

• Exchanges must specify the asset, contract size, delivery locations, and delivery dates.
• The party with the short position typically chooses when alternatives are specified.
• When ready to deliver, the short position files a notice of intention with the exchange, indicating the asset grade and delivery location.

The Asset

• For commodities, exchanges must specify acceptable grades due to quality variations.
• ICE specifies frozen concentrates that are US Grade A with a Brix value of not less than 62.5 degrees for its orange juice futures contract.
• Some commodities allow a range of deliverable grades, but the price is adjusted accordingly.
• Financial assets in futures contracts are generally well-defined, such as the Japanese yen.
• The underlying asset in the Treasury bond contract is any US Treasury bond that has a maturity between 15 and 25 years.
• The underlying asset in the Treasury note futures contract is any Treasury note with a maturity of between 6.5 and 10 years.
• The exchange has a formula for adjusting the price received according to the coupon and maturity date of the bond delivered.

The Contract Size

• The contract size specifies the amount of the asset to be delivered under one contract.
• Contract size should accommodate both small hedgers/speculators and larger players.
• Agricultural products may have contract values of $10,000 to $20,000.
• Treasury bond futures contracts have a face value of $100,000.
• "Mini" contracts are sometimes introduced to attract smaller investors, such as the CME Group’s Mini Nasdaq 100 contract

Delivery Arrangements

• The delivery location must be specified, especially for commodities with significant transportation costs.
• For the ICE frozen concentrate orange juice contract, delivery is to exchange-licensed warehouses in Florida, New Jersey, or Delaware.
• Alternative delivery locations may result in price adjustments.

Delivery Months

• Futures contracts are identified by their delivery month.
• Exchanges specify the delivery period, which can be the entire month.
• Delivery months vary by contract based on market participant needs.
• Corn futures traded by the CME Group have delivery months of March, May, July, September, and December.
• Exchanges determine when trading begins and ends for a contract month.

Price Quotes

• Exchanges define how prices are quoted,
• US crude oil futures are quoted in dollars and cents.
• Treasury bond and Treasury note futures prices are quoted in dollars and thirty-seconds of a dollar

Price Limits and Position Limits

• Daily price movement limits are often specified.
• Limit down is when the price moves down by the daily price limit.
• Limit up is when the price moves up by the daily price limit.
• A limit move is a move equal to the daily price limit.
• Trading typically ceases when a contract is limit up or limit down, the exchange can change the limits.
• Daily price limits aim to prevent speculative excesses.
• Position limits restrict the maximum number of contracts a speculator can hold to prevent market influence.

Convergence of Futures Price to Spot Price

• As the delivery period approaches, the futures price converges to the spot price.
• During the delivery period, the futures price equals or is very close to the spot price.
• Arbitrage opportunities ensure this convergence.
• If the futures price is above the spot price, traders can sell futures, buy the asset, and make delivery for a profit.
• If the futures price is below the spot price, companies can buy futures and wait for delivery.

Daily Settlement

• Margin accounts are used to avoid contract defaults.
• Investors deposit funds into a margin account, with the initial deposit known as the initial margin.
• The margin account is adjusted daily to reflect gains or losses, known as daily settlement or marking to market.
• Daily settlement is not merely an arrangement between broker and client.
• Brokers pay the exchange clearing house when there's a price decrease and receive money when there's a price increase.
• Investors can withdraw balances exceeding the initial margin.
• A maintenance margin is set below the initial margin.
• If the balance falls below the maintenance margin, a margin call is issued, requiring the investor to restore the account to the initial margin level.
• Extra funds deposited are known as a variation margin.
• If the variation margin is not provided, the broker closes out the position.

Further Details

• Brokers often pay interest on margin account balances.
• Treasury bills or shares can be deposited in lieu of cash for initial margin requirements.
• Futures contracts are settled daily, while forward contracts settle at the end of their life.
• Minimum margin levels are set by the exchange clearing house and depend on the price variability of the underlying asset
• Maintenance margin is typically about 75% of the initial margin.
• Bona fide hedgers may have lower margin requirements than speculators.
• Day trades and spread transactions may also have lower margin requirements.
• Margin requirements are the same for short and long positions.

