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CHAPTER 1 Futures Markets Introduction. In this chapter, we introduce futures markets and their key players. This chapter is organized into the following sections: Forward Contracts Versus Futures Contracts Institutions Facilitating Futures Trading Structure of Futures Exchanges

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Chapter 1 futures markets introduction
CHAPTER 1Futures Markets Introduction

  • In this chapter, we introduce futures markets and their key players. This chapter is organized into the following sections:

  • Forward Contracts Versus Futures Contracts

  • Institutions Facilitating Futures Trading

  • Structure of Futures Exchanges

  • Clearinghouses’ Role in Futures Markets

  • Types of Futures Contracts

  • The Social Function of Futures Markets

  • Futures Markets’ Regulatory Framework and Taxation

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Forward contracts
Forward Contracts

  • A forward contract is an agreement between two parties (counterparties) for the delivery of a physical asset (e.g., oil or gold) at a certain time in the future for a certain price that is fixed at the inception of the contract.

  • Forward contracts can be customized to accommodate any commodity, in any quantity, for delivery at any point in the future, at any place.

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Example st bernard puppy
EXAMPLE: St. Bernard Puppy

  • Counterparties: Buyers and Seller

  • Asset/Commodity: St. Bernard Pup

  • Delivery/Payment Time: 6 weeks

  • Priced Fixed: $400

  • Buyer: Dog Fancier has a long position

  • Seller: Breeder has a short position

  • Trading Volume: Occurs when one trader buys & another sells

  • Open Interest: Number of open contracts obligated for delivery

  • If the dog owner had completed similar contracts for six different dogs, the open interest would be 6.

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Future contracts
Future Contracts

  • Futures contracts are highly uniform and well-specified commitments for a carefully described good (quantity and quality of the good) to be delivered at a certain time and place (acceptable delivery date) and in a certain manner (method for closing the contract) and the permissible price fluctuations are specified (minimum and maximum daily price changes).

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Futures contract standardized terms
Futures Contract Standardized Terms

  • Quantity

  • Quality

  • Expiration months

  • Delivery terms

  • Delivery differentials

  • Delivery dates

  • Minimum price fluctuation

  • Daily price limits

  • Trading days and hours

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Cbot wheat futures contract
CBOT Wheat Futures Contract

  • Quantity: 5,000 bushels per contract.

  • Quality: No. 2 Soft Red, No. 2 Hard Red Winter No. 2 Dark Northern Spring, or No. 1 Northern Spring.

  • Expiration: July, September, December, March, & May.

  • Delivery Terms: Wheat must be delivered at a “regular” or approved warehouse (e.g., warehouses located Chicago Switching District).

  • Delivery: Any business days in the delivery month.

  • Payment: Seller received payment and delivers a warehouse receipt to the buyer.

  • Price Fluctuation:1/4 cent per bushel.

  • Daily Price Limit: Trading price on a given day cannot differ from the preceding day's closing price by more than 30 cents/bushel ($1,500/contract).

  • Trading Days: Wheat trades from 9:30 a.m. to 1:15 p.m. Chicago time.

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Institutions facilitating futures contract trading
Institutions Facilitating Futures Contract Trading

  • There are two types of organizations that facilitate futures trading:

  • Exchange

  • Exchanges are non-profit or for-profit organizations that offer standardized futures contracts for physical commodities, foreign currency and financial products.

  • Clearinghouse

  • A clearinghouse is agency associated with an exchange, which settles trades and regulates delivery. Clearinghouses guarantee the fulfillment of futures contract obligations by all parties involved.

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The organized exchange
The Organized Exchange

  • Not-for-Profit Organization Structure

  • Members hold exchange memberships or seats that allow them to:

    • Trade on the exchange

    • Have a voice in the exchange’s operation

  • For-Profit Organization Structure

  • Members receive shares or stocks.

  • DemutualizeConversion of an exchange from not-for-profit to for-profit.

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Organized exchange trading systems
Organized Exchange: Trading Systems

  • Futures contracts trade by two systems:

  • Open Outcry

  • Open outcry is a trading room where traders literally “cry out” their bids to locate another trader who is willing to trade with them.

  • Electronic Trading PlatformsContracts are traded through electronic computer networks. Electronic trading represents over 50% of futures contracts trading.

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Organized exchange trading players
Organized Exchange: Trading Players

  • Speculator

  • A trader who enters the futures market in pursuit of profit, accepting risk in the endeavor.

  • Hedger

  • A Trader who enters the futures market to reduce some pre-existing risk exposure.

  • Broker

  • An Individual or firm acting as an intermediary by conveying customers’ trade instructions. Account executives or floor brokers are examples of brokers.

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  • Guarantee that the traders will honor their obligations (solves issues of trust).

  • Each trader has obligations only to the clearinghouse, not to other traders.

  • Each exchange uses a futures clearinghouse.

  • Clearinghouses may be part of a futures exchange (division), or a separate entity.

  • Due to 2000 CFMA, clearing arrangements vary across industries.

