Futures Markets and Contracts

Futures are a lot like forwards, but more institutionalized.  They trade on organized exchanges (forwards do not).  They are highly standardized (forwards are not).  A single clearinghouse serves as the counterparty.  They are regulated by the government (futures are not).

Uniformity promotes market liquidity.

Speculator vs Hedger - speculator seeks to gain, hedger seeks to manage his own risk.

Clearinghouse acts as the buyer for every seller, and the seller for every buyer.  All traders can reverse their positions.  Also no worry about defaulting.

Buying on Margin
In stocks/bonds, margin is a percentage of the market value of the asset.

In futures, margin is a performance guarantee.  There is no loan or interest charges.  Traders must post margins and settle their accounts on a daily basis.

Initial margin - money that must be deposited before any trading takes place.

Maintenance margin - amount of margin that must be maintained.  If you fall below this, you have to get back up to INITIAL margin, not just maintenance margin - different than equity accounts.

Variation margin - funds that need to be deposited to bring account back to initial.  If account margin is above initial margin, you can take funds out or use the margin for additional positions.

Settlement price is NOT just the last trade - it is the average of prices of trades over the last period of trading (aka the closing period) and is set by the exchange.  Prevents manipulation by traders.

Leverage is much higher in futures accounts (vis a vis equity accounts I assume) because the margin is lower typically.

Price Limits - prices on futures can only move within a specified band each day.  If eq price is above or below, no trades will take place.  A full move is called a limit move.

Marking to market - process of adjusting the margin balance based on the price movements that day.  Gains and losses due to price changes accrue directly to margin account, and if you go below the maintenance margin you have to put in cash to get back to the initial margin.

How to terminate prior to expiration (4 ways):

• Delivery (rare) - actually delivering prior to expiration
• In cash settlement, delivery is not an option (sooooo...how does this terminate the contract?)
• Make a "Reverse" trade in the futures market - this is the most common.  This is called a closing trade.  The counterparty is the clearinghouse.
• Exchange for Physicals - find a trader with an opposite position and settle up between yourselves.  Contact the clearinghouse and tell them what happened.  Different from delivery.

Delivery Options in Futures - some futures allow the short party options on what, when and where to deliver.  Options can be of significant value.

T-Bill Future Contracts - quoted as 100 minus annualized discount.  Ex, price of 98.50 on a 90 day bill means an annual discount of 0.0150 and an actual discount of 0.0150 * (90/360) = 0.00375 and a delivery price of 996,250.  T-bills are not as important as they used to be - big global issuers tend to look to Eurodollar futures more these days.

Eurodollar Futures - based on 90 day LIBOR.  This is an add on yield rather than a discount yield.  However prices follow the T-Bill convention and equal 100 - annualized LIBOR in percent.  Minimum price is 1 'tick' or 0.01%.  A quote of 97.60 corresponds to an annual LIBOR of 2.4% and an effective 90 day yield of 2.4% * (90 / 360) = 0.6%.  Each price change tick e.g. 98.52 to 98.51 is a $25 change per $1 mm contract.

Treasury Bonds Futures Contracts - bonds greater than 15 yrs.  Face of $100,000.  Deliverable.  Quoted as a percent and fractions of a percent (1/32 increments).  Short has option to deliver one of several bonds and will deliver the cheapest - so this option is valuable.  Each bond has a conversion factor - adjusts the long's payment at delivery so that more valuable bonds receive higher pmt.  Long pays futures price times the conversion factor (multiplier).

Stock Index Futures - Most popular is S&P 500 index in Chicago.  Cash settlement, based on multiplier of 250.  Index level of 1,000.  Each contract worth $250,000.  Each index point = $250 change.  Multipliers can vary for other contracts.

Currency Futures - smaller than the currency forwards mkt.  Contracts are set in units of the foreign currency and quoted in the domestic currency.  Peso contract is MXP 500,000 and Euro is EUR 125,000.  A change of 0.0001 USD in MXP is a loss of 50 USD on the MXP 500,000 unit and a loss of 12.50 USD on the EUR 125,000 unit.