This chapter provides an overview of futures contracts, including their history and development. It discusses key concepts such as contract specifications, margin requirements, order types, categories of futures contracts, and pricing models such as cost of carry and basis. The chapter also outlines futures exchanges and compares features of futures versus forward contracts.

1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 5
Futures
August 2012

2. Chapter summary and outline
This chapter provides the history and development of futures
contracts, futures exchanges in Singapore and overseas, features
of futures contracts and their trading mechanisms. The chapter
also covers important concepts in futures such as cost of carry,
basis and pricing of futures contracts.
Chapter outline:
• Introduction to the futures industry
• Elements of financial futures
• Contract specifications
• Financial futures versus cash market
• Application of futures contracts
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3. Introduction To Futures
History of the Futures Industry
• Organized trading in forward contracts was found to occur in as early as the
17th century in the rice markets of Japan.
• In 1848, 82 merchants from the Chicago area founded the Chicago Board
of Trade (“CBOT”)
• Many of the developments revolved around standardized contract
specifications and deposits for losses called margin maintenance.
• Forward contracts were not standardized and closed bilaterally without an
exchange as the medium
• Futures contracts provided users with a tool to minimize price risk but also
to virtually eliminate default risk by their counterparts through the margin
maintenance process instituted by the exchange to settle any losses on the
contracts.
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4. What Are Futures?
• Forwards
– are an obligation to buy or sell a certain commodity at a fixed price agreed today
for a future delivery.
– Contract between the buyer and seller established now for fulfillment at a later
date.
– Only between the buyer and seller and if either party defaults, the other will have
to enforce the contract based on its terms and conditions.
– Flexible and allows both parties to meet their requirements precisely.
– Hard to enforce the contract if one of the parties defaults due to financial or other
reasons.
– Forward contracts whose terms are negotiable
• Futures
– contracts have standardized amounts; specific characteristics, fixed maturity
dates and are traded in an organized exchange.
– Trading in futures through an exchange, participants are required to place a
margin payment with a member of the exchange.
– Margin will enable the exchange to guarantee trades done through them.
– Price movements reached a level that caused the margin to be drawn down, the
exchange member will call the client to top-up the margin.
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5. Differences Between Forwards and Futures
• Forwards
– are much more flexible than futures
• Able to hedge out their risk absolutely with the exact amount, quality of the
commodity, and required future date
– Flexibility comes with risk
• Risk with the counterparty
• Futures
– exchanges take away this risk but traders have to accept the specifics of the
contracts that are stipulated by the exchange.
– Risk is not perfectly hedged as contracts in question may be of a different quality
from the commodities that have to be hedged.
– Delivery date may fall in between those that are traded on the exchange.
– Amount may be different from what is being offered by the futures exchange
– Very important to choose the right contract;
• One that would mimic the price movements of the commodity in question.
• The risk associated with hedging with a futures contract that is very close to
but not having exactly the same characteristics with the underlying is called
mismatch risk.
– Basis risk – risk of underlying price not moving in line with the futures price
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6. Futures Exchanges
• Physical facilities are provided for buyers and sellers to converge and
conduct business;
• Information about markets and prices are collected and disseminated;
• Orders are collected and executed and contracts are cleared, maintained
and settled;
• A framework is provided for arbitrating disputes and settling differences that
may arise in the course of trading.
• Reputation and financial stability of the exchange is very important, as the
exchange is the principal party to every contract that is bought or sold.
• Enough safeguards so members do not default and that margin deposits
that are placed with its members are safe, even during times of crisis.
• Cost of transactions such as clearing fees, execution fees and the level of
margin maintenance need to be as competitive as possible.
• Level of participation in an exchange for a particular contract is important,
as the liquidity of a contract will affect the bid-offer spread quoted.
• Cost of initiating and closing positions or hedging and un-hedging positions.