  • Clearinghouses are “perfectly hedged” by maintaining no futures market position of their own.

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The function of clearinghouses in futures markets
The Function of Clearinghouses in Futures Markets

  • Obligations without a clearinghouse



Obligations with a clearinghouse





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Margin and daily settlement
Margin and Daily Settlement

  • MarginA good-faith deposit (or performance bond) made by a prospective trader with a broker. Margin can be posted in cash, bank letter of credit or short-term U.S. Treasury instruments.

  • Daily Settlement

  • Process by which traders are required to realize any losses in cash immediately (marked-to-the-market). The losses are usually deducted from the margin deposit.

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Types of margin

  • There are 3 types of margin:

  • Initial MarginDeposit that a trader must make before trading any futures.

  • Maintenance MarginWhen margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin.

  • Variation MarginAdditional margin required to bring an account up to the required level.

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Futures market obligations
Futures Market Obligations

Table 1.2 shows a typical trading situation.

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Futures market obligations1
Futures Market Obligations

  • Based on Table 1.2, a trader purchases an oat Contract at 171 cents/ bushel at the close of day 0. The initial margin is $1,400.

  • DAY 1

    Contract closed @ 168 cents/bushel.

    Loss: 3 cents/bushel or $150 .

    Required maintenance margin: $1,100.

    Initial Margin $1,400(-) Daily Settlement 150New Margin Balance $1,250

  • DAY 2

    Loss: 4 cents/bushel or $200

    Margin Balance $1,250(-) Daily Settlement 200New Margin Balance $1,050

    Trader’s margin is below the maintenance margin. Margin call occurs.

    Variation Margin needed: $350

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Account equity margin requirements
Account Equity & Margin Requirements

  • Figure 1.3 illustrates the account equity and margin requirements at different price levels.

  • Insert figure 1.3 here

Notice that the trader would have received two margin calls.

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Margin cash flows
Margin Cash Flows

Trader A




Trader B

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Closing a futures position
Closing a Futures Position

  • There are 3 ways to close a futures position:

    • Delivery or cash settlement

    • Offset or reversing trade

    • Exchange-for-physicals (EFP) or ex-pit transaction

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Closing a futures position delivery or cash settlement
Closing a Futures Position: Delivery or Cash Settlement

  • DeliveryMost commodity futures contracts are written for completion of the futures contract through the physical delivery of a particular good.

  • Cash settlementMost financial futures contracts allow completion through cash settlement.

  • In cash settlement, traders make payments at the expiration of the contract to settle any gains or losses, instead of making physical delivery.

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Completion of futures contracts
Completion of Futures Contracts

Notice that very few contracts are delivered or settled in cash.

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Delivery differential
Delivery Differential

  • Sometimes the quantity and quality do not exactly match the quantity and quality specified in the contract. In these cases, shorts are given the option of delivering non-standard commodities at non-standard delivery points. However, they may have to pay a surcharge or “delivery differential” relative to standard terms of the futures contracts.

  • There are 2 types of delivery differential:

    • Quality Differentials

    • Location Differential

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Delivery differential1
Delivery Differential

  • Example: CBOT Corn ContractQuality differentialGrade differential based on the standard “par” delivery grade.

  • Premium grade: No. 1 YellowPremium grade price differential : 1.5cents/bushelPrice: $3.015/bushel

  • Par grade: No. 2 YellowPar grade price: $3/bushel

  • Lower grade: No. 3 YellowLower grade Price differential : 1.5 cents/bushel or Price: $2.985/bushel

  • Location differentialBased relative to the standard delivery point or points specified in the futures contracts.

  • Premium Location: 2 cents/bushel for delivery at terminals between Lockport & Seneca, Illinois

  • Par Location: Terminals between Chicago & BurnsHarbor, Indiana

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Closing a futures position offset or reversing trade
Closing a Futures Position: Offset or Reversing Trade

  • If you previously sold a futures contract, you can close out your position by purchasing an identical futures contract. The exchange will cancel out your two positions. Table 1.4 illustrates a reversing trade.

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Closing a futures position exchange for physicals efp
Closing a Futures Position: Exchange-for-Physicals (EFP)

  • Two traders agree to a simultaneous exchange of a cash commodity and futures contracts based on that cash commodity. Table 1.5 illustrates a EFP transaction.

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Types of futures contracts
Types of Futures Contracts

  • In this section, we will examine the following types of futures contracts:

  • Physical Commodity

  • Foreign Currency

  • Interest-Earning Asset

  • Index (Stock Index)

  • Individual Stocks

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Future contracts physical commodity
Future Contracts: Physical Commodity

  • Contracts on physical commodities include:

    • Agricultural contracts

    • Metallurgical contracts

    • Energy contracts

  • These commodities, excluding electricity, are physically settled and are highly storable.

  • Trading varies from commodity to commodity.

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Futures contracts index based
Futures Contracts: Index Based Asset

  • Traders must fulfill their obligation by reversing trade or cash settlement at the end of trading.

