AN INTRODUCTION TO FUTURES MARKETS

LECTURER: DR. GARY TAN

AN INTRODUCTION TO FUTURES MARKETS 1

AN INTRODUCTION TO FUTURES MARKETS

 LEARNING OBJECTIVES
At the end of this topic, students should be able to:
 Know what futures and forward contracts are
 Differentiate OTC and exchange traded forwards and futures
 Identify the different types of futures and forward market participants
 Understand the mechanics of trading futures and forwards
 READING
 see chapters mapping on MyUni

AN INTRODUCTION TO FUTURES MARKETS 2

MAJOR CLASSES OF DERIVATIVES

Derivatives
A derivative is a
Options financial instrument Futures
that derives its value
An option is a contract from the price of an A futures contract
between two parties underlying instrument provides the buyer with
providing the buyer the a specified quantity and
right, but not the quality of the underlying
obligation, to buy / sell a asset at a future date for
quantity of some a specified price.
underlying asset at a
particular price on or
before a specified date.

AN INTRODUCTION TO FUTURES MARKETS 3

A DEFINITION OF FORWARDS & FUTURES CONTRACTS

 Forwards

 Agreement between two parties that call for delivery of

an asset at a future point in time with a price agreed
upon today
 Futures

 A forward contract that has standardised terms, is

traded in an organised exchange, and follows daily
settlement procedures where losses from one party are
paid to the other.
AN INTRODUCTION TO FUTURES MARKETS 4
TRADING FUTURES/FORWARDS

 Forward markets contain DEFAULT RISK – risk of one party reneging

 Forward contracts are not easily exchangeable due to unique contract
arrangements
 Futures markets mitigate the above problems

AN INTRODUCTION TO FUTURES MARKETS 5

TRADING OTC FORWARDS

 Legal documentation in the form of a ‘Master Agreement’ is undersigned by

all parties.
 One common Master Agreement is provided by the International Swaps and
Derivatives Association
 www.isda.org

AN INTRODUCTION TO FUTURES MARKETS 6

TRADING OTC FORWARDS

 Covers, liquidation, non-payment (default), payment arrangements and

specific terms and conditions relevant to the contract
 OTC processing involves
 Front office (execute transactions, authority to trade)
 Middle office (risk management – credit, market, liquidity and legal risk)
 Back office (admin to keep records)

AN INTRODUCTION TO FUTURES MARKETS 7

ORGANISED FUTURES TRADING

 Exchanges manage contract development

 Standardised terms and conditions
 Delivery Cycles
 Delivery Terms
 Daily Price Limits and Trading Halts
 Margin accounting

AN INTRODUCTION TO FUTURES MARKETS 8

ROLE OF THE CLEARING HOUSE

 Assumes the role of intermediary between buyers and sellers.

 Covers its risk exposure by requiring
 Initial margins
 Maintenance margins
 Marked to market accounting
 Above margins act as a good-faith bond

AN INTRODUCTION TO FUTURES MARKETS 9

MARKING TO MARKET

 The process of marked-to-market is sometimes called Daily Settlement

 When your balance falls below the maintenance margin you receive a
margin call
 Additional funds must be provided to the CH. These extra funds are
called the variation margin.

AN INTRODUCTION TO FUTURES MARKETS 10

 Source: InteractiveBrokers.com

https://www.interactivebrokers.co.uk/en/index.php?f=40539&hm=au&ex=us&rgt=0&rsk=1&pm=0&
MARGIN REQUIREMENTS rst=040404010101080101

AN INTRODUCTION TO FUTURES MARKETS 11

AN EXAMPLE OF MARGIN REQUIREMENT

 Assume a trader has US$550, 000 in his future trading account and the
initial and maintenance margin for trading one Bitcoin future is US$130,
843.75 and US$104, 675.00 respectively.
 Day 1
 The trader expects Bitcoin price to rise in the coming two weeks. He
decides to buy 4 contracts of the CME BITCOIN FUTURE (contract size:
5 Bitcoins) at US$49,105 per Bitcoin. Initial margin required to initiate this
trade is US$523,375 (US$130,843 × 4 contracts) and the maintenance
margin required is US$418,700 (US$104,675 × 4 contracts).