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7. Futures Exchanges - 2
• Electronic platforms has replaced the open-outcry system for many
contracts
• Dark pools
– Trading volumes created by institutional orders that are unavailable to the public
and may be transacted away from the public exchanges.
– Advantage of dark pools => reduces market impact of moving big trades.
– Objection to dark pools is the lack of transparency.
• Three main types of dark pools:-
− Those set up by independent companies;
− Those which are broker-owned and are limited to its clients;
− Those created by public exchanges
• Singapore Exchange Limited
– Merger or Stock Exchange of Singapore (“SES”) and the Singapore International
Monetary Exchange (“SIMEX”).
– Electronic screen-based system
– Derivative products, which are also traded electronically, include short-term and
long-term interest rate and equity index futures and options on futures, structured
warrants and certificates.
– Commodities exchange that now trades and clears palm oil contracts.
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8. Margin Requirements
• Margin
– A good faith deposit to guarantee the participant’s performance of contractual
obligations
– Essentially a security to cover any initial loss that may result from adverse price
movement and are not a partial payment for the instrument
– Margin placed with futures broker with whom the participant transacts
• Maintains the same with another futures broker or a clearing member firm,
which must make a margin deposit with the Clearing House.
• Failure by a customer to make a margin deposit does not relieve the clearing
member from the responsibility of having to make a deposit with the Clearing
House
– Margin amount is determined on the basis of contract and market risks, reflected
in the price volatility
– Margin levels vary among hedge, speculative, and spread positions, contracts
and/ or delivery months, and may differ among customers
– Futures brokers must set minimum margin levels for customers at levels that are
not less than those established by the futures exchanges
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9. Margin Requirements - 2
Initial Margin
• Total amount of margin per contract required by the broker when a customer
opens a futures position
• Good faith deposit that the contract will be honoured
• May be deposited in cash or on some exchanges, in the form of qualifying
securities (such as treasury bills) or a standby letter of credit
• Exchange sets minimum initial margin requirements, futures brokers may
set requirements which may exceed (but cannot be less than) those set by
the exchanges.
• Usually small relative to the total value of the contract
– Not more than one or two days’ price fluctuation in the market
• Exchanges and brokers may amend their initial margin requirements in
response to various market limitations
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10. Margin Requirements - 3
Maintenance/ Variation Margin
• Minimum amount that must be maintained on deposit by the customer with
the broker at all times.
– If customers’ net equity (cumulative net margin deposits + unrealised/ realised
gains - unrealised/realised losses + commission charges) does not fall below this
amount, there is no request for additional funds even though there has been a
negative market movement against the futures position.
– If balance in the margin account falls below the maintenance level, a variation or
maintenance margin call is issued and the account must be returned to the initial
margin level immediately or by a stipulated time.
• Margin calls must always be settled in cash
• Maintenance margin process primarily used for small individual customers
• Institutional accounts => settle on variation margin basis.
– Daily price fluctuation (mark-to-market) always settled with customer in cash
– Gains are paid to the customer and the customer must pay the broker for any
mark-to-market losses
– Balance of the margin account is always kept at the initial margin level
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11. Modes of Settlement
• Value of a futures contract is ultimately tied to the underlying product or
instrument via each contract’s specifications.
