05-11-2020

Mechanism of Futures Markets

Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore

Contract Specifications
• Light sweet crude oil on CME -
http://www.cmegroup.com/trading/energ
y/crude-oil/light-sweet-
crude_contract_specifications.html
• NIFTY futures on NSE -
https://www.nseindia.com/products/cont
ent/derivatives/equities/cnx_nifty.htm
• Gold futures on MCX -
https://www.mcxindia.com/products/bull
ion/gold
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The Specifications of a Futures

Contract
• The Asset
• The Contract size
• Delivery Arrangements
• Price Quotes
• Price Limits & Position Limits

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Specification of Asset
• The financial assets in Futures Contracts are generally
well defined and no specification is required

• In case of commodity there might be quite a variation

in the quality of what is available in the marketplace
• Commodity futures exchange specifies the acceptable
grade(s) of the commodity

• For some cases a range of grades can be delivered, but

the price received depends on the grades chosen.
– In that case price is adjusted in a way established by the
exchange.

The contract size

• If the contract size is too large, smaller
investors will be unable to use the exchange.
• If the contract size is too small, trading
might become expensive.
• In some cases exchanges have introduced “mini”
contracts to attract smaller investors.
• In India index or stock futures have a contract
value of around Rs. 5 lacs. Ex. NIFTY futures
market lot is 75 and the May 2016 futures price
as on 9 May is 7860.

Delivery arrangements
• Delivery place must be specified by the
exchange.
– Important for commodities that involve significant
transportation costs
• In case of alternative delivery locations
– The price received by short position holder is
sometimes adjusted according to location chosen by
him.
• In financial futures delivery usually do not take place.
• Most traders choose to close out their positions.

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Price Limits and Position Limits

• Price Limits - purpose:
– To prevent large price movements due to speculation
excesses
– When price of underlying asset moves rapidly,
exchange readjusts the limit.
• Position Limits: Position limits are the
maximum number of contracts that a speculator
may hold.
– The purpose of these limits is to prevent speculators
from exercising undue influence on the market.

Futures Contracts in India

• Equity index futures -
https://www1.nseindia.com/products/content/derivatives/equities/
fo.htm
• Single stock futures – as above
• Currency futures - US Dollars (USD), Euro (EUR), Great Britain
Pound (GBP) and Japanese Yen (JPY) -
https://www1.nseindia.com/products/content/derivatives/currency
/cd.htm
• Interest rate futures - contracts based on 6 year, 10 year and 13 year
G-secs and 91 day GOI T-bill -
https://www1.nseindia.com/products/content/derivatives/irf/irf.ht
m
• Commodity futures - https://www.mcxindia.com/# and
http://www.ncdex.com/index.aspx#

Closing Out Positions

• Closing out a position means entering into the
opposite type of trade from the original
one

• Example:
– Long position holder in August cotton futures can
close out his position anytime before August by selling
the same contract on cotton
– The total gain or loss is the difference in August
cotton future price between the start day and the
closing out day.

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Convergence of Futures to Spot

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

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Margins
• Two types of margins:
- Trading margin collected by a member
from a trader
- Clearing margin collected by the Exchange
Clearing house from a member

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Trading Margin
• A margin is cash or marketable
securities deposited by an investor with
his or her broker.

• The balance in the margin account is

adjusted to reflect daily settlement.

• Margins minimize the possibility of a

loss through a default on a contract.
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Trading Margin Operation

• Margin account
• Initial margin
• Daily settlement / Marking to market
• Maintenance margin
• Margin Call
• Variation margin

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Trading Margin Operation

• Consider an investor who contacts his or her
broker/member on Monday, April 18, 2016,
to buy two April 2016 Reliance futures
contracts on the NSE.
• Current futures price is Rs.1060 per share.
• Since the contract size is 500 shares, the
investor has contracted to buy a total of 1000
shares at this price.
• The broker will require the investor to deposit
funds in what is termed as a margin account.

