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• Futures exchanges pioneered practices now adopted by over-the-counter markets.

Background

• Key exchanges include CME Group, InterContinental Exchange (ICE), Eurex, BM&F BOVESPA, and Tokyo Financial Exchange.
• A trader buys (long position) or sells (short position) a futures contract through a broker
• Traditionally, floor traders met physically to determine prices.
• Electronic trading now matches traders.

Example: Unanticipated Delivery

• A new employee mistakenly bought instead of selling live cattle futures contracts, resulting in the financial institution holding a long position in two contracts.
• The institution had to accept delivery of live cattle at a distant location and arrange for their care until the next cattle auction

Supply and Demand

• The price agreed upon reflects the current futures price, influenced by supply and demand.
• More sellers than buyers lower the price, attracting new buyers to restore balance.
• More buyers than sellers raise the price, attracting new sellers to restore balance.

Closing Out Positions

• Most futures contracts are closed before delivery by taking the opposite trade.
• A trader who initially bought a contract can close by selling one, and vice versa.
• Profit/loss is determined by the change in futures price between the initial trade and the closing trade.
• Delivery is unusual but ties the futures price to the spot price.

Futures Contract Specifications

• Exchanges detail the agreement, specifying the asset, contract size, delivery location, and delivery date.
• 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.

The Asset

• For commodities, exchanges stipulate acceptable grades.
• ICE specifies US Grade A frozen concentrated orange juice with a minimum Brix value of 62.5 degrees.
• Some contracts allow a range of deliverable grades with price adjustments.
• Financial assets are well-defined (e.g., Japanese yen).
• Treasury bond contracts allow bonds with 15-25 years to maturity.
• Treasury note contracts allow notes with 6.5-10 years to maturity.
• The exchange adjusts the price based on coupon and maturity date in Treasury contracts.

Contract Size

• Contract size is an important decision for exchanges
• Too large may exclude smaller hedgers/speculators.
• Too small may make trading expensive due to per-contract costs.
• Size depends on the likely user; agricultural contracts may be $10,000-$20,000, while financial futures are higher.
• Treasury bond contracts involve $100,000 face value instruments.
• "Mini" contracts attract smaller investors, like the CME Group’s Mini Nasdaq 100 contract.

Delivery Arrangements

• Delivery locations must be specified
• Important for commodities with transportation costs.
• ICE orange juice contracts deliver to licensed warehouses in Florida, New Jersey, or Delaware.
• Prices may be adjusted based on the delivery location chosen by the short position.

Delivery Months

• Contracts are identified by delivery month
• Exchanges specify the exact delivery period.
• Corn futures have delivery months of March, May, July, September, and December.
• Exchanges determine when trading begins and ends for each contract month.
• Trading usually ceases a few days before the last delivery day.

Price Quotes

• Exchanges define how prices are quoted (e.g., dollars and cents for crude oil, dollars and thirty-seconds of a dollar for Treasury bonds).

Price Limits and Position Limits

• Daily price movement limits are specified by the exchange
• Limit down: price moves down by the daily price limit.
• Limit up: price moves up by the daily price limit.
• Limit move: a move equal to the daily price limit.
• Trading typically ceases when a contract is limit up or limit down.
• Exchanges can sometimes change the limits.
• Limits aim to prevent large price movements from speculative excesses.
• Controversial whether price limits are beneficial to futures markets.
• Position limits are the maximum number of contracts a speculator can hold.
• Position limits prevent speculators from unduly influencing the market.

Convergence of Futures Price to Spot Price

• As the delivery period nears, futures price converges to the spot price.
• During the delivery period, futures price equals or is very close to the spot price.
• If the futures price is above the spot price, traders can:
  • Sell a futures contract
  • Buy the asset
  • Make delivery for a profit.
• Arbitrage lowers the futures price.
• If the futures price is below the spot price:
  • Companies acquire the asset by entering a long futures contract
  • Wait for delivery
• This raises the futures price.

Operation of Margin Accounts

• Exchanges organize trading to avoid contract defaults through margin accounts
• An investor buying two December gold futures contracts deposits funds in a margin account.
• Initial margin is the amount deposited when the contract is entered.
• Daily settlement or marking to market adjusts the margin account daily to reflect gains or losses.
• If the futures price drops, the account is reduced; if it rises, the account is increased.
• A trade is settled at the close of the day it takes place and subsequently settled each day thereafter
• Daily settlement isn't just between broker and client, it involves the exchange clearing house

Withdrawing and Maintaining

• Investors can withdraw any balance exceeding the initial margin.
• A maintenance margin, lower than the initial margin, ensures the balance doesn't become negative.
• If the balance falls below the maintenance margin, a margin call is issued.
• The investor must top up the account to the initial margin level by the end of the next day
• Extra funds are called a variation margin.
• Failure to provide the variation margin results in the broker closing out the position.
• Margin requirements can be satisfied by depositing securities.
• Treasury bills are accepted at about 90% of face value; shares at about 50% of market value.
• Futures are settled daily, unlike forward contracts settled at the end.
• Futures are effectively closed out and rewritten at a new price each day.
• Minimum margin levels are set by the exchange clearing house based on the price variability of the underlying asset.
• The higher the variability, the higher the margin levels.
• Maintenance margin is usually about 75% of the initial margin.
• Hedgers may have lower margin requirements than speculators due to lower default risk.
• Day trades and spread transactions often have lower margin requirements than hedge transactions.
• Margin requirements are the same on short and long futures positions.

