MBF1243 Derivatives Prepared by Dr Khairul Anuar. Lecture 2 Mechanics of Futures Markets

Transcription

1 MBF1243 Derivatives Prepared by Dr Khairul Anuar Lecture 2 Mechanics of Futures Markets

2 Specification of Futures Contracts Available on a wide range of assets Exchange traded Specifications need to be defined in the agreement: What can be delivered (specifying the asset) How much will be delivered (contract size), Where it can be delivered, & When it can be delivered Settled daily 2

3 Specification of Futures Contracts-The Asset When the asset is a commodity, there may be variation in the quality. NYBOT specify concentrated orange juice futures contract as orange solids from Florida and/or Brazil that are US Grade A with Brix value of not less than 62.5 degrees Financial assets in futures contract are generally well defined and unambiguous (eg. no need to specify Japanese Yen). 3

4 Specification of Futures Contracts- Contract Size Specifies the amount of the asset that has to be delivered under one contract If too large, those who to hedge small exposures will be unable to use the exchange If too small, trading may be expensive as cost associated with each contract traded. The size of the contract depends on the likely user. For agri products it might be $10,000 to $20,000, but for financial futures it might higher. Eg. Treasury bond futures on the CBT, face value would be $100,000 4

5 Specification of Futures Contracts- Delivery Arrangement and Months Place of delivery must be specified by the exchange Important when it involves transportation costs. Eg for NYBOT frozen concentrate orange juice contract, delivery is to Florida, New Jersey or Delaware. The exchange must specify the precise period during the month when delivery can be made. For corn futures on CBOT, delivery months are March, May, July, September and December. 5

6 Convergence of Futures to Spot (Figure 2.1, page 29) 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. To see why this is so, we first suppose that the futures price is above the spot price during the delivery period. Traders then have a clear arbitrage opportunity: 1. Sell (i.e., short) a futures contract 2. Buy the asset 3. Make delivery. 6

7 Convergence of Futures to Spot (Figure 2.1, page 29) These steps are certain to lead to a profit equal to the amount by which the futures price exceeds the spot price. As traders exploit this arbitrage opportunity, the futures price will fall. Suppose next that the futures price is below the spot price during the delivery period. Companies interested in acquiring the asset will find it attractive to enter into a long futures contract and then wait for delivery to be made. As they do so, the futures price will tend to rise. The result is that the futures price is very close to the spot price during the delivery period. Spot Price Futures Price Futures Price Spot Price (a) Time (b) Time Figure 2.1 Relationship between futures price and spot price as the delivery period is approached: (a) Futures price above spot price; (b) futures price below spot price. 7

8 The Operations of Margins If two investors get in touch with each other directly and agree to trade an asset in the future for a certain price, there are obvious risks. One of the investors may regret the deal and try to back out. Alternatively, the investor simply may not have the financial resources to honor the agreement. One of the key roles of the exchange is to organize trading so that contract defaults are avoided. This is where margins come in. 8

9 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 referred to as marking to market Margins minimize the possibility of a loss through a default on a contract 9

10 Illustration how margins work Consider an investor who contacts his or her broker to buy two December gold futures contracts. Suppose that the current futures price is $1,250 per ounce. Because the contract size is 100 ounces, the investor has contracted to buy a total of 200 ounces at this price. The broker will require the investor to deposit funds in a margin account. The amount that must be deposited at the time the contract is entered into is known as the initial margin. We suppose this is $6,000 per contract, or $12,000 in total. At the end of each trading day, the margin account is adjusted to reflect the investor s gain or loss. This practice is referred to as daily settlement or marking to market. 10

11 Illustration how margins work Suppose, for example, that by the end of the first day the futures price has dropped by $9 from $1,250 to $1,241. The investor has a loss of $1,800 (= 200 x $9), because the 200 ounces of December gold, which the investor contracted to buy at $1,250, can now be sold for only $1,241. The balance in the margin account would therefore be reduced by $1,800 to $10,200. Similarly, if the price of December gold rose to $1,259 by the end of the first day, the balance in the margin account would be increased by $1,800 to $13,800. A trade is first settled at the close of the day on which it takes place. It is then settled at the close of trading on each subsequent day. 11

