Chapter 2

Futures Markets and

Central Counterparties

Options, Futures, and Other Derivatives, 11th Edition, Copyright ©

John C. Hull 2021 1
Futures Contracts
Available on a wide range of assets
Exchange traded
Specifications need to be defined:
What can be delivered,
Where it can be delivered, &
When it can be delivered
Settled daily

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 2
Convergence of Futures to Spot (Figure 2.1)

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 3
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

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 4
Margin Cash Flows
A retail trader has to bring the balance in the margin
account up to the initial margin when it falls below the
maintenance margin level
A member of the exchange clearing house only has
an initial margin and is required to maintain the
balance in its account at that level every day.
These daily margin cash flows are referred to as
variation margin
A member of the exchange is also required to
contribute to a default fund
Options, Futures, and Other Derivatives, 11th Edition,
Copyright © John C. Hull 2021 5
Example of a Futures Trade
A retail trader takes a long position in 2
December gold futures contracts on June
5
contract size is 100 oz.
futures price is US$1,750
initial margin requirement is
US$6,000/contract (US$12,000 in total)
maintenance margin is US$4,500/contract
(US$9,000 in total)
Options, Futures, and Other Derivatives, 11th Edition,
Copyright © John C. Hull 2021 6
A Possible Outcome (Table 2.1)
Day Trade Settle Daily Cumul. Margin Margin
Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,750.00 12,000
1 1,741.00 −1,800 − 1,800 10,200
2 1,738.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,736.20 −780 −2,760 9,240
7 1,729.90 −1,260 −4,020 7,980 4,020
8 1,730.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,726.90 780 −4,620 15,180

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 7
Margin Cash Flows When Futures
Price Increases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 8
Margin Cash Flows When Futures Price
Decreases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 9
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
Options, Futures, and Other Derivatives, 11th Edition,
Copyright © John C. Hull 2021 10
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

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 11
Crude Oil Trading on May 21,
2020 (Table 2.2)
Open High Low Prior Last Change Volume
Settle Trade

Jul 2020 33.53 34.66 33.26 33.49 33.96 +0.47 356,081

Aug 2020 33.93 35.05 33.78 33.94 34.40 +0.46 118,534

Dec 2020 35.18 36.08 35.06 35.23 35.76 +0.53 78,825

Dec 2021 37.87 38.49 37.78 37.91 38.15 +0.24 22,542

Dec 2022 40.30 40.74 39.92 40.27 40.24 −0.03 3,732

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 12
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

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 13
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?

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 14
Types of Orders
Limit Discretionary
Stop-loss Time of day
Stop-limit Open
Market-if touched Fill or kill

Options, Futures, and Other Derivatives, 11th Edition, Copyright

© John C. Hull 2021 15
Regulation of Futures
In the US, the regulation of futures
markets is primarily the responsibility of
the Commodity Futures and Trading
Commission (CFTC)
Regulators try to protect the public
interest and prevent questionable trading
practices

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 16
 Accounting & Tax
Ideally hedging profits (losses) should be
recognized at the same time as the losses
(profits) on the item being hedged
Ideally profits and losses from speculation
should be recognized on a mark-to-market
basis
Roughly speaking, this is what the accounting
and tax treatment of futures in the U.S. and
many other countries attempt to achieve
Example ex.2.18
Options, Futures, and Other Derivatives, 11th Edition,
Copyright © John C. Hull 2021 17
Forward Contracts vs Futures Contracts (Table
2.3)

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 18
 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 quoted as USD
per unit of foreign currency. Other currencies
(e.g., CAD and JPY) are quoted as units of the
foreign currency per USD.

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 19
OTC Derivatives Transactions:
Bilateral Clearing vs Central Clearing

CC
CCP
CC
CP

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 20
Bilaterally Cleared Derivatives
Transactions
Usually governed by an ISDA Master agreement with a
credit support annex (CSA)
The agreement explains the rights of one party if the other
party defaults
The CSA defines the collateral which must be posted
If one party defaults, the other party is entitled to keep any
collateral that has been posted up to what is necessary to
settle its claims
Traditionally CSAs have required variation margin but not
initial margin (e.g., LTCM in Business Snapshot 2.2)

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 21
Post-Crisis Regulations 1
Standard transactions between financial
institutions must be cleared through CCPs
Non-standard transactions can be cleared
bilaterally
A transaction with a non-financial corporation
can be cleared bilaterally

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 22
Post-Crisis Regulations 2
New regulations for non-standard trades
between financial institutions that are not
cleared centrally require the financial
institutions to have CSAs where both initial
margin and variation margin are posted
The initial margin is posted with a third party

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 23
 Trading irregularities
Typically future markets operate efficiently.
One irregularity that might occur is when a
trader group tries to “corner the market”
Strategy:
- huge long position on future and try to
- limit the supply of the assets
As maturity approaches, the group do not close
its position => number of future contract>
available commodity => short squeezed and F
and rise.

Options, Futures, and Other Derivatives, 11th Edition,

Copyright © John C. Hull 2021 24