Understanding Futures Contracts

Futures Contracts

• A financial contract between two parties establishes terms for a future transaction
• The underlying transaction is firm and obligations are contractually binding

Economic Clauses in Futures Contracts

• Asset (equity, interest rate, index, currency, commodity)
• Number of underlyings (or notional amount)
• Price
• Transaction date
• Transaction settlement date

Trading Futures

• Futures trade on organized markets like stock exchanges
• Exchanges decide contract availability (underlying, maturity)
• Supervisory bodies define legal/economic clauses
• Parties negotiate only the future's price on the contract conclusion date

Settlement Methods

• Physical delivery: Delivering quantity of underlyings on settlement date for cash
• Cash settlement: One party pays the other the difference between the underlying's price at maturity and the originally agreed price, multiplied by the number of underlyings

Economic Role of Futures

• Enable the transfer of risk between market participants

How Participants Use Futures

• To hedge exposure to financial risks such as equity price fluctuations, interest rate variations, stock market index changes, and foreign exchange rate fluctuations
• To gain exposure to financial risk using leverage

Organization of Futures Market

• Futures trade on organized markets, often electronically
• Trading is order-driven using limit price orders in an order book; market players include sell-side dealers and buy-side participants
• Only market participants can place orders; non-members use a broker to execute orders on the customer’s behalf
• Futures trade by contract, each specifying a number of underlyings

Trading Specifics

• State whether orders are opening (increase position) or closing (decrease position) transactions

Open Interest

• Stock exchanges state the number of open contracts at the clearing house

Tick Size

• Stock market bodies define a minimum price change increment
• The tick size for an SMI index future is one point

Tick Value

• Stock market authorities define values for futures with non-deliverable underlyings that settle in cash
• For an SMI index, one index point is worth CHF 10

Clearing House as Central Counterparty

• The clearing house functions as a central counterparty, becoming the legal counterparty to both buyer and seller in a futures trade

Clearing House Members

• Only clearing house members can be official counterparties
• Exchange participants' trades must be assigned to a member, so the clearing house might not record customer positions directly

Principal-to-Principal Clearing Model

• Clearing members are the official counterparties for all assigned futures contracts

Segregated Accounts

• Members must register customer futures contracts separately from their own
• The aim is to easily transfer customer positions to another clearing member if a member defaults

Segregation Benefits and Costs

• Segregation minimizes customer risk in case of a clearing house member default (transit, settlement, fellow customer risks)
• Fees charged to the customer are higher

Margins

• Clearing houses require members to deposit guarantees or "margins" due to the risk of member default

Margin Calls

• If a member's collateral is insufficient, the clearing house issues a margin call
• If collateral isn't delivered, the clearing house can liquidate contracts and use collateral to cover losses

Bank Practices

• Banks pass on clearing house margins to customers based on their risk policies

Closing Positions

• Positions can be reduced or closed before maturity by taking an opposite trade, adding "closing"

Corporate Actions

• The clearing house adjusts derivative contracts for corporate actions, using adjustment methods depending on the action type
• Adjustments are published on the clearing house website

Settlement

• Physical settlement occurs on a delivery-versus-payment (DVP) basis between the clearing house and member

Single Stock Futures

• Agreement between two parties which establishes the terms of a transaction on an equity to be settled on a future date
• The seller commits to sell, and the buyer commits to buy, the underlying equity based on contract terms

Seller's Perspective

• On the contract date, the seller knows the future selling price and has a "short position"
• Profit is made if the equity's market price is lower than agreed at maturity

Buyer's Perspective

• The buyer knows the future purchase price and has a "long position"
• Profit is made if the equity's market price is higher than agreed at maturity

Customer Use Cases for Selling Single Stock Futures

• To hedge against a fall in the price of the underlying equity
• To gain exposure to a fall in the price by using leverage

Customer Use Cases for Buying Single Stock Futures

• To hedge against a rise in the price of the underlying equity
• To gain exposure to a rise in the price by using leverage

Contract Specifications

• Single stock futures trade by contract, with each contract specifying a number of equities
• Stock market authorities define contract sizes

Contract Maturity

• Stock market bodies also define contract maturity dates, creating several contracts for listed underlyings with different maturities