• Cash settled
– Cash amount representing gain/loss paid to/from the exchange
• Settled by physical delivery
– Underlying product is transferred to the futures contract buyer by the seller
Mutual Offset Trading System (“MOS”)
• Identical contracts can be traded in more than one exchange
– Trade in a contract can be done in any of the participating exchanges and
transferred to and liquidated in another
– Trader can open a contract in one exchange and close it in another
– 3-month Eurodollar and 3-month Euroyen Futures contracts traded in SGX, for
example, are set up for mutual offset with the CME
• Advantage of MOS
– Better management of positions as the outstanding contracts can be
consolidated across participating exchanges;
– Lower costs as only one set of margin applies; and
– Improved market liquidity for instruments traded in this system
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12. Types of Orders
• Order must include Price, Quantity, Commodity type, Buy or sell, Market
order, Limit order, Opening only order, Discretionary only order
• Types of Orders
– Market-if touched order (MIT)
– Stop order
– Stop limit order
– Market on close order (MOC)
– Fill or kill order (FOK)
– One cancels the other order (OCO)
– Scale order
– Good till cancelled order (GTC)
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13. Categories of Futures Contracts
• Futures contracts are designed for products in a broad range of categories
round the world and these include:-
– Agriculture
– Energy
– Metals credit
– Equity
– Foreign exchange
– Interest rates
– Others like Real estate and weather
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14. Categories of Futures Contracts - 2
• Short Term Interest Rates Futures
– Underlying asset of an interest rate futures contract may be a Eurocurrency (a
currency that is lent or borrowed outside its country of origin) time deposit
– Asset can also be a government treasury bill, usually of 90-day tenor
– Short-term interest rate futures contract is quoted as 100 x (1-R) where R is the
annualized interest rate for that period of say 90 days
• Currency Futures
– Designed to reflect changes in the USD value of the currency
– Quoted in USD per currency
• Stock Index Futures
– Benchmark for the performance of various global stock markets.
– Mathematical composite
• Price-weighted average e.g. STI Index and Nikkei 225 Index
• Market-value-weighted or capitalization-weighted average e.g. SGX All
Share Index
• Equally weighted average
• Commodity/Energy/Metal/Chemical Futures
– Price of one unit of the underlying product quoted in USD terms
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15. Packs and Bundles
• Hedging where the period concerned is longer than a single contract, new
orders known as packs and bundles for Eurodollar futures are now
available.
• Packs
– the simultaneous sale or purchase of an equally weighted, consecutive series of
four Eurodollar futures.
– four contract months in the strip are executed in a single transaction, eliminating
the inconvenience of partial fills
– Eurodollar packs are available beginning with each quarterly expiry month out all
10 years of the yield curve
• Eurodollar Bundle
– consists of the simultaneous sale or purchase of one each of a series of
consecutive Eurodollar futures contracts.
– Eurodollar Bundles are available in 1-, 2-, 3-, 4-, 5-, 6-, 7-, 8-, 9- and 10-year
terms to maturity
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16. Contract Specifications
Futures Exchanges and Futures Contracts
• Futures contracts
– Very specific in nature in terms of their descriptions and other listing details
– Between exchanges, specifications of each type of contract for the same
underlying product may be different or the liquidity or popularity of that contract
may differ between exchanges.
– Trading hours is another important element
Contract Specifications
• Contract Size
– Usually in amounts small enough to provide a meaningful trade/hedge but not
too small which will incur huge transaction costs.
• Contract Months
– Only an efficient number of delivery dates (usually one every calendar month or
one every quarter) that is feasible and suitable for trading/hedging a particular
underlying product.
– Main purpose is to ensure that liquidity is sufficient
– As opposed to being diluted over a possible 250 days
– Liquidity in trading is usually better nearby contract months
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17. Contract Specifications - 2
• Minimum Price Fluctuation/ Value per Tick
– Minimum change in the value of the contract in monetary terms
• Daily Price Limit
– Maximum price change allowed for a given contract within a day
• Last Trading Day
• Delivery and Settlement
– Cash or by physical delivery
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18. Contract Specifications - 3
Examples of Product Specifications: SGX Eurodollar Futures
• Eurodollar futures
– Eurodollar future prices move in the opposite direction of interest rates
– Eurodollar Futures Price = 100.00 - Implied forward rate
• Hedging
− Hedging against higher interest rates => sell Eurodollar futures
− Hedge against lower interest rate => buy Eurodollar futures
• Dollar value of each basis point
– Each contract signifies a value equivalent to USD 1 million.
– One tick is one basis point.
– Since Eurodollar futures are 90-day interest rate contracts:-
– Value of one basis point
= (USD 1,000,000 x 0.01 x 90) / 36,000= USD 25
• Eurodollar futures traded SGX are under the mutual offset trading
agreement with the CME.
