CHAPTER 1
Futures Markets Introduction
In this chapter, we introduce futures markets and their key
players. This chapter is organized into the following
sections:
1. Forward Contracts Versus Futures Contracts
2. Institutions Facilitating Futures Trading
3. Structure of Futures Exchanges
4. Clearinghouses’ Role in Futures Markets
5. Types of Futures Contracts
6. The Social Function of Futures Markets
7. Futures Markets’ Regulatory Framework and Taxation
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1
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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2
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
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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Forward Versus Futures
COMPARISON
FORWARD
FUTURES
Trade on organized exchanges
No
Yes
Use standardized contract terms
No
Yes
Use associate clearinghouses to
guarantee contract fulfillment
No
Yes
Require margin payments and daily
settlements
No
Yes
Close easily
No
Yes
Regulated by identifiable agencies
No
Yes
Any quantity
Yes
No
Any product
Yes
No
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Futures Contract Standardized Terms
1. Quantity
2. Quality
3. Expiration months
4. Delivery terms
5. Delivery differentials
6. Delivery dates
7. Minimum price fluctuation
8. Daily price limits
9. Trading days and hours
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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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7
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
Not-for-Profit Organization Structure
Members hold exchange memberships or seats that allow
them to:
1. Trade on the exchange
2. Have a voice in the exchange’s operation
For-Profit Organization Structure
Members receive shares or stocks.
Demutualize
Conversion of an exchange from not-for-profit to for-profit.
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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 Platforms
Contracts are traded through electronic computer
networks. Electronic trading represents over 50% of
futures contracts trading.
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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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Major Futures Exchange
Table 1.6
Major Futures Exchanges in the World for 2003
EXCHANGE
Eurex (Germany)
Chicago Mercantile Exchange (USA)
Chicago Board of Trade (USA)
Euronext-Liffe (Netherlands)
Mexican Derivatives Exchange (Mexico)
Bolsa de Mercadorias e Futuros (Brazil)
New York Mercantile Exchange (USA)
Tokyo Commodity Exchange (Japan)
London Metals Exchange (UK).
Korea Stock Exchange (South Korea)
Sydney Futures Exchange (Australia)
National Stock Exchange of India (India)
SIMEX (Singapore)
International Petroleum Exchange (UK)
OM Stockholm (Sweden)
Tokyo Grain Exchange (Japan)
New York Board of Trade (USA)
Bourse de Montreal (Canada)
MEFF Renta Variable (Spain)
Tokyo Stock Exchange (Japan)
Total Top 20 2003 Futures Volume
Source: Futures Industry Association.
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2003 Volume
(Futures Only)
668,650,028
530,989,007
373,,669,290
273,121,004
173,820,944
113,895,061
111,789,658
87,252,219
68,570,154
62,204,783
41,831,862
36,141,561
35,356,776
33,258,385
22,667,198
21,084,727
18,822,048
17,682,999
17,109,363
15,965,175
Top 20 %
Volume
24.55
19.49
13.72
10.03
6.38
4.18
4.10
3.20
2.52
2.28
1.54
1.33
1.30
1.22
.83
.77
.69
.65
.63
.59
2,723,882,242
100%
12
Clearinghouses
1. Guarantee that the traders will honor their obligations
(solves issues of trust).
2. Each trader has obligations only to the clearinghouse,
not to other traders.
3. Each exchange uses a futures clearinghouse.
4. Clearinghouses may be part of a futures exchange
(division), or a separate entity.
5. Due to 2000 CFMA, clearing arrangements vary across
industries.
6. Clearinghouses are “perfectly hedged” by maintaining
no futures market position of their own.
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The Function of Clearinghouses
in Futures Markets
Obligations without a clearinghouse
Buyer
Seller
Obligations with a clearinghouse
Buyer
Clearinghouse
Chapter 1
Seller
14
Major Futures Clearing Organizations
Table 1.7
Major Futures Clearing Organizations
Clearinghouse
Affiliated Exchanges
The Clearing Corporation (CCorp)
US Futures Exchange and the
Merchants Exchange of St. Louis
Chicago Mercantile Exchange
Clearinghouse
Chicago Mercantile exchange
With clearing link to CBOT
Kansas City Board of Trade Clearing
Corporation
Kansas City Board of Trade
Energy Clear Corporation
Exempt Commercial Markets
MGE Clearinghouse
Minneapolis Grain Exchange
NYMEX Clearinghouse
New York Mercantile Exchange
New York Clearing Corporation
New York Board of Trade
The Options Clearing Corporation
OneChicago, NQLX, & option
exchanges
The London Clearinghouse
Exempt Commercial Markets and OTC
markets
Sources: The CFTC web site, www.cftc.gov.