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Trading Margin Operation

• The amount that must be deposited at the time
the contract is first entered into is known as the
initial margin.
– This is determined by the broker.
– Suppose, the initial margin is is Rs.20,000 per
contract, or Rs.40,000 in total
• At the end of each trading day, the margin
account is adjusted to reflect the investor's gain
or loss.
– This is known as marking the account to market
due to daily settlement.

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Trading Margin Operation

• The investor is entitled to withdraw any
balance in the margin account in excess of
the initial margin.
• To ensure that the balance in the margin
account is above a minimum level, a
maintenance margin is set.
– This is somewhat lower than the initial margin
– Suppose also that the maintenance margin is
Rs.15,000 per contract, or Rs.30,000 in total.
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Trading Margin Operation

• If the balance in the margin account falls below
the maintenance margin, the investor receives a
margin call.
– Investor is requested to top up the margin account to
the initial margin level within a very short period of
time.
• The extra funds deposited are known as a
variation margin.
– If the investor does not provide the variation margin,
the broker closes out the position by selling the
contract.
• Suppose the contract is closed out on April 26 at Rs1020.
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Trading Margin Operation

• 1000 Reliance stock futures bought on April 18, 2016 at
Rs. 1060 and sold on April 26 at Rs. 1020 each.
Date Settle. Daily Margin Var. Cum.
Price Gain/loss Balance Margin Var. Mar
18 April 1065 +5000 45000

20 April 1041.1 -23900 21100* 18900 18900

21 April 1044.05 +2950 42950 18900

22 April 1041.80 -2250 40700 18900

25 April 1016.35 -25450 15250 24750 43650

26 April 1020 +3650 43650 43650

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Trading Margin Operation

• On the contract expiry date i.e. 28 April, 2016, the investor will
receive back Rs. 33,650 from the member/exchange based on the
following calculation.

• Selling price = 1000*Rs. 1020 = Rs. 10,20,000

Buying price = 1000*Rs. 1060 = Rs. 10,60,000
Net loss = Rs. 40,000

• Total money already paid to the member / exchange

= Initial margin + Cumulative Variation margin
= Rs. 40,000 + Rs. 43,650 = Rs. 83,650

• Net money to be received back by the investor = Rs. 43,650

• The investor has excess margin on April 18,21 and 22.

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Exchange Clearing House

• Exchange clearinghouse: The exchange
clearinghouse is an adjunct of the exchange and acts as
an intermediary in futures transactions.

• Features:
– It guarantees the performance of the parties to each transaction.
– Brokers who are not clearinghouse members themselves must
channel their business through a member.
– The main task of the clearinghouse is to keep track of all the
transactions that take place during a day so that it can calculate
the net position of each of its members.

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Clearing Margin
• Clearing margin: Just as an investor is required to
maintain a margin account with his or her broker, a
clearinghouse member is required to maintain a margin
account with the clearinghouse, known as a clearing
margin.

• In the calculation of clearing margins, the exchange

clearinghouse calculates the number of contracts
outstanding on either a gross or a net basis .
– The gross basis adds the total of all long positions entered into
by clients to the total of all the short positions entered into by
clients.
– The net basis allows these to be offset against each other for
proprietary trading.

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Some more Terminology

• Open Interest: the total number of contracts
outstanding
– equal to number of long positions or number of short
positions
• Settlement Price: the price just before the final bell
each day
– used for the daily settlement process (daily gains and
losses and margin requirements)
• Volume of Trading: the number of trades in 1 day

• When a new trade is completed, open interest may go up

or down or remain the same.

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Cash Settlement
• Some financial futures, such as those on stock indices,
are settled in cash
– This is because it is inconvenient or impossible to deliver the
underlying asset
• When a contract is settled in cash, it is marked to market
at the end of the last trading day and all positions are
declared closed.
• The settlement price on the last trading day is the
closing spot price of the underlying asset.
– This ensures that the futures price converges to the spot price

• Example: All futures traded at NSE are settled in cash.

