Chapter 1 1 CHAPTER 1 Futures Markets Introduction In this chapter, we introduce futures markets and their key players. This chapter is organized into the following sections: 1. Forward Contracts Versus Futures Contracts 2. Institutions Facilitating Futures Trading 3. Structure of Futures Exchanges 4. Clearinghouses’ Role in Futures Markets 5. Types of Futures Contracts 6. The Social Function of Futures Markets 7. Futures Markets’ Regulatory Framework and Taxation
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Chapter 1 1
CHAPTER 1Futures Markets Introduction
In this chapter, we introduce futures markets and their key players. This chapter is organized into the following