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Margin and Daily Settlement
Margin
A 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:
1. Initial Margin
Deposit that a trader must make before trading any
futures.
2. Maintenance Margin
When 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.
3. Variation Margin
Additional margin required to bring an account up to
the required level.
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Futures Market Obligations
Table 1.2 shows a typical trading situation.
Table 1.2
Futures Market Obligations
The oat contract is traded by the Chicago Board of Trade. Each contract is for
5,000 bushels, and prices are quoted in cents per bushel.
(a)
Party 1
Party 2
Buys 1 SEP contract for oats at 171
cents per bushel
(b)
Party 1
Clearinghouse
Buys 1 SEP contract for oats at 171
cents per bushel
(c)
Sells 1 SEP contract for oats at 171
cents per bushel
Agrees to delivery to Party 1 a SEP
contract for oats at a price of 171
cents per bushel
Party 2
Clearinghouse
Sells 1 SEP contract for oats at 171
cents per bushel
Agrees to receive from Party 2 1 SEP
contract for oats and to pay 171 cents
per bushel
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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
(-) Daily Settlement
New Margin Balance
$1,400
150
$1,250
DAY 2
Loss: 4 cents/bushel or $200
Margin Balance
(-) Daily Settlement
New Margin Balance
$1,250
200
$1,050
Trader’s margin is below the maintenance margin. Margin
call occurs.
Variation Margin needed:
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$350
19
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
Trader A
Clearing
member
Clearinghouse
Non-clearing
member
Trader B
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Closing a Futures Position
There are 3 ways to close a futures position:
1. Delivery or cash settlement
2. Offset or reversing trade
3. Exchange-for-physicals (EFP) or ex-pit transaction
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Closing a Futures Position: Delivery or
Cash Settlement
Delivery
Most commodity futures contracts are written for
completion of the futures contract through the physical
delivery of a particular good.
Cash settlement
Most 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
Table 1.3
Completion of Futures Contracts
via Delivery or Cash Settlement
October 1, 2002BSeptember 30, 2003
Delivered or Settled in Cash
Commodity Group
Volume
Grains
Oilseeds
Livestock
Other Agricultural
Energy/Wood
Metals
Financial Instruments
Currencies
All Commodities
28,917,090
30,917,636
7,190,906
15,560,473
94,635,656
18,602,108
760,292,234
30,032,897
986,149,000
Contracts
98,235
51,143
36,107
95,344
839,221
209,186
7,115,757
682,095
9,125,088
Percentage
0.33
0.17
0.50
0.61
0.89
1.12
0.94
2.27
0.93
Source: Commodity Futures Trading Commission, Annual Report, 2003.
Notice that very few contracts are delivered or settled
in cash.
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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 nonstandard 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:
1. Quality Differentials
2. Location Differential
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Delivery Differential
Example: CBOT Corn Contract
Quality differential
Grade differential based on the standard “par” delivery grade.
Premium grade:
Premium grade price differential :
Price:
No. 1 Yellow
1.5cents/bushel
$3.015/bushel
Par grade:
Par grade price:
No. 2 Yellow
$3/bushel
Lower grade:
Lower grade Price differential :
Price:
No. 3 Yellow
1.5 cents/bushel or
$2.985/bushel
Location differential
Based 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 & Burns
Harbor, Indiana
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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.
Table 1.4
The Reversing Trade
May 1
May 10
Party 1's Initial Position
Bought 1 SEP contract for oats
at 171 cents per bushel
Party 1's Reversing Trade
Sells 1 SEP contract for oats at
180 cents per bushel
Party 2
Sold 1 SEP contract for oats at 171
cents per bushel
Party 3
Buys 1 SEP oats contract at 180
cents per bushel
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Closing a Futures Position: Exchange-forPhysicals (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.
Table 1.5
An Exchange-for-Physicals Transaction
Before the EFP
Trader A
Long 1 wheat futures
Wants to acquire actual wheat
Trader B
Short 1 wheat futures
Owns wheat and wishes to sell
EFP Transaction
Trader A
Trader B
Agrees with Trader B to purchase
Agrees with Trader A to sell wheat and
wheat and cancel futures
cancel futures
Receives wheat; pays Trader B
Delivers wheat; receives payment from
Trader A
Reports EFP to exchange; exchange a- Reports EFP to exchange; exchange
djusts books to show that Trader A is adjusts books to show that Trader B is
out of the market
out of the market
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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
Contracts on physical commodities include:
1. Agricultural contracts
2. Metallurgical contracts
3. Energy contracts
These commodities, excluding electricity, are physically
settled and are highly storable.
