CFA Level I Derivatives

Futures Markets and Contracts

www.irfanullah.co

1
 Contents
1. Introduction
2. Futures Trading
3. Clearinghouse, Margins, and Price Limits
4. Delivery and Cash Settlement
5. Futures Exchanges
6. Types of Futures Contracts

www.irfanullah.co 2
 1. Introduction
A futures contract is an agreement between two parties in which one party, the buyer,
agrees to buy from the other party, the seller, an underlying asset or other derivative,
at a future date at a price agreed on today.

Forwards Futures

Private contracts Exchange-traded

Over-the-counter Standardized
Unique contracts Guaranteed by clearinghouse
Default risk present Effectively no default risk
No margin Margin required
Little regulation Regulated

www.irfanullah.co 3
 Futures Markets
Price is the only term set by the two parties; the exchange sets all other terms
Standardization increases liquidity

Underlying commodity Futures transactions are reported to the exchange and

the regulatory authority; price is made public
Type of settlement

Quantity Exchange guarantees the performance of the other party

through the clearinghouse; clearinghouse is the
Currency counterparty to each party
Grade

Delivery month

Last trading date

Tick size

www.irfanullah.co 4
 2. Futures Trading
Pit trading

Electronic trading

Long position and short position

Profit/loss on a daily basis

Close an existing position through a process called offsetting

www.irfanullah.co 5
 A Futures Trade
July cotton futures calls for delivery of 50,000 pounds of
cotton in July; futures price is $1.00 per pound

Contract value is 50,000 x $1.00 = $50,000

Long obligated to buy 50,000 pounds in July at $1.00/pound

Short obligated to sell 50,000 pounds in July at $1.00/pound

www.irfanullah.co 6
 An Example of Offsetting
In January, you purchase a June futures contract on the KSE100 Index. You decide to close this
position in March. How can this be done?

John is a futures trader. In March he takes a short position in KSE 100 Index expiring in August. Two
weeks later he decides to close out his position. How can this be done?

www.irfanullah.co 7
 Example
A silver futures contract requires a long trader to buy 5,000 oz. of silver. A trader buys
one December futures contract at a price of $23/oz. What is the maximum loss this
trader could have? Another trader sells one December silver futures contract. What is
the maximum loss?

www.irfanullah.co 8
 3. Clearinghouse, Margins, and Price Limits
When taking a long or short position in a futures contract trader must deposit
sufficient funds to meet the initial margin requirement

Money deposited can be thought of as a down payment; it can also be thought of

as collateral or a performance bond

Margin requirements are set by the clearinghouse and are based on price volatility

If account balance falls below maintenance margin, trader must bring the balance
back to initial margin the next day; difference between initial margin and
maintenance margin is called the variation margin

Settlement price

www.irfanullah.co 9
 Margin Balance
Consider a futures contract in which the current price is 100. The initial margin requirement is 5 and the
maintenance margin requirement is 3. You go long 10 contracts.

Day Beginning Funds Settlement Price Gain/Loss Ending

Balance Deposited Price change Balance
0 0 50 100.00 50
1 50 0 99.20 -0.80 -8 42
2 42 0 96.00 -3.20 -32 10
3 10 40 101.00 5.00 50 100
4 100 0 103.50 2.50 25 125
5 125 0 103.00 -0.50 -5 120
6 120 0 104.00 1.00 10 130

Marking to Market = Daily Settlement

Reference: Exhibit 1

www.irfanullah.co 10
 Margin Balance
Holder of Short Position of 10 Contracts

Day Beginning Funds Settlement Futures Price Gain/Loss Ending

Balance Deposited Price change Balance
0 0 50 100.00 50
1 50 0 99.20 -0.80 8 58
2 58 0 96.00 -3.20 32 90
3 90 0 101.00 5.00 -50 40
4 40 0 103.50 2.50 -25 15
5 15 35 103.00 -0.50 5 55
6 55 0 104.00 1.00 -10 45

Example 1

www.irfanullah.co 11
 Margin treatment in
Securities Market
Margin indicates how much an
investor can borrow
40% initial margin requirement means
investor must put in at least 40% and
can borrow up to 60%
25% maintenance margin means
investors equity must be at least 25%
If equity falls below 25%, he needs to
come back to 25%
www.irfanullah.co
Futures Market
Margin indicates how much trader
must deposit as collateral/down
payment
10% initial margin means trader must
deposit at least 10% in account
If balance falls below maintenance
margin, trader must get back to initial
margin
12
 Price Limits
Price limits are exchange-imposed limits on how much the contract price can change
from the previous days settlement price

