Quantitative methods for economics and business

LECTURE N. 4

G. Oggioni
[email protected]

Septembe 23rd , 2020

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Mechanics of Futures Markets

Futures Contracts
Available on a wide range of assets
Exchange traded
Settled daily
Specifications need to be defined:
What can be delivered (commodity vs. financial assets);
How much it can be delivered (contract size);
Where it can be delivered (the delivery location has to be specified);
When it can be delivered (monthly delivery);
Price quotes (dollars, cents, ecc.);
Price limits (upper and lower bounds on price movement);
Position limits (maximum number of contract that a speculator can hold).

The vast majority of futures contracts do not lead to delivery.

The reason is that most traders choose to close out their positions prior to the delivery
period specified in the contract.
Closing out a position means entering into the opposite trade to the original one.

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Futures Price: Convergence of Futures to Spot

Futures price, like any other price, is determined by the laws of supply and demand.
As the delivery period for a futures contract is approached, the futures price converges to the
spot price of the underlying asset.
When the delivery period is reached, the futures price equals, or is very close to, the spot
price.

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Why does it happen?

Assume that the futures price is above the spot price during the delivery period.
Traders can:
Buy the asset
Enter into a short futures contract
Make delivery

⇓
The futures price will fall and become close to the spot price!!

Assume that the futures price is below the spot price.

A company interested in buying the asset can:
Enter into a long futures contract
Make delivery

⇓
The futures price will rise and become close to the spot price!!

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Margins

A margin is cash or marketable securities deposited by an investor with his or her broker.
Margins are introduced to avoid or minimize contract defaults.
The balance in the margin account is adjusted to reflect daily settlement.

Example
An investor takes a long position in two December gold futures contracts on June 5.
Contract size is 100 oz.
Contracting to buy a total of 200 oz (2 contracts).
Futures price is US$1250 oz.
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)

Terminology
Initial margin: amount that must be deposited when entering into the contract;
Daily settlement: adjustments to reflect the investor’s daily gain or loss;
Maintenance margin: additional margin set to ensure that the balance in the margin account never
becomes negative;
Variation margin: extra funds deposited.

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A Possible Outcome

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Further Details

The investor is entitled to withdraw any balance in the margin account in excess of the initial
margin;
When the margin account falls below the maintenance margin, the investor has to top up the
margin account to the initial margin level by the end of the next day (Variation margin);
If the investor does not provide the variation margin, the broker closes out the position;
Most brokers pay investors interest on the balance in a margin account;
To satisfy the initial margin requirements, an investor can usually deposit securities with the
broker as treasury bills or shares;
Minimum levels for initial and maintenance margins are set by the exchange, even though
individual brokers may require greater margins;
Margin levels are determined by the variability of the price of the underlying asset.

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Clearing house

A clearing house acts as an intermediary in futures transactions.

The main task of the clearing house is to keep track of all the transactions that take place
during a day, so that it can calculate the net position of each of its members.
Brokers who are not members themselves must channel their business through a member.
Clearing house members have margin accounts that are adjusted for gains and losses at the
end of each trading day in the same way as are the margin accounts of investors.

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Margin Cash Flows When Futures Price Decreases

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Margin Cash Flows When Futures Price Increases

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Some Terminology

Prices: opening price, the highest price achieved in trading during the day,
and the lowest price achieved in trading during the day

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

Open interest: the total number of contracts outstanding equal to the

number of long positions (or, equivalently, the number of short positions)

Key Points About Futures

1. They are settled daily
2. Closing out a futures position involves entering into an offsetting trade
3. Most contracts are closed out before maturity.

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Futures quotes for crude oil trading on May 26, 2010

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About the settlement price...
Normal markets: Futures price increases with the maturity of the futures contract
Inverted markets: Futures price decreases with the maturity of the futures contract

About the open interest...

Can the volume of trading in a day be greater than the open interest?

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Market quotes

Futures quotes are available from exchanges and from several online sources

https://futures.tradingcharts.com/marketquotes/

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Delivery

If a futures contract is not closed out before maturity, it is usually settled by delivering the
assets underlying the contract.
The period during which delivery can be made is defined by the exchange and varies from
contract to 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.
The decision on when to deliver is made by the party with the short position whose decision
is notified to the exchange clearing house.
The exchange then chooses a party with a long position to accept delivery.
The exchange passes this notice of intention to deliver on to the party with the oldest
outstanding long position.
Parties with long positions must accept delivery notices.

Three important days

1. First notice day: the first day on which a notice of intention to make delivery can
be submitted to the exchange
2. Last notice day: the last day this notice can be submitted to the exchange
3. Last trading day: a few days before the last notice day

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Collateralization in OTC Markets

http://www.investopedia.com/video/play/collateral/

→ Collateralization is used to prevent credit risk, namely the risk that a credit is not honored.

→ Credit risk has traditionally been a feature of the OTC markets!

It is becoming increasingly common for transactions to be collateralized in OTC markets.
In general, the collateralization in the OTC markets is similar to the practice of posting
margin in futures markets.
Consider transactions between companies A and B
A could be required to post collateral with B equal to the value of its outstanding
transactions with B when this value is positive.
If A defaults, B is entitled to take possession of the collateral.

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Clearing Houses and OTC Markets

Traditionally transactions have been cleared bilaterally in OTC markets

Following the 2007-2009 crisis, there has been a requirement for most standardized OTC
derivatives transactions to be cleared centrally through clearing houses.
Bilateral Clearing vs Central Clearing House

Assuming that a clearing house accepts the transaction between two parties A and B, it
becomes their counterparty.
The clearing house takes on the credit risk of both A and B.
It manages this risk by requiring an initial margin and daily variation margins from them.

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Forward Contracts vs Futures Contracts

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