AN INTRODUCTION TO FUTURES MARKETS 12

EXAMPLE OF MARGIN
 If the daily settlement price is US$49,445 per Bitcoin, the
unrealized profit for Day 1 is:
 Unrealized profit: US$(49,445 - 49,105) ×5 ×4 contracts =
US$6,800
 The trader may withdraw this US$6,800 profit from his account if
he wishes.
 Assume that the trader decides to keep the profit in his account.
 Account balance at the end of Day1: US$550,000 + US$6,800 =
US$556,800
 As the account balance is above the maintenance margin of
US$418,700 required for holding the position, there is no margin call.

AN INTRODUCTION TO FUTURES MARKETS 13

EXAMPLE OF MARGIN

 Day2
 Bitcoin price increase as a result of market sentiment. The future contract
settles at US$51,455 per Bitcoin.
 Opening balance: US$556,800
 Unrealized profit for Day2: US$(51,455 – 49,445) ×5 × 4 contracts =
US$40,200
 Account balance at the end of Day 2: US$556,800 + US$40,200 =
US$597,000
 As the account balance is above the maintenance margin of US$418,700
required for holding the position, there is no margin call.

AN INTRODUCTION TO FUTURES MARKETS 14

EXAMPLE OF MARGIN

 In the following days, Bitcoin price rose and fell, resulting in the account balance as
follows:

AN INTRODUCTION TO FUTURES MARKETS 15

EXAMPLE OF MARGIN

 Day 12:
 Opening balance: US$435,600
 Day 11 settlement price: US$43,385
 Day 12 settlement price: US$41,990
 Unrealized loss for Day 12: US$ (41,990 – 43,385) × 5 × 4 contracts = -
US$27,900
 Account balance at the end of Day 12: US$435,600 – US$27,900 =
US$407,700
 As the account balance is now below the maintenance margin of US$418,700
required for holding 4 contracts of CME BITCOIN FUTURE, a margin call is
triggered.

AN INTRODUCTION TO FUTURES MARKETS 16

EXAMPLE OF MARGIN

 The trader has 2 choices to meet the margin call:

 Choice 1.Top up his account to the initial margin level.

 This replenishment of funds has to be carried out within 2 business days
from the day of the short fall. In this example, the trader is required to
top up his account by US$115,675 so as to bring his account balance back
to initial margin level of US$ US$523,375.

AN INTRODUCTION TO FUTURES MARKETS 17

EXAMPLE OF MARGIN

Topping up the
trading account

AN INTRODUCTION TO FUTURES MARKETS 18

EXAMPLE OF MARGIN

 Choice 2. Liquidate all or some of the contracts

 Instead of topping up the trading account with additional funds, the trader
may decide to liquidate (close out) all, or some contracts so as to ensure
that his account has sufficient margin to hold the remaining contracts.

 In this example, the trader is required to liquidate at least 1 contract so

as to ensure that there is sufficient margin to hold the remaining 3
contracts. Initial margin required for 3 contracts is US$392,531.25, which
is within the account balance of US$407,700.

AN INTRODUCTION TO FUTURES MARKETS 19

HOW CAN MARGINS BE MET?
Margin obligations are calculated at the end of trading each day and ASX
Clear notifies each broker of the margin obligations for each of that
broker’s accounts early the next trading day.
 Cash
 A broker may require you to provide cash to enable the broker to meet
their margin obligations to ASX Clear.
 Collateral
 In addition to, or as an alternative to cash, you may wish, (subject to
your broker and/or ASX Clear agreeing), to provide certain types of
collateral.
 Details of eligible collateral are published on the ASX website at
https://www2.asx.com.au/data/data/acceptable_stocks.pdf
AN INTRODUCTION TO FUTURES MARKETS 20
DELIVERY AND CASH SETTLEMENT
 Two business days before expiry
 Position Day
 Short informs CH it intends to deliver

 Notice of Intention Day

 CH contacts long to inform of delivery

 Delivery Day
 Long pays the short and takes delivery

 MOST contracts are not delivered, but rather parties take offsetting
positions prior to delivery.

