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Ch02 Fundamentals of Futures and Options Markets

Futures contracts are exchange-traded agreements to buy or sell an asset at a predetermined price on a specified date in the future. Margins are deposited with brokers to minimize the risk of default, and positions are marked to market daily through cash settlement. Most futures contracts are closed out before maturity through an offsetting trade rather than physical delivery of the underlying asset. Forwards are similar agreements traded over-the-counter rather than on an exchange.

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446 views

Ch02 Fundamentals of Futures and Options Markets

Futures contracts are exchange-traded agreements to buy or sell an asset at a predetermined price on a specified date in the future. Margins are deposited with brokers to minimize the risk of default, and positions are marked to market daily through cash settlement. Most futures contracts are closed out before maturity through an offsetting trade rather than physical delivery of the underlying asset. Forwards are similar agreements traded over-the-counter rather than on an exchange.

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Mechanics of Futures

Markets
Chapter 2

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 1
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, 7th Ed, Ch 2, Copyright © John C. Hull 2010 2
Margins
 A 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
 Margins minimize the possibility of a loss
through a default on a contract

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 3
Example of a Futures Trade

 An investor takes a long position in 2


December gold futures contracts on
June 5
 contract size is 100 oz.
 futures price is US$900
 margin requirement is US$2,000/contract
(US$4,000 in total)
 maintenance margin is US$1,500/contract
(US$3,000 in total)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 4
A Possible Outcome
Table 2.1, Page 27

Daily Cumulative Margin


Futures Gain Gain Account Margin
Price (Loss) (Loss) Balance Call
Day (US$) (US$) (US$) (US$) (US$)

900.00 4,000
5-Jun 897.00 (600) (600) 3,400 0
. . . . . .
. . . . . .
. . . . . .
13-Jun 893.30 (420) (1,340) 2,660 + 1,340 = 4,000
. . . . . .
. . . . .
. . . . . .
19-Jun 887.00 (1,140) (2,600) 2,740 + 1,260 = 4,000
. . . . . .
. . . . . .
. . . . . .
26-Jun 892.30 260 (1,540) 5,060 0

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 5
Other Key Points About Futures

 They are settled daily


 Closing out a futures position involves
entering into an offsetting trade
 Most contracts are closed out before
maturity

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 6
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, 7th Ed, Ch 2, Copyright © John C. Hull 2010 7
Some Terminology

 Open interest: the total number of contracts


outstanding. This equals to number of long
positions or number of short positions
 Settlement price: the price just before the
final bell each day. This is used for the daily
settlement process
 Volume of trading: the number of trades in 1
day

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 8
Convergence of Futures to Spot
(Figure 2.1, page 25)

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 9
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, 7th Ed, Ch 2, Copyright © John C. Hull 2010 10
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, 7th Ed, Ch 2, Copyright © John C. Hull 2010 11
Profit from a Long Forward or
Futures Position

Profit

Price of Underlying
at Maturity

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 12
Profit from a Short Forward or
Futures Position

Profit

Price of Underlying
at Maturity

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 13
Forward Contracts vs Futures
Contracts (Table 2.3, page 40)

Forward Futures
Private contract between two parties Traded on an exchange
Not standardized Standardized
Usually one specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final settlement usual Usually closed out prior to maturity
Some credit risk Virtually no credit risk

Fundamentals of Futures and Options Markets, 7th Ed, Ch 2, Copyright © John C. Hull 2010 14

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