The Clearing House and Its Members

• A clearing house intermediates futures transactions.
• The clearing house guarantees the performance of each transaction.
• Clearing house members must channel business through a member and post margin with the member
• The clearing house calculates each member's net position
• Members provide initial margin based on the total contracts cleared and contribute to a guaranty fund.
• Variation margin is paid to the exchange clearing house if transactions lose money, and received if they gain.
• Initial margin is usually calculated on a net basis, offsetting short positions against long positions.

Credit Risk

• The margining system pays traders when they profit.
• Futures markets were tested during the 1987 S&P 500 index decline.
• Clearing houses had sufficient funds to pay those with short futures positions.

OTC Markets

• OTC markets involve companies agreeing to derivatives transactions without an exchange
• Credit risk is a traditional feature
• The OTC market has borrowed ideas from exchange-traded markets to reduce credit risk.

Central Counterparties

• CCPs clear standard OTC transactions, similar to exchange clearing houses.
• CCP members provide initial and daily variation margin, and contribute to a guaranty fund.
• Once an OTC derivative transaction is agreed, it can be presented to a CCP
• The CCP becomes the counterparty to both parties, like a clearing house for futures.
• CCPs take on the credit risk of both parties.
• Transactions are valued daily with variation margin payments.
• OTC participants can clear trades through a CCP member and provide margin to the CCP.
• Legislation requires most standard OTC transactions between financial institutions to be handled by CCPs to manage systematic risk
• CCP members are required to provide initial margin to the CCP

Bilateral clearing

• OTC transactions not cleared through CCPs are cleared bilaterally.
• Companies A and B enter into a master agreement covering all trades, often including a credit support annex (CSA).
• CSAs require A or B, or both, to provide collateral, similar to the margin required by exchange clearing houses or CCPs.
• Collateral agreements usually require daily valuation of transactions
• New regulations introduced in 2012 require both variation and initial margin for bilaterally cleared transactions between financial institutions
• Initial margin is typically segregated and posted with a third party.
• Collateral reduces credit risk in the bilaterally cleared OTC market.

Long-Term Capital Management’s Big Loss

• Long-Term Capital Management (LTCM) always collateralized bilaterally cleared transactions.
• LTCM's strategy was convergence arbitrage and was required to post collateral
• When Russia defaulted on its debt (1998), a "flight to quality" occurred.
• Spreads between liquid and illiquid instruments in LTCM’s portfolio increased dramatically.
• LTCM was required to post collateral on both bought and shorted bonds.
• High leverage led to difficulties, positions were closed, and LTCM lost ~$4 billion.

Futures Trades vs. OTC Trades

• Initial margin provided in cash usually earns interest.
• Daily variation margin for futures contracts does not earn interest, because it constitutes the daily settlement.
• OTC transactions are not settled daily
• Daily variation margin earns interest when in the form of cash
• Securities can be used to satisfy margin/collateral requirements.
• The market value of securities is reduced by a haircut for margin purposes.

Market Quotes

• Futures quotes are available from exchanges and online sources.

Prices

• Quotes include opening price, highest price, and lowest price during the day.
• The opening price represents prices at the start of trading
• Settlement price is used to calculate daily gains, losses, and margin requirements.
• The most recent trading price and price change from the previous day’s settlement price are also shown
• If $1,425.3 proved to be the settlement price on May 14, 2013, the margin account of a trader with a long position in one contract would lose $900 on May 14 and the margin account of a trader with a short position would gain this amount on May 14.

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).
• Large day trading volume can exceed beginning or end-of-day open interest.

Patterns of Futures

• Normal market: Futures prices increase with contract maturity (gold, wheat, live cattle).
• Inverted market: Futures prices decrease with maturity.
• Some commodities showed mixed patterns (crude oil, corn, soybeans).

Delivery

• Few futures contracts lead to delivery.
• Delivery procedures are important for determining the futures price.
• The exchange defines the delivery period.
• The short position (investor A) decides when to deliver.
• Investor A's broker issues a notice of intention to deliver to the exchange clearing house.
• The exchange chooses a party with a long position to accept delivery.
• The notice is passed to the party with the oldest outstanding long position.
• Long positions must accept delivery notices.
• Notices are transferable for a short time if long investors find another party to take delivery.
• Delivery involves accepting a warehouse receipt in return for payment and taking responsibility for all warehousing costs.
• For livestock futures, there may be costs associated with feeding and looking after the animals
• Financial futures are delivered by wire transfer.
• The price paid is usually the most recent settlement price, adjusted for grade/location.
• The entire delivery procedure generally takes 2-3 days.
• Key dates: first notice day, last notice day, and last trading day.
• Avoid delivery by closing out long positions before the first notice day.