The Clearing House and Its Members

• A clearing house acts as an intermediary and guarantees transaction performance.
• Brokers who are not clearing house members must operate through a member and post margin.
• The clearing house tracks daily transactions to calculate each member's net position.
• Clearing house members provide initial margin reflecting the total number of contracts cleared.
• Daily transactions are settled, with members providing variation margin to the clearing house for losses and receiving it for gains.
• Initial margin is calculated on a net basis, offsetting short positions against long positions.
• Clearing house members contribute to a guaranty fund, which is used if a member fails to provide variation margin.

Credit Risk

• The margining system ensures funds are available to pay traders when they profit.
• The system was tested on October 19, 1987, when the S&P 500 index declined over 20%.
• Clearing houses had sufficient funds to ensure that everyone who had a short futures position on the S&P 500 got paid off.
• Some brokers went bankrupt because, without their clients’ money, they were unable to meet margin calls on contracts they entered into on behalf of their clients.

OTC Markets

• Over-the-counter (OTC) markets involve derivatives transactions agreed upon without an exchange.
• Credit risk is a feature of OTC derivatives markets, where a default by one party can cause losses for the other.
• The OTC market has adopted ideas from exchange-traded markets to reduce credit risk.

Central Counterparties

• CCPs are clearing houses for standard OTC transactions, similar to exchange clearing houses.
• CCP members provide initial margin and daily variation margin and contribute to a guaranty fund.
• Once an OTC transaction is accepted by a CCP, it becomes the counterparty to both original parties.
• CCPs take on the credit risk of both parties.
• Regulators require most standard OTC transactions between financial institutions to be handled by CCPs due to systemic risk concerns.

Bilateral Clearing

• OTC transactions not cleared through CCPs are cleared bilaterally.
• A master agreement, including a credit support annex (CSA), covers all trades between two companies.
• CSAs require parties to provide collateral, similar to margin.
• Collateral agreements typically value transactions daily, with parties providing collateral to cover changes in value.
• New regulations in 2012 require initial margin and variation margin for bilaterally cleared transactions between financial institutions.
• Collateral reduces credit risk in the bilaterally cleared OTC market.

Futures Trades vs. OTC Trades

• Initial margin, when provided in cash, usually earns interest.
• Daily variation margin for futures contracts does not earn interest because it constitutes daily settlement.
• Variation margin in the OTC market earns interest because transactions are not settled daily.
• Securities can be used for margin/collateral, with their market value reduced by a haircut.

Market Quotes

• Futures quotes are available from exchanges and online sources.
• Information includes the underlying asset, contract size, and price quotation method.

Prices

• Table 2.2 includes the opening price, the highest price, and the lowest price in trading.
• The opening price represents prices at the start of trading.

Settlement Price

• The settlement price is used to calculate daily gains, losses, and margin requirements.
• The settlement price is typically the price at which the contract traded immediately before the end of a day’s trading session.
• Table 2.2 shows the previous day’s settlement price, the most recent trading price, and the price change from the previous day.

Trading Volume and Open Interest

• Trading volume is the number of contracts traded in a day.
• Open interest is the number of contracts outstanding (long or short positions).
• High day-trader activity can result in trading volume exceeding open interest.

Patterns of Futures

• Futures prices exhibit different patterns.
• A normal market has settlement futures prices increasing with maturity.
• An inverted market has settlement futures prices decreasing with maturity.

FORWARD vs. FUTURES CONTRACTS

• Forward contracts are traded OTC, lack standardization, and usually settle on a single delivery date.
• Futures contracts are standardized, exchange-traded, settled daily, and typically closed out before maturity.

Profits from Forward and Futures Contracts

• Forward contracts realize gains/losses at the contract's end.
• Futures contracts realize cumulative gains/losses daily through settlement procedures.

Foreign Exchange Quotes

• Both forward and futures contracts trade actively on foreign currencies.
• Futures prices quoted as USD per unit of foreign currency.
• Forward prices are quoted in the same way as spot prices.