– Positions in SGX are fungible with those in CME
– Allows traders to better manage overnight positions and also help to reduce
overall trading cost.
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19. Futures Pricing Models
• Cost of Carry Model
– Futures pricing, like forward pricing, is often explained in terms of cost of carry
• i.e. in terms of the spot market price adjusted by the cost of holding/carrying
that commodity until futures contract maturity.
– Actual price may show a small divergence from the theoretical price.
• Due to market imperfections, which often result from credit risk of
counterparties in the underlying cash instrument, or market liquidity risk of
the underlying or the futures markets.
– Indifference analysis
• compares the total cost of buying the spot commodity and evaluating the
financing cost involved in holding the commodity to the future date with the
cost of buying the futures contract.
• When futures contract is properly priced, the buyer or seller should be
indifferent as to the two alternatives
• Anticipatory Pricing Model
– Futures prices reflect the consensus opinion of futures market participants as to
the value of spot commodity by the time the futures contract matures.
– Better liquidity in the futures market for some commodities, activities in the
futures market sometimes may lead the spot market in price movement.
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20. Basis
• Futures contracts are priced on a net cost of financing basis.
– The cash and carry arbitrage forms the link between futures and the underlying
security.
– Eventually, the total cost to the user for buying now and incurring financing costs
should be equal to the cost of buying the futures price.
• Difference between the cash price and futures price is known as the basis.
• Futures price is not necessarily a good predictor of what the spot price will
be at the expiry date, but future and spot price will converge at expiry
Factors Affecting Basis
• Cost / Return of carry
– Depends on the difference between cost of funds and the yield on the underlying
assets
• Time to maturity
– Greater the mismatch between the maturity dates of the cash and futures
contracts, the greater will be the basis.
– As the expiry date draws near, the net financing cost declines and forces the
basis toward zero.
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21. Basis - 2
Factors Affecting Basis (cont.)
• Yield curve changes
– Changes in the shape of the yield curve affect the basis as well.
– Positive basis => futures price is lower than cash price in a backwardation
relationship
– Negative basis => futures price is higher than cash price in a contango
relationship
– Steepening in the yield curve will cause the basis to widen in the former and to
narrow in the latter.
• Relative liquidity of cash and futures markets
– Position adjustments are reflected first through the futures market, while the cash
market remains unchanged
– Futures market leads the cash market for some commodities, for example, US
Treasury bonds, any news that affects the commodities will be first felt in the
futures market.
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22. Basis - 3
Factors Affecting Basis (cont.)
• Market rates versus administered rates
– More volatile than administered rates
• Expectations of market participants
– Market sentiment swings to one extreme or another, the basis between cash and
futures will widen.
• Differences in coupons between fixed income instruments
– Changes in market rates affect the prices of two fixed income instruments
bearing different coupons differently.
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23. Pricing of Futures Contracts
Pricing of the Three Month Interest rate Futures Contract
• For two sequential periods, the arbitrage process ensures that the average
rate for the two periods will be equal to the rate for the entire period
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24. Pricing of Futures Contracts - 2
Pricing of currency futures: Interest rate parity theory
• Assuming on day 1, 1 USD equals to S amount of a certain currency, say
ABC.
• After d days, using the amount of 1 USD, 1 USD will accrue interest at a
rate of RUSD while the currency will accrue interest at a rate of RABC.
• Hence, after d days, 1 USD and S amount of ABC will have respectively
grown to:-
• Using the indifference analysis, the 1 USD at the future date must equal:
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25. Pricing of Futures Contracts - 3
Pricing of stock index futures
• Futures price
= Spot (Cash) price + Financing cost - Income from stock or Futures Price
= Spot Price + Interest – Dividend
• For stock index futures, the spot price is the spot index value, financing cost
is the interest on the value of the spot index portfolio and the income is the
dividends received from holding the index portfolio.
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