Mechanics of Futures Markets Chapter 2 Fundamentals of

Mechanics of Futures Markets Chapter 2 Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 1

Futures Contract l Futures Contract: An agreement to buy or sell an asset for a certain price at a certain time in the future. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 2

Accounting for Derivatives l Banking Regulation and Supervision Agency § § l Change in Turkish Uniform Chart of Accounts Addition of new accounts for derivatives § 22207 Türev Finansal Araçlar Reeskontları § 27805 Türev Finansal Araçlardan Alacaklar § 39005 Türev Finansal Araçlardan Borçlar CMB Serial V Communique No 51 Financial Intermediaries § Special chart of accounts for derivative transactions § Separate account for each customer §

l Turkish Accounting Standards Board § § § l TMS 32 TMS 39 TFRS 7 For further information: § § www. bddk. org. tr www. vob. org. tr www. tmsk. org. tr http: //kisi. deu. edu. tr/guluzar. kurt/

Futures Contract: Closing a Position l Entering into an opposite trade to the original one that opened the position. Ex: To buy 5 July corn futures contracts on May 6 To sell 5 July corn futures contacts on June 20 l Total Gain(Loss): The change in the futures price between May 6 and June 20. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 5

Futures Contracts l l l Available on a wide range of underlyings Exchange traded Specifications need to be defined: l l What can be delivered, Where it can be delivered When it can be delivered Settled daily Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 6

Price Quotes l Prices are quoted in a way that is convenient and easy to understand. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 7

Price Limits and Position Limits l Daily price movement limits are specified by the exchange: Limit Down l Limit Up Price moves down/up by an amount equal to the daily price limit. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 8

Convergence of Futures Price to Spot Price l Ex: Futures Price > Spot Price l l They will be equal or almost equal on maturity date There is an arbitrage oppurtunity, so; l l Short a futures contract Buy the asset Make delivery Ex: Futures Price < Spot Price l Long Futures Contract Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 9

Marking to Market l l l The broker requires the investor to deposit funds in a margin account. (Initial Margin) Maintenance Margin Gain & Loss are calculated daily. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 10

Example of a Futures Trade l An investor takes a long position in 2 December gold futures contracts on June 5 l l contract size is 100 oz. futures price is US$400 margin requirement is US$2, 000/contract (US$4, 000 in total) maintenance margin is US$1, 500/contract (US$3, 000 in total) Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 11

A Possible Outcome Table 2. 1, Page 27 Day The long position holder contracted to buy at $400, but now it can be sold at $397 Futures Price (US$) Daily Gain (Loss) (US$) Cumulative Gain (Loss) (US$) 400. 00 Margin Account Margin Balance Call (US$) 4, 000 5 -Jun 397. 00. . . (600). . . 3, 400. . . 13 -Jun 393. 30. . . (420). . . (1, 340). . . 2, 660 + 1, 340 = 4, 000. . . < 3, 000 19 -Jun 387. 00. . . (1, 140). . . (2, 600). . . 2, 740 + 1, 260 = 4, 000. . . 26 -Jun 392. 30 260 (1, 540) 5, 060 0 Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 12

The Clearinghouse and Clearing Margins l Exchange clearinghouse: l l acts as an intermediary in futures transactions. Guarantees the performance of the parties to each transaction. Keeps track of all the transactions that take place during a day. Has members; just members can do transactions. l l Net position of each member can easily be calculated. Each member has to maintain a margin account with the clearinghouse. (Clearing margin) Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 13

Margins l l l 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 Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 14

Purpose of the Margining System l To ensure that traders do not walk away from their commitments. l Credit Risk (=Default Risk) l To avoid this risk, in OTC markets are imitating the margining system (colletarelization) Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 15

OTC Market (colletarelization) l Company A l Contract is valued each day using a pre-agreed valuation methodology. If the value of the contract to Company A increased, Company B would required to pay collateral equal to this increase to Company A. l l Company B Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 16

Patterns of Futures Prices l Futures price increases as the time to maturity increases. (Normal market) Futures Price 5 / 2009 12 / 2009 Contract Maturity Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 17

Patterns of Futures Prices l Futures price decreases as the time to maturity increases. (Inverted market) Futures Price 5 / 2009 12 / 2009 Contract Maturity Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 18

Profits from Forward and Futures Contracts Profit 40, 000 Profit Exchange Rate -40, 000 a)Long position b) Short Position Price can’t be lower than zero… Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 19

Example (Futures vs. Forwards) (pg. 42) l Investor A takes long position in a 90 -day forward contract on £ 1 million. The forward price is 1. 6000 dollars per pound. Investor B takes a long position in 90 -day futures contracts on £ 1 million. The futures price is also 1. 6000 dollars per pound. At the end of the 90 days, the exchange rate proves to be 1. 8000. l Outcome: Investors A and B each make a total gain equal to (1. 8000 -1. 6000) x 1, 000 = $200, 000 Investor A’s gain is made entirely on the 90 th day. Investor B’s gain is realized day by day over the 90 -day period. On some days investor B may realize a loss, whereas on other days he or she will realize a gain. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 20

Foreign Exchange Quotes l Futures Prices l l Futures prices are always quoted as the number of U. S. Dollars per unit of the foreign currency or as the number of U. S. Cents per unit of the foreign currency. TL 1 = $0, 578 l Forward prices l l Forward prices are always quoted in the same way as spot prices. (British Pound, the Euro) Forward quotes show the number of U. S. Dollars per unit of the foreign currency and directly comparable with futures quotes. For other currencies: $1 = TL 1. 73 Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 21

Types of Traders l There are two types of traders; l l l Commission brokers They are following the instructions of their clients and charge a commission for doing so. Locals are trading on their own account All are hedgers, speculators or arbitrageurs: l l l Scalpers are watching for very short terms and hold positions for only a few minutes. Day traders hold their positions for less than one trading day Position traders hold their positions for much longer periods of time. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 22

Types of Orders l l l l Limit order Stop order (Stop-loss order) Stop-limit order Market-if-touched order (MIT) (Board order) Discretionary Order (Market-not-held order) A time-of-day order Open order (good-till-canceled order) Fill-or-kill order Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 23

Types of Orders l Limit order l l A limit order specifies a particular price. The order can be executed only at this price or at one more favorable to the investor. Stop order l A stop order specifies a particular price. Suppose a stop order to sell at $30 is issued when the market price is $35. It becomes an order to sell when and if the price falls to $30. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 24

Types of Orders l Stop-limit order l l A market-if-touched order l l It is a combination of stop order and limit order. Suppose that at the time the market price is $35, a stop-limit order to buy is issued with a stop-price of $40, and the limit price of $41. It is executed at the best available price after a trade occurs at a specified price or at a price more favorable than the specified price. It is designed to ensure that profits are taken if sufficiently favorable price movements occur. A discretionary order l It is traded as a market order except that execution may be delayed at the broker’s discretion in an attempt to get a better price. Fundamentals of Futures and Options Markets, 5 th Edition, Copyright © John C. Hull 2004 2. 25