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Problem No. - 1
If the balance in a trader’s account falls
below the maintenance margin level, the
trader will have to deposit additional
funds into the account. The additional
funds required is called the:
A. Initial margin.
B. Margin call.
C. Marking to market.
D. Variation margin.

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Problem No. – 1 (Ans.)

• Answer: D. Variation margin.

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Problem No. - 2
If only one transaction occurs today for
both a buyer and a seller for a given
futures contract, there MUST be:
A. One open interest for that futures contract
today.
B. No trading volume today for that futures
contract.
C. One contract of trading volume for that
contract today.
D. No open interest for that contract today.
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Problem No. – 2 (Ans.)

• Answer: C. One contract of trading
volume for that contract today.

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Problem No. 3
A trader buys two July futures contracts on
orange juice. Each contract is for the delivery of
15,000 pounds. The current futures price is 160
cents per pound, the initial margin is $6,000 per
contract, and the maintenance margin is $4,500
per contract.
a. What price change would lead to a margin call?
b. Under what circumstances could $2,000 be
withdrawn from the margin account?

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Problem No. 3 (Ans.)

a. If futures price of frozen orange juice
falls to 150 cents per lb
b. If futures price of frozen orange juice
rises to 166.67 cents per lb

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Problem No. 3 (Explanation)

• For margin call reduction required in
margin account = $6000 - $4,500 =
$1,500 per contract = 10 cents per pound
• So future price should be reduced by 10
cents per pound
• $2,000 can be withdrawn if each contract
rises by $1,000 = rise of $1000/15000 per
pound = rise of 6.67 cents

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Problem No. 4
At the end of one day a clearinghouse member is
long 100 contracts, and the settlement price is
$50,000 per contract. The original margin is
$2,000 per contract. On the following day the
member becomes responsible for clearing an
additional 20 long contracts, entered into at a
price of $51,000 per contract. The settlement
price at the end of this day is $50,200. How
much does the member have to add to its margin
account with the exchange clearinghouse?
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Problem No. 4 (Ans.)

The member has to add to its margin
account = $36,000

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Problem No. 4 (Explanation)

• The clearinghouse member is required to
provide 20*$2,000 = $40,000 as initial margin
for the new contracts
• There is a gain of ($50,200 - $50,000)*100 =
$20,000 from existing contracts
• There is also a loss of ($51,000 - $51,200)*20 =
$16,000 from new contracts
• The member must therefore add = 40,000 –
20,000 + 16,000 = $36,000

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Problem No. 5
Suppose that on October 24, 2009, a
company sells one April 2010 live-cattle
futures contract. It closes out its position
on January 21, 2010. The futures price
(per pound) is 91.20 cents when it enters
into the contract, 88.30 cents when it
closes out its position, and 88.80 cents at
the end of December 2009. One contract is
for the delivery of 40,000 pounds of cattle.
What is the total profit?
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Problem No. 5 (Ans.)

Total profit = $1,160

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Problem No. 5 (Explanation)

Total profit
= total no. of cattle/contract * (Futures
price when entered – futures price when
closed)
= 40000*(0.9120 – 0.8830)
= $1,160

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Problem No. 6
What position is equivalent to a long
forward contract to buy an asset at K on a
certain date and a put option to sell it for K
on that date?

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Problem No. 6 (Ans.)

Payoff from
Long Forward
Payoff from
Long Put

K K
Price of Underlying ST
-P
at Maturity, ST

The payoff from a long position in a forward contract on one unit of

an asset = ST - K
The payoff from a long position in a European put option
= Max (K – ST, 0) - P

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Problem No. 6 (Ans.)

Payoff from
Long Call

K
ST K ST
-C

Combining the two positions, we gets a long call.

The payoff from a long position in a European call option
= Max (ST – K, 0) - C

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