Trading varies from commodity to commodity.
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Future Contracts: Physical Commodity
AGRICULTURAL
METALLURGICAL
ENERGY
Grains - corn, oats,
rice, wheat
Gold
Heating oil
Silver
Crude oil
Aluminum
Natural gas
Platinum
Unleaded gasoline
Livestock - live
hogs, cattle
Forest - lumber and
plywood
Coal, propane
Textiles - cotton
Electricity
Foodstuffs - rice
cocoa, coffee,
orange juice, sugar
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Futures Contracts: Foreign Currency and
Interest-Earning Asset
Foreign Currency
Interest-Earning Assets
Australian dollar
Treasury bills
Brazilian Real
Notes
Russian Ruble
Bonds
New Zealand dollar
Eurodollar deposits
Swedish Krona
Interest rate swaps
South African Rand
Fed funds
Norwegian Krone
Municipal bonds
British pound
Canadian dollar
Japanese yen
Swiss franc
Mexican peso
Euro
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Futures Contracts: Index Based
Traders must fulfill their obligation by reversing trade or
cash settlement at the end of trading.
EXAMPLE OF INDEX BASED CONTRACTS
US Exchanges
Foreign Exchanges
Broad-Based stock indexes
Foreign Stock Indexes
S&P 500
British FTSE 100
Dow Jones Industrial Average
French CAC 40
Russell 2000
Dow Jones Euro Stoxx 50
NASDAQ 100
German DAX
Style-Based Indexes
Brazillian Bovespa stock
S&P Barra Growth
Japanese Nikkei 225
S&P Barra Value
Korean KOSPI 200
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Future Contracts on Individual Stocks
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
INSERT FIGURE 1.5 HERE
Chapter 1
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Changing Commodity Trading Volume
INSERT FIGURE 1.6 HERE
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Social Function of Futures Markets
Futures markets meet the needs of three groups of users:
1. Those who wish to discover information about future
prices of commodities
2. Those who wish to speculate
3. Those who wish to hedge
There are two main social functions of futures markets:
1. Price discovery
2. 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 Markets
PRICE DISCOVERY
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
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
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
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 privatelynegotiated between large, sophisticated contract
counterparties.
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Futures Markets Levels of Regulation
(Market Regulators)
1. Brokers
2. Exchanges and clearinghouses
3. National Futures Association (NFA), industry selfregulatory body
4. Commodity Futures Trading Commission (CFTC),
federal governmental agency
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Market Regulators: Brokers
The Broker is responsible for:
1. Knowing the customer's position and intentions.
2. Ensuring that the customer does not disrupt the market
or place the system in jeopardy.
3. Keeping the customer's trading activity in line with
industry regulations and legal restrictions.
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Market Regulators: Exchange &
Clearinghouses
Futures exchanges and clearinghouses formulate and
enforce rules to:
1. Prohibit fraud
2. Prohibit dishonorable conduct
3. Prevent defaulting on contract obligations
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Abusive Trading Practices
Table 1.8
Abusive Trading Practices
Pre-arranged trading
Accommodation trading
Trading before customers orders, front running
Bucketing
Wash trading
Curb trading
Agreeing to some aspect of a transaction before it is
openly executed on the exchange floor.
Entering transactions to assist another floor participant in accomplishing improper trading objectives.
Trading for one's personal account or an account in
which one has an interest, while having in hand any
executable customer order in that contract.
Failing to introduce an order to the marketplace,
traditionally occurring when a broker noncompetitively takes the other side of a customer order to the
detriment of the customer or other members.
Entering transactions to provide the appearance of
trading activity without resulting in a change in
market position.
Trading after the official close of trading.
Source: Government Accounting Office, “Automation Can Enhance Detection of
Trade Abuses but Introduces New Risks,” September 1989.
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Market Regulators: National Futures
Association (NFA)
The NFA seeks to prevent fraudulent and manipulative acts
by:
1. Screening and test applicants for registration.
2. Requiring members who handle customer funds to
maintain adequate capital.
3. Requiring members to keep accurate trading records.
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Market Regulators: Commodity Futures Trading
Commission (CFTC)
CFTC protects market participants from manipulation,
abusive trading practices, and fraud by enforcing
regulatory oversight of:
1. Futures exchanges
2. Futures clearinghouses
3. NFA
The heart of the CFTC’s market surveillance is its largetrader 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
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
FASB ACCOUNTING RULES
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 Initiatives
TAXATION OF FUTURES TRADING
1981 LAW
Futures positions must be marked-to-market at the end of the
year.
ACT of 1986
Stipulates that short-term and long-term capital gains will be
taxed at one rate.
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