Cash Settlement

• Some financial futures (e.g., stock indices) are cash-settled.
• All outstanding contracts are closed on a predetermined day.
• The final settlement price is set equal to the spot price of the underlying asset at the open/close of trading that day

Types of Traders and Types of Orders

• Two main types of traders are executing trades: futures commission merchants (FCMs) and locals.
• FCMs charge a commission for following the instructions of their clients
• Locals trade on their own account.
• Individuals are classified as hedgers, speculators, or arbitrageurs.
• Speculators are scalpers, day traders, or position traders.
• Scalpers profit from short-term price changes.
• Day traders hold positions less than one day.
• Position traders hold positions longer-term.

Types of Orders

• Market order: executed immediately at the best available price.
• Limit order: executed at a specific price or better.
  • Cannot guarantee that the order will be executed since the limit price may never be reached
• Stop order/stop-loss order: executed at the best available price once the price reaches the specified level, limits losses.
• Stop-limit order: becomes a limit order when the stop price is hit.
• Market-if-touched (MIT) order or board order: executed at the best available price once a trade happens at a specified price or better, useful for profit-taking.
• Discretionary/market-not-held order: execution may be delayed by the broker for a better price.
• Time conditions:
  • Day order: expires at the end of the trading day.
  • Time-of-day order: can be executed during a specific time.
  • Open/good-till-canceled order: in effect until executed or the contract expires.
  • Fill-or-kill order: must be executed immediately or not at all.

Regulation

• In the United States, futures markets are regulated by the Commodity Futures Trading Commission (CFTC), established in 1974.
• The CFTC communicates prices to the public, futures traders report their outstanding positions
• CFTC licenses those offering services to the public, investigates backgrounds, and sets minimum capital requirements.
• The CFTC addresses complaints and disciplines individuals when appropriate.
• The National Futures Association (NFA) was formed in 1982 and prevents fraud.
• The Dodd–Frank Act (2010) expanded the role of the CFTC.

Trading Irregularities

• Investor groups may attempt to "corner the market."
• They take a large long futures position and control the supply of the commodity.
• When contracts near maturity, outstanding contracts can exceed available commodities for delivery
• Short positions desperately close out, causing large price increases.
• Regulators increase margin requirements, impose position limits, or prohibit trades.
• Other irregularities can involve traders front running

Accounting

• Accounting standards recognize changes in market value of futures contracts when they occur.
• Hedge accounting is used only if the contract is hedging, gains/losses are recognized when the hedged item's gains/losses are recognized.
• Derivative instruments must be included on the balance sheet at fair market value as according to Accounting for Derivative Instruments and Hedging Activities
• Disclosure requirements have also increased
• Hedge accounting can only be used if the hedging instrument is highly effective and there is an assessment of this effectiveness
• The International Accounting Standards Board has issued the International Accounting Standards Board (IAS) 39

Tax

• US tax rules classify gains/losses as capital gains/losses or ordinary income.
• Corporate capital gains are taxed at the same rate as ordinary income
• Capital losses are deductible only to the extent of capital gains, carried back three years, and forward five years.
• Noncorporate short-term capital gains are taxed at the same rate as ordinary income.
• Long-term capital gains are subject to a maximum capital gains tax rate of 15%
• Capital losses are deductible to the extent of capital gains plus $3,000 of ordinary income.
• Capital gains are carried forward indefinitely
• Positions in futures contracts are treated as closed out on the last day of the tax year and classified as 60% long term and 40% short term, the "60/40" rule.
• Net losses from the 60/40 rule can be carried back three years to offset gains
• Hedging transactions are exempt from the 60/40 rule
• Hedging is defined as reducing price changes or currency fluctuations with respect to property held to produce ordinary income.

Forward vs. Futures Contracts

• Forward contracts are private agreements, not standardized, with one delivery date, settled at the end
• Futures contracts are traded on an exchange, standardized, with a range of delivery dates, settled daily, and closed out prior to maturity.

Profits from Forward and Futures Contracts

• Forward contracts realize the whole gain/loss at the end.
• Futures contracts realize the gain/loss daily through settlement procedures.

Foreign Exchange Quotes

• Futures prices where one currency is the US dollar are always quoted as the number of US dollars per unit of the foreign currency or as the number of US cents per unit of the foreign currency.
• Forward prices are always quoted in the same way as spot prices.
• For the British pound, the euro, the Australian dollar, and the New Zealand dollar, the forward quotes show the number of US dollars per unit of the foreign currency and are directly comparable with futures quotes
• For other major currencies, forward quotes show the number of units of the foreign currency per US dollar (USD).