12 Margin Cash Flows A 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 bring the balance in its account up to that level every day. These daily margin cash flows are referred to as variation margin A member is also required to contribute to a default fund 12

13 Example of a Futures Trade Table 2.1 illustrates the operation of the margin account for one possible sequence of futures prices in the case of the investor considered earlier. The maintenance margin is assumed to be $4,500 per contract, or $9,000 in total. On Day 7, the balance in the margin account falls $1,020 below the maintenance margin level. 13

14 A Possible Outcome (Table 2.1) 14

15 The Clearing House and Clearing Margins A clearing house acts as an intermediary in futures transactions. It guarantees the performance of the parties to each transaction. 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. A broker is required to maintain a margin account with a clearing house member and the clearing house member is required to maintain a margin account with the clearing house. The latter is known as a clearing margin. The margin accounts for clearing house members are adjusted for gains and losses at the end of each trading day in the same way as are the margin accounts of investors The whole purpose of the margining system is to ensure that funds are available to pay traders when they make a profit. 15

16 The Clearing House and Clearing Margins -Margin Cash Flows When Futures Price Increases Clearing House Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader 16

17 The Clearing House and Clearing Margins -Margin Cash Flows When Futures Price Decreases Clearing House Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader 17

18 Some Terminology : This is the price used for calculating daily gains and losses and margin requirements. the price just before the final bell each day used for the daily settlement process Trading volume is the number of contracts traded. Open interest is the number of contracts outstanding, that is, the number of long positions or, equivalently, the number of short positions. 18

19 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 19

20 Crude Oil Trading on May 14, 2013 (Table 2.2, page 36) Open High Low Prior Settle Last Trade Change Volume Jun ,901 Aug ,830 Dec ,179 Dec ,606 Dec ,181 20

21 Collateralization in OTC Markets It is becoming increasingly common for transactions to be collateralized in OTC markets Consider transactions between companies A and B These might be governed by an ISDA Master agreement with a credit support annex (CSA) The CSA might require A to post collateral with B equal to the value to B of its outstanding transactions with B when this value is positive. 21

22 Collateralization in OTC Markets continued If A defaults, B is entitled to take possession of the collateral The transactions are not settled daily and interest is paid on cash collateral See Business Snapshot 2.2 for how collateralization affected Long Term Capital Management when there was a flight to quality in

23 Clearing Houses and OTC Markets Traditionally most transactions have been cleared bilaterally in OTC markets Following the crisis, the has been a requirement for most standardized OTC derivatives transactions between dealers to be cleared through central counterparties (CCPs) CCPs require initial margin, variation margin, and default fund contributions from members similarly to exchange clearing houses 23

24 Bilateral Clearing vs Central Clearing House 24

25 New Regulations New regulations for trades between dealers that are not cleared centrally require dealers to post both initial margin and daily variation margin The initial margin is posted with a third party 25

26 Delivery As mentioned earlier in this chapter, very few of the futures contracts that are entered into lead to delivery of the underlying asset. Most are closed out early. Nevertheless, it is the possibility of eventual delivery that determines the futures price. An understanding of delivery procedures is therefore important. 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 26

27 Types of Orders Limit Stop-loss Stop-limit Market-if touched Discretionary Time of day Open Fill or kill 27

28 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 28

29 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 29

30 Forward Contracts vs Futures Contracts (Table 2.3, page 43) FORWARDS Private contract between 2 parties Non-standard contract Usually 1 specified delivery date Settled at end of contract Delivery or final cash settlement usually occurs Some credit risk FUTURES Exchange traded Standard contract Range of delivery dates Settled daily Contract usually closed out prior to maturity Virtually no credit risk 30

31 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. 31