Settlement Dates

• The settlement date is usually defined by the equity's settlement standards, e.g., T+2

Standardized Conditions

• Standard contracts specify number of equities (contract size), transaction date, and settlement date; parties negotiate on price and number of contracts

Practical Example: Hedging with Banco Santander Equities

• Mr Klein wants to sell 500 Banco Santander equities in September 20xx to repay a mortgage. To hedge against a fall in the share price, they use futures.
• Mr Klein chooses a futures contract maturing in September 20xx, with Eurex setting the maturity date as the third Friday of that month and setting the settlement date as T+2
• One future contract covers 100 Banco Santander equities, so Mr Klein sells five contracts.

Future Price Calculations

• Banco Santander equity is EUR 4.70 on initiation
• No dividends are paid
• The period until the settlement date for the future is 90 days
• The 3-month EURIBOR rate is 2%

Future Price Formula

• Ft,T = St × (1 + R T−t × (T−t)/(360 or 365)
• St represents the equity price and R T−t is the annualized interest rate

Basis

• The difference between futures and spot price, in the example EUR 0.0235
• The basis reflects the cost of financing without any dividend payments

Contract Settlement

• Can be physical or cash settled

Physical Settlement

• Mr Klein delivers 500 equities to his counterparty for EUR 2,361.75 (=500 EUR 4.7235) on the settlement date (third Friday of September plus two trading days)

Cash Settlement

• Requires the closing price of Banco Santander equity on the contract maturity date
• If the price is lower than the futures contract, Mr Klein receives the difference
• If the price is higher, Mr Klein pays the difference

Dividend Adjustments

• Futures contracts are not entitled to ordinary dividends
• Future prices must be adjusted to account for potential dividend payments from the underlying equity

Index Futures Formula

• Ft,t = St × (1 + RT-t × (T-t) / 360 (or 365) ) – Div × (1 + RT-t1 × (T-t₁) / 360 (or 365))

Index Futures

• Agreement between two parties which establishes the terms of an index transaction that will be settled on a future date
• The underlying index is an official market index (SMI, EURO STOXX 50, S&P 500)
• The seller commits to sell, and the buyer commits to buy, the underlying index based on contract terms
• Since an index cannot be physically delivered, settlement is in cash

Index Point Value

• Index futures are quoted in index points, each with assigned monetary value defined by stock market bodies

Example

• On Eurex, the value of one SMI future index point is CHF 10
• A future negotiating at 8,500 points represents CHF 85,000
• On Eurex, the value of one EURO STOXX 50 future index is EUR 10
• A future negotiating at 3,200 points represents EUR 32,000

Index Futures Contracts - Short Position

• The seller knows the realization price on the contract date and has a "short position." A gain occurs if the market value is lower than the negotiated price at maturity

Index Futures Contracts - Long Position

• The buyer knows the purchase price on the contract date and has a "long position." A gain occurs if the market value is higher than the negotiated price at maturity

Using Index Futures to Hedge

• Hedge a fall in the price of the underlying index
• Gain exposure to a fall in the price of the underlying index by using leverage.

Mr. Klein Example

• Mr. Klein has a CHF 1.2 million SMI portfolio. To finance a house purchase in six months and hedge losses from index falls, he sells SMI futures
• On the transaction date, the SMI future price is 8,600 points (CHF 10 per point or CHF 86,000 per contract). Mr Klein sells 14 contracts.
• There is no physical delivery; settlement is on the contract date value
• If the index is 8,000 points, Mr. Klein receives CHF 6,000 per contract (CHF 84,000 total)
• If the index is 9,000 points, Mr. Klein pays CHF 4,000 per contract (CHF 56,000 total)

Cash Settlement

• Cash settlement is on the trading day following the contract maturity date (T+1)

Initial Margin

• This covers potential losses if a member defaults, due to futures value changes between trading days
• Calculated with estimates of market risk, converted to margin parameters
• Clearing houses use risk models for parameters. They are published daily as absolute values or percentages of the closing price

Initial Margin Example: Nestlé Single Stock Future

• Margin parameter: 7.50%
• Nestle equity closing price: CHF 74.30
• Contract size: 100 equities
• Initial margin: CHF 557.25 (=7.5 percent×CHF 74.30×100)