AN INTRODUCTION TO FUTURES MARKETS 21

MAKING A TRADE

 Price and time priority basis. Trading rules are detailed in SFE legal
documentation and also list all forms of trades possible (eg. limit and market
orders)
 Trades registered with the clearing house under the clearing participants
name.

AN INTRODUCTION TO FUTURES MARKETS 22

MAKING A TRADE

 SFE clearing co-operation acts as intermediary between buyer and seller

 Handles assessment of participant creditworthiness /default risk, etc.
 Provides registry of who owns what
 Handles all margins
 Clearing House rules available at www.asx.com.au

AN INTRODUCTION TO FUTURES MARKETS 23

TRANSACTION COSTS

 Futures markets involve very low trading costs.

 Far cheaper than equity/fixed income market
 Offers more liquidity

AN INTRODUCTION TO FUTURES MARKETS 24

AUSTRALIAN FUTURES

 ASX owns:
 The Sydney Futures Exchange (SFE)
 Licensing of futures brokers
 Determining membership of SFE
 Registration of client advisers
 Financial Restrictions for SFE members
 Monitoring of Member operations

 Clearing House
 Australian Securities and Investment Commission (ASIC)

AN INTRODUCTION TO FUTURES MARKETS 25

ASX RANGE OF PRODUCTS
 ASX (SFE)
 90-day/3 year/ 10 year Treasury Bonds
 All Ordinaries Share Price Index (SPI*)
 Single share Futures, Examples:
 ANZ, BHP, NAB

 Commodities:
 Wool
 Broad Wool (23 Micron)
 Fine Wool (19 Micron)
 Greasy Wool (21 Micron)
 Wheat

 Electricity:
 Base Load
 Peak Load

AN INTRODUCTION TO FUTURES MARKETS 26

SPI 200

 The value of a SPI200 contract

 $25 for 1 index point
 25 times its current index value
 Example:
 Index at 3200
 Cost (Exposure) $80 000 (25 x 3200)
 If Index rises to 3250, contract worth $81,250
 Gain of $1250

 Contract specifications
 Determined by the SFE market by-laws
 Example on next page:

AN INTRODUCTION TO FUTURES MARKETS 27

 Source: ASX.com

ASX INDEX FUTURES CONTRACT

SPECIFICATION
AN INTRODUCTION TO FUTURES MARKETS 28
CHICAGO MERCANTILE EXCHANGE(CME)
Source from: https://www.cmegroup.com/

AN INTRODUCTION TO FUTURES MARKETS 29

CME RANGE OF PRODUCTS

 Agriculture
 Energy
 Equity Index
 FX
 Interest rates
 Metals

AN INTRODUCTION TO FUTURES MARKETS 30

WTI CRUDE OIL FUTURES
Source from: https://www.cmegroup.com/trading/energy/micro-wti-crude-oil-futures.html#contract-specifications

AN INTRODUCTION TO FUTURES MARKETS 31

CRUDE OIL FUTURES ON CME
Source from: https://www.cmegroup.com/market-data/delayed-quotes/energy.html

AN INTRODUCTION TO FUTURES MARKETS 32

TAX TREATMENT

 FRAs
 Forward Sales
 Generally, assessable income is derived when item is delivered to purchaser

 Forward Purchases
 Deductions generally made when delivery of asset takes place
 Exceptions exist where deductions have not been deferred until delivery.

 Fees are immediately deductible/assessable for purchaser/seller.

 If used to raise finance, FRA may be treated as a debt interest.

AN INTRODUCTION TO FUTURES MARKETS 33