Mechanics of futures and forward markets
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Mechanics of Futures and Forward Markets. 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. Example of a Futures Trade.

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Mechanics of Futures and Forward Markets

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Mechanics of futures and forward markets

Mechanics of Futures and Forward Markets


Futures contracts

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


Example of a futures trade

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$400

    • margin requirement is US$2,000/contract (US$4,000 in total)

    • maintenance margin is US$1,500/contract (US$3,000 in total)


A possible outcome table 2 2 page 24

A Possible OutcomeTable 2.2, Page 24

Daily

Cumulative

Margin

Futures

Gain

Gain

Account

Margin

Price

(Loss)

(Loss)

Balance

Call

Day

(US$)

(US$)

(US$)

(US$)

(US$)

400.00

4,000

5-Jun

397.00

(600)

(600)

3,400

0

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

13-Jun

393.30

(420)

(1,340)

2,660

1,340

4,000

+

=

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

3,000

<

19-Jun

387.00

(1,140)

(2,600)

2,740

1,260

4,000

+

=

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

26-Jun

392.30

260

(1,540)

5,060

0


Other key points about futures

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


Some terminology

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 marking to market process

  • Volume of trading: the number of trades in 1 day


Questions

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?


Regulation of futures

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


Accounting tax

Accounting & Tax

  • If a contract is used for

    • Hedging: it is logical to recognize profits (losses) at the same time as on the item being hedged

    • Speculation: it is logical to recognize profits (losses) on a mark to market basis

  • Roughly speaking, this is what the treatment of futures in the US & many other countries attempts to achieve


Forward contracts

Forward Contracts

  • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price

    • There is no daily settlement. At the end of the life of the contract one party buys the asset for the agreed price from the other party


How a forward contract works

How a Forward Contract Works

  • The contract is an over-the-counter (OTC) agreement between 2 companies

  • No money changes hands when first negotiated & the contract is settled at maturity

  • The initial value of the contract is zero


The forward price

The Forward Price

  • The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero)

  • The forward price may be different for contracts of different maturities


Example table 2 7 page 42

ExampleTable 2.7, Page 42

  • May 8: a company enters into a LONG forward contract to BUY £1,000,000 @ 1.8381 US$/£ in 90 days

  • August 6: the exchange rate is 1.8600 US$/£

  • In accordance with the contract terms , the company pays US$1,838,100 & receives £1,000,000;

  • The company’s profit is US$21,900 since the sterling can be immediately sold for US$1,860,000


Profit from a long forward position

Profit

Price of Underlying

at Maturity

Profit from aLONG Forward Position


Profit from a short forward position

Profit

Price of Underlying

at Maturity

Profit from a SHORT Forward Position


Forward contracts vs futures contracts

Forward Contracts vs Futures Contracts

  • TABLE 2.6 (p. 39)

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 maturity

Settled daily

Delivery or final cash

Contract usually closed out

settlement usually occurs

prior to maturity


Forward price vs futures price

Forward Price vs Futures Price

  • In theory, the futures price for a contract should be almost the same as the forward price for a contract with the same maturity on the same asset.


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