Initial Margin Example: Swiss Market Index (SMI) Future

• Margin parameter: 648.90 points
• One index point: CHF 10
• Margin parameter: CHF 6,489 (=648.9×CHF 10)
• Initial margin per contract: 6,489 CHF
• 10 contracts: CHF 64,890

Collateral

• Initial margin is covered with securities or cash collateral
• Clearing houses determines eligible securities

Variation Margin

• Allows non-defaulting parties to cover losses from trading with a defaulting counterparty by determining contract replacement value
• Calculated daily by the clearing house (potentially intra-day)

The Daily Settlement Price (DSP)

• The reference price used by a clearing house to calculate unrealised gains or losses

Cash flow is affected by:

• Initial margin
• Any execution fees

During The Contract

• Variation margin (usually each trading day)

When The Contract matures

• Cash settlement or delivery
• Return of initial margin
• Any execution fees

Taxes in Switzerland

• No turnover tax (stamp duty) on futures transactions
• Transaction taxes are collected in some countries

Tax on Capital

• Tax can be collected based on the customer’s domicile and can be tax-deductible
• The customer may pay clearing fees, collateral management fees, or reporting fees

Example Margin Parameters: Nestle Single Stock Future

• Margin parameter is 7.50%
• Closing price of Nestle equity is CHF 74.30
• 100 equities are in the futures contract
• Initial margin is CHF 557.25 or (7.5% x CHF 74.30 x 100)

Value Date For:

• Initial Margins Value: The contract conclusion date
• Variation margins: The margin calculation date
• Futures Transactions: Depends on market standards

Market Transaction

• t+2 is the settlement date for the underlying
• T+2 equals the contract maturity date plus 2 days

Index Futures

• Trades on the day after the contract maturity date

Leverage

• Futures investing allows implicit leverage
• Futures offer exposure and compared to direct investment, less investment is needed

Ex Ante Calculation

• (Transaction amount underlying the futures contract/amount of initial margin)

Ex Post Calculation

• (Return on cash invested in the futures contract)/(percentage growth of the underlying)

Scenario: Leverage of 10

• Underlying up one-percent: +10 percent to the investor
• Underlying down one-percent: -10 percent to the investor

Asset management constraints

• mandates limit usage
• positions should not produce leverage over the entire portfolio
• the customer must have all the necessary cash to settle

Regulatory Considerations

• Investment funds must always state investment constraints on derivatives in their policy (prospectus)

Investor Requirements

• Must understand the complexities of futures
• Must be comfortable with the risks
• Financial institutions are expected to collect signed documentation, or document oral discussions about it

Risks in Futures Investing

• Potential max loss varies by the type of direction (long or short)
• Losses can be unlimited for short positions in single stock futures
• Losses are limited to cash for long positions

Price Risks

• The replacement value is closely linked with the derivatives as “derivatives”
• Leverage amplifies losses

Counterparty Risks

• The other party cannot pay for obligations if they become insolvent
• Customer exposure is connected to the clearing default unless members can be transferred to other parties

What Is The Fellow Customer Risk?

• Collateral could be exposed to another member or themselves, in addition to losses suffered by another customer
• If a member cannot honour the margin, the risk is that the customer deposited is used to cover the losses

Legal Basis Is:

• the separation of customer deposits

Basis Risks

• Future is not fully covered if there is a required risk exposure

High Operational Risks When Transmitting Orders:

• Check the size or that it could reduce exposure

Understanding The Important of Following Legal Rules:

• Asset mandate is essential
• Understanding how to respect duties and how to gather enough information
• Transferring the collateral to another clearing house of the member

Liquidity Of Risk:

• Not being able to meet the set margin
• Positions can be closed

Not Having Collateral For Contract

• Not having the instruments to meet the collateral set out in contract

Other Additional Risks

• Market Liquidity
• Credit Quality
• And Securities (Repledging)

A big factor is Tax:

• Not having a similar tax treatment for different types of cash flows

Risk Assessment

• Country
• Contract Clearing
• Counterparty Inability
• Accounting Rules: Transparency