FUTURES AND

OPTIONS (FIN645)
Chapter 3


PRINCIPLES OF FUTURES
Dr. Nur Zahidah Binti Bahrudin
Center of Economics and Finance Studies
Faculty of Business and Management
Universiti Teknologi MARA (UiTM)
42300 Puncak Alam Campus.
 Introduction

 Futures contract – a contract to buy or sell a specified
security at a specified price and time.
 Futures contract must be opened today and close-out
later.
 Buyer and seller obligated to fulfill their futures
contract at a maturity date according to the terms
specified today.
 Term “future” buyer must fulfill obligation at a future
date (maturity date).
Basic Requirement for a Viable Future
Market

Deep Market
• Every futures market must have sufficient number of buyers and sellers
in order to provide continuous opportunity for trade.

Easy Grading
• Since focus is on agricultural product, the commodity selected for
trading must be easily graded, and standardized grading.

Free Fluctuation
• Prices must be free to fluctuate without any government control or
monopoly power.
• Prices volatility leads to higher risks for buyer and seller.

• Business communities must be ready to participate actively and

regularly in order to provide sufficient liquidity in the market.
Active Participation • Producers and consumers of commodities must be committed to the use
of futures as a means to protect their position in the cash market.
 Underlying Instrument
Every futures contract has its underlying
physical instrument, traded in the cash
market.
Eg: BMDB is futures market, BMSB is the Grade or Quality
cash market (CPO) Physical commodity- the grade or quality of the


underlying instrument is specified in futures
contracts to ensure that participants trade the same
type and quality of underlying instrument.
• Commodity futures – graded on technical
Price or Quotations requirement.
Similar to cash market, futures • Financial futures – graded on the quality of the
prices are quoted in the same financial requirements.
basic units as its underlying
instrument.
Eg: CPO futures prices quoted
in RM per tonne because.
Physical palm oil quoted in RM.

Contract
Specifications Expiry date
The last day of trading in a
Contract size particular contract month, and
Refers to the number of futures contract ceases to exist
units or amount after expiry date.
represented by each Eg: CPO futures it the 15th of the
futures contract. contract month, which there
Eg: cont.size of CPPO after, ceases to exist.
Contract month
futures is 25 tonnes of
Has specified contract month, which is
palm oil
the month of maturity Every futures
market must enable trades of futures in
the spot or current month and future or
forward months.
 Close contract using Offsetting or
Settlement

• Futures contract closed- out by taking the
opposite position to the original position.
Offsetting • Eg: open position with buying, offsett position
with selling

• Outstanding contract, which has not been closed-

out, must be settled at maturity.
• Date of maturity, trader are required by exchange
Settlement
to settle the due contract.
• Settlement depend on the types of futures.
• Commodity & financial futures : settled through
delivery or cash settlement
 Market Participants
• Non-owners of physical


• Owner of the physical or commodity or financial
financial instrument. instrument and not involved
• Wants to protect business in the true businesses.
from price risk. • Speculate on price
movements is their major
concern, known as risk-taker.

Hedgers Speculator

Spreader Arbitrageur

• Speculator who has dual • Investors have dual

positions or contract at positions at one time-
one time. buying futures (BMDB)
• Speculate on price and selling physical (cash
movements is their mkt) and vice-versa.
major concern, known • Arbitraging on the price
as risk-taker. distortion between cash
and futures markets.
 Market Participants

Hedgers- owner of the physical or financial
Spreader – Speculator who has dual positions or contract
at one time.
Spread : taking two opposite positions simultaneously,
instrument.
buying one contract and selling the other in the futures
Want to protect business from price risk.
market.
Hedging considered as insurance mechanism.
Can reduce risk, profit from one futures position will be
They know their losses in one market (cash market)
more than loss in another contract.
will be compensated with gain in another market
Spread the risk and spreader has lesser risk.
(futures market)
Three different types of spread: Inter-market spread
Inter-month spread
Inter-commodity spread

Speculator – non-owners of physical commodity or

financial instrument and not involved in the true
businesses.
Motivated by profits based on favorable price
Arbitrageur
movements.
– investors have dual positions at one time- buying
Speculate on price movements is their major concern, futures (BMDB) and selling physical (cash mkt) and vice-
known as risk-taker. versa.
When market favour them, they will get huge profit. Arbitraging on the price distortion between cash and
The active participations of speculators is one of the futures markets.
main factor of the successfully of futures market. Take advantage of the temporary mispricing of two
They provide liquidity to the market for futures related instruments with little risk.
trading.
Has only one position or contract at one time.
 Trading Practicalities
Types of position

LONG SHORT
- LONG- BUY futures contract. - SHORT- SELL futures contract.
Expect BULLISH on its underlying in Expect BEARISH on its underlying in
the future the future
Strategy - BUY today at LOWER Strategy - SELL today at HIGHER
price, SELL later at HIGHER price price, BUY later at LOWER price prior
prior to or at maturity. to or at maturity.
 Margin Requirement

• Amount deposited when
contract is purchase or sold.
• Minimum amount to be
maintained by an investor
• Faith money to fulfill the throughout the life of his
obligation. contract (outstanding cont.)
• Will be returned when • Below initial margin.
contract close out- after • If amount in the margin
deducting commission Initial Maintenance account less than maitainace
charges and losses. margin, investors have to top
Margin Margin up his account.

• Amount in the margin

Variable • Act when investor need to
account that vary according to Margin Call top-up any shortfall so that
the closing prices. Margin the amount in the margin
• Works like a deposit with a account is equal to the initial
bank; initial margin margin.
considered as initial deposit • Broker will call the investor
and variable margin as a for margin.
current balance or margin. • Enforceable when current
margin fallen below its
maintenance margin.
 Basis

 Difference between the cash price (spot price) of
underlying instrument (physical) and the futures
price (contract).
Basis = Futures price – cash price
 Future price normally traded above the cash price or
“premium” because risk involved in the future.
 Known as normal or “contago” market.
 Premium – include carrying charge that added to the
value of the contract, ie; warehousing, storage or
financing cost of holding the asset.
 Cont…

 Basis is not constant, futures price can be traded
below cash price.
 When futures price is trading at “discount”, it is
abnormal o backwardation market (Futures price
below spot price).
 Positive basis- futures price is trading at “premium”.
 Convergence

 Cash and futures price move in the same direction,
though not the same amount.
 Both prices will converge at one price at the date of
maturity, known as “maturity price”. Cash and
futures price shall be the same at expiry for
settlement purposes (financial futures must be
settled by cash).
 Nay mispricing will lead to opportunity for arbitrage
activities.
 Volume and Open Interest

 Volume- number of contract trades. In futures, it is a
total of purchases or sale for a given contract month.
 Open interest – numbers of outstanding contracts for
a given contract month. It is a contract that yet to be
closed-out or expired.
 Open interest can reflect the level of confidence
among investors.