Limit move: price freezes at one of the limits

Limit up: price stuck at upper limit

Limit down: price stuck at lower limit

Limit locked: situation where transaction cannot take place because price would be
beyond the limits

www.irfanullah.co 13
 4. Delivery and Cash Settlement
When an exchange designs a futures contract, it specifies whether the contract will
terminate with delivery or cash settlement
Futures trader can close out a given position by taking the opposite position before
expiration
Delivery, cash settlement and closeout are equivalent (Exhibit 2)
Because of the inconvenience of dealing with a physical commodity, most parties prefer cash
settlement or closeout
Consider a futures contract which expires on 21 Aug. A trader takes a long position on 19 Aug at
a price of 40. On 20 Aug the settlement price is 42. At expiration the settlement price is 43.

www.irfanullah.co 14
 Delivery and Exchange for Physicals
Contracts designed for delivery may have features that complicate
delivery
Delivery may occur over several days, or any day during a business month
Short may have an option to decide where to deliver
Delivery options are valuable for the short party

In an exchange for physicals (EFP), the long and short arrange an

alternative delivery procedure
Long and short settle contract outside exchanges regular procedure but report
the transaction to the exchange

www.irfanullah.co 15
 5. Futures Exchanges
A futures exchange is a legal corporate entity whose shareholders are
its members

Member acts as a floor traders (locals) or brokers (futures commissions

merchants)

Several trading styles

Scalpers hold positions for short periods, making money on the bid-ask spread
Day traders hold positions for longer but close by end of day
Position traders hold positions open overnight

Exhibit 3: The Worlds 20 Leading Futures Exchanges

www.irfanullah.co 16
 6. Types of Futures Contracts
Short-Term Interest Rate Futures Contracts
Treasury Bill Futures
Eurodollar Futures
See Exhibit 4 for a list of active
commodity futures and financial
futures. This section focuses on
financial futures.

Intermediate- and Long-Term Interest Rate Futures Contracts

Stock Index Futures Contracts

Currency Futures Contracts

www.irfanullah.co 17
 Treasury Bill Futures
Based on a 90-day $1,000,000 U.S. Treasury bill, cash settlement
Price is quoted using the IMM Index: 100 Rate
6.25% discount rate IMM Index = 93.75 Actual price = $984,375

What is the actual price if IMM Index = 93.76

Once basis point move is equivalent to $25
Minimum tick size is one-half basis point or $12.50

www.irfanullah.co 18
 Eurodollar Futures
Eurodollar futures contracts are more active and are considered more important
relative to T-bill futures
LIBOR is the rate for high quality private borrowers and is less influenced U.S.
government policies relative to T-bill rates

Eurodollar futures are based on $1 million notional principal and 90-day LIBOR
Quoted as 100 annualized 90-day LIBOR in percent
Settle in cash
One tick = 1 basis point which represents $25 per contract

www.irfanullah.co 19
Intermediate-and Long-Term Interest Rate Futures Contracts
This section focuses on the U.S. Treasury bond futures which are based on the
delivery of $100,000 par value U.S. Treasury bonds with any coupon but with
maturity of at least 15 years
Price is based on points and 32nds
Since the short has the option to deliver one of several bonds, the exchange defines a standard
or hypothetical bond which has a conversion factor of 1
Each bond is assigned a conversion factor based on its characteristics; this puts all bonds on
equal footing

Cheapest-to-deliver bond: amount received for delivering bond is largest relative to

price of bond in the open market

www.irfanullah.co 20
 Stock Index Futures Contracts
FTSE 1000, Nikkei 225, CAC 40, DAX 30, S&P 500

S&P 500 Stock Index futures are the most popular

Cash settlement
Multiplier of $250

Example: The S&P 500 Stock Index futures contract is quoted at 1,240.00. The next
day the price goes up to 1,241.00. What is your gain if you were long 10 contracts?

www.irfanullah.co 21
 Currency Futures
In the U.S., the primary currencies on which trading occurs are the euro,
Canadian dollar, Swiss frank, Japanese yen, British pound, Mexican peso
and Australian dollar.

Contracts are set in units of the foreign currency, and the price is stated in
USD/unit
Example: EUR125,000 quoted at $0.8555/euro
Contract price: 125,000 * 0.8555 = $106,937.50

www.irfanullah.co 22
 Summary
Similarities and differences between forwards and futures
Futures trading
Initial margin
Maintenance margin
Mark-to-market, daily settlement
Concept of margin in securities markets and futures markets
Price limits
Types of futures contracts: T-bill, Eurodollar, stock index and
currency

www.irfanullah.co 23
 Conclusion
Read the summary

Review learning objectives

Example

Practice problems

Practice questions from other sources

www.irfanullah.co 24