FUTURES CONTRACT
• Futures contract- A commitment to buy or sell at a specified future
settlement date a designated amount of a specific commodity or
asset.
• The contract specifies the asset the contract size, the date of delivery,
place of delivery, price quotation, trading unit, deliverable grade, last
trading day, last delivery day, trading hours and ticker symbol
Open interest and volume
Trade #
Buyer
Seller
Volume
(cumulative)
OI (after trade)
Positions after
trade
1
A (new long)
B (new short)
1
1
A: +1, B: –1
2
C (new long)
D (new short)
2
2
A: +1, B: –1, C:
+1, D: –1
3
A (closing)
D (closing)
3
1
A: 0, B: –1, C:
+1, D: 0
Margin
• When a contract is entered into both the buyer and seller are
required to deposit an initial margin.
• When an investor goes long it buys from clearing house and when it
goes short it sells to clearing house.
• Clearing house maintains neutral position in both long and short
contracts.
• The number of outstanding contracts at any point of time is known as
open interest.
• At the end of each trading day the margin account is adjusted to
reflect investors gain or loss.
• The gain and losses are netted against initial margin. This is called
marking to market.
• Future- Spot Parity theorem
• Futures contract can be used to hedge changes in the value of
underlying asset.
• If the asset plus future portfolio has no risk then the hedged position
must provide a rate of return equal to the rate on other risk free
investment
• Rate of return on hedged stock portfolio= (FO +D)-SO / SO
• Next, (FO +D)-SO / SO = rf
• FO = SO (1+rf -d)
• Futures market Arbitrage
• Cost of carry relationship is also called parity relationship; for
multiperiod application;
• FO = SO (1+rf -d)T
• For continuous compounding;
• F = Se ^ ((rf -d) x t)
• The divergence of future and spot price is known as basis.
• Convergence- As the delivery month approaches the basis declines
until future and spot prices are same.
• Normal Backwardation- Expected basis is negative as the market is
dominated by short hedgers who attempt to avoid the risk associated
with decrease in price of commodity.
• Contango- the speculators bid up the prices of contracts which results
in positive basis and then they make profit only if they net short and
future price declines
• Expectations principle- it is based on the argument that futures prices
are an unbiased estimate of expected future spot prices as would be
expected in efficient spot market hence the basis is zero.