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Future contracts on individual stocks
Future Contracts on Individual Stocks Asset

  • Permitted for trade in United States after the passage of the Commodity Futures Modernization Act of 2000 (CFMA).

  • Also called “single stock futures” in the United States and “universal futures” in Great Britain.

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Relative importance of commodity types
Relative Importance of Commodity Types Asset


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Changing commodity trading volume
Changing Commodity Trading Volume Asset


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Social function of futures markets
Social Function of Futures Markets Asset

  • Futures markets meet the needs of three groups of users:

    • Those who wish to discover information about future prices of commodities

    • Those who wish to speculate

    • Those who wish to hedge

  • There are two main social functions of futures markets:

    • Price discovery

    • Hedging

  • Speculation is not regarded as a social function by itself, but it may have socially useful by-products.

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Social function of futures markets1
Social Function of Futures Markets Asset


  • Futures market information helps people make better estimates of future prices.

  • Futures market information helps people with their production or consumption decisions.

  • Example: silver Mine


  • Hedging is the prime social rationale for futures trading.

  • Hedgers have a pre-existing risk exposure that leads them to use futures transactions as a substitute for a cash market transaction. By doing so, they are able to reduce or eliminate their risk.

  • Example:wheat Farmer

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Regulation of futures markets
Regulation of Futures Markets Asset

  • CEA

  • Grain Futures Act of 1922, superseded by the Commodity Exchange Act (CEA) of 1936.

  • The CEA was last amended by the Commodity Futures Modernization Act of 2000 (CFMA).

  • CFMA

  • Promotes competition and innovation in futures markets.

  • Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform (the three P’s).

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The cfma s three tiers of regulation
The CFMA’s Three Tiers of Regulation Asset

  • First Tier- Agricultural Commodities

  • Futures on commodities (agricultural commodities) that Congress judged to be potentially susceptible to manipulation and that are offered to members of the public.

  • Second Tier- Exempt Futures Contracts

  • Futures contracts on metals and energy that are judged to be less susceptible to manipulation.

  • Third Tier- Trade Principal to Principal Basis

  • Contracts on financial products (swaps) that are privately-negotiated between large, sophisticated contract counterparties.

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Futures markets levels of regulation market regulators
Futures Markets Levels of Regulation (Market Regulators) Asset

  • Brokers

  • Exchanges and clearinghouses

  • National Futures Association (NFA), industry self-regulatory body

  • Commodity Futures Trading Commission (CFTC), federal governmental agency

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Market regulators brokers
Market Regulators: Brokers Asset

  • The Broker is responsible for:

    • Knowing the customer's position and intentions.

    • Ensuring that the customer does not disrupt the market or place the system in jeopardy.

    • Keeping the customer's trading activity in line with industry regulations and legal restrictions.

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Market regulators exchange clearinghouses
Market Regulators: Exchange & Clearinghouses Asset

  • Futures exchanges and clearinghouses formulate and enforce rules to:

    • Prohibit fraud

    • Prohibit dishonorable conduct

    • Prevent defaulting on contract obligations

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Abusive trading practices
Abusive Trading Practices Asset

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Market regulators national futures association nfa
Market Regulators: National Futures Association (NFA) Asset

  • The NFA seeks to prevent fraudulent and manipulative acts by:

    • Screening and test applicants for registration.

    • Requiring members who handle customer funds to maintain adequate capital.

    • Requiring members to keep accurate trading records.

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Market regulators commodity futures trading commission cftc
Market Regulators: Commodity Futures Trading Commission (CFTC)

  • CFTC protects market participants from manipulation, abusive trading practices, and fraud by enforcing regulatory oversight of:

    • Futures exchanges

    • Futures clearinghouses

    • NFA

  • The heart of the CFTC’s market surveillance is its large-trader electronic reporting system. This reporting system helps identify potential concentrations of market power within a market and to enforce speculative position limits.

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Insert figure 1 7 here
Insert figure 1.7 here (CFTC)

  • Figure 1.7 shows the place of the CFTC in the regulatory structure of the futures industry in the United States.

  • Insert Figure 1.7 here

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Recent regulatory initiatives
Recent Regulatory Initiatives (CFTC)


    In 1998, The FASB adopted new rules for disclosure of risk positions in firms’ derivatives positions.

  • CFMA 2000

    Allows futures trading on individual stocks and narrow-based stock indexes.

    Clarifies the legal status of privately-negotiated swap transactions.

    Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform.

    Allows exchanges to bring new contracts to market without prior regulatory approval.

    Establishes a set of standards, that permit futures exchanges and clearinghouses to use different methods to achieve federal requirements.

    Gives the CFTC clear authority to stop certain illegal, foreign exchange transactions aimed at defrauding small investors.

    Gives the CFTC separate oversight authority with respect to clearinghouse organizations.

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Recent regulatory initiatives1
Recent Regulatory Initiatives (CFTC)


    1981 LAWFutures positions must be marked-to-market at the end of the year.

    ACT of 1986Stipulates that short-term and long-term capital gains will be taxed at one rate.

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