Futures Markets and
Central Counterparties
Chapter 2
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Futures Contracts
Available on a wide range of underlyings
Exchange traded
Specifications need to be defined:
What can be delivered,
Where it can be delivered,
When it can be delivered
Settled daily
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Convergence of Futures to Spot (Figure
2.1, page 46)
Future
s Spot
Price Price
Spot Future
Price s
Price
Ti Ti
me me
( (
a b
) )
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Margin
Margin is cash or marketable securities deposited by an
investor with his or her broker
The balance in the margin account is adjusted to reflect daily
settlement
Margin minimizes the possibility of a loss through a default on
a contract
Retail traders provide initial margin and, when the balance in
the margin account falls below a maintenance margin level,
they must provide variation margin bringing balance back up
to initial margin level.
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Example of a Futures Trade (page 47-
48)
A retail investor takes a long position in
2 December gold futures contracts
contract size is 100 oz.
futures price is US$1250
initial margin requirement is
US$6,000/contract (US$12,000 in total)
maintenance margin is US$4,500/contract
(US$9,000 in total)
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
A Possible Outcome (Table 2.1, page 48)
Day Trade Settle Daily Cumul. Margin Margin
Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,250.00 12,000
1 1,241.00 −1,800 − 1,800 10,200
2 1,238.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,236.20 −780 −2,760 9,240
7 1,229.90 −1,260 −4,020 7,980 4,020
8 1,230.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,226.90 780 −4,620 15,180
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Key Points About Futures
They are settled daily
Closing out a futures position is easy. It
involves entering into an offsetting trade
Most contracts are closed out before maturity
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Exchange Clearing House
The exchange clearing house has members
who provide initial margin and daily variation
margin
Brokers who are not members must channel
their business through a member. The member
will then require margin from the broker
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Margin Cash Flows When Futures
Price Increases
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Margin Cash Flows When Futures Price Decreases
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
OTC Markets: Bilateral Clearing
Transactions governed by an agreement,
typically an ISDA Master Agreement,
between two sides
A credit support annex (CSA) defines the
collateral that has to be posted by each side
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
CCPs and OTC Markets
Following the 2007-2009 crisis, there has
been a requirement for standardized OTC
derivatives transactions between financial
institutions to be cleared centrally though
clearing houses known as central
counterparties (CCPs)
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Operation of CCPs
The operation of a CCP is very similar to that
of an exchange clearing house
It has members who provide initial margin
(based on their outstanding contracts with the
CCP) and variation margin
If not a member, a company can clear its
transactions through a member
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Bilateral Clearing vs Central
Clearing
CCP
C
C
C
C
C
P
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Some Terminology
Open interest: the total number of contracts
outstanding
equal to number of long positions or number of short
positions
Settlement price: the price just before the final
bell each day
used for the daily settlement process
Volume of trading: the number of trades in one
day
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Crude Oil Trading on May 13,
2015 (from Table 2.2, page 54)
Open High Low Prior Last Change Volume
settle trade
Jun 2015 61.23 61.85 60.19 60.75 60.20 −0.55 379,797
Sept 2015 63.30 63.49 62.03 62.58 62.03 −0.55 39,663
Dec 2015 64.22 64.39 63.05 63.58 63.05 −0.53 54,902
Dec 2016 65.82 65.99 64.86 65.48 64.91 −0.57 20,212
Dec 2017 66.86 67.08 66.25 66.83 66.25 −0.58 3,087
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Delivery
If a futures contract is not closed out before maturity, it is
usually settled by delivering the assets underlying the contract.
When there are alternatives about what is delivered, where it is
delivered, and when it is delivered, the party with the short
position chooses.
A few contracts (for example, those on stock indices and
Eurodollars) are settled in cash
When there is cash settlement contracts are traded until a
predetermined time. All are then declared to be closed out.
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Futures Price Patterns
Futures prices can be
an increasing function of maturity: normal market
a decreasing function of maturity: inverted market
partly normal, partly inverted
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Questions
When a new trade is completed what
are the possible effects on the open
interest?
Can the volume of trading in a day be
greater than the open interest?
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Types of Orders
Limit Discretionary
Stop-loss Time of day
Stop-limit Open
Market-if touched Fill or kill
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Regulation of Futures
Regulation is designed to protect
the public interest
Regulators try to prevent
questionable trading practices by
either individuals on the floor of
the exchange or outside groups
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Accounting & Tax
It is logical to recognize hedging profits (losses)
at the same time as the losses (profits) on the
item being hedged
It is logical to recognize profits and losses from
speculation as they are incurred
Roughly speaking, this is what the accounting
and tax treatment of futures in the U.S. and many
other countries attempts to achieve
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Forward Contracts
A forward contract is an OTC agreement to
buy or sell an asset at a certain time in the
future for a certain price
There is no daily settlement (but collateral
may have to be posted). At the end of the
life of the contract one party buys the asset
for the agreed price from the other party
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Profit from a Long Forward or
Futures Position
Profi
t
Price of Underlying
at Maturity
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Profit from a Short Forward or
Futures Position
Profi
t
Price of Underlying
at Maturity
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Forward Contracts vs Futures
Contracts (Table 2.3, page 61)
FORWARD FUTUR
S ES
Private contract between 2 parties Exchange traded
Non-standard Standard contract
contract
Usually 1 specified delivery Range of delivery dates
date
Settled at end of contract Settled
daily
Delivery or final
settlement
cash usually occurs prior to
maturity
Some credit risk Virtually no credit risk
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
Foreign Exchange Quotes
Futures exchange rates are quoted as the number of
USD per unit of the foreign currency
Forward exchange rates are quoted in the same way
as spot exchange rates. This means that GBP, EUR,
AUD, and NZD are USD per unit of foreign
currency. Other currencies (e.g., CAD and JPY) are
quoted as units of the foreign currency per USD.
Fundamentals of Futures and Options Markets, 9th Ed, Global Edition, Ch 2, Copyright © Pearson
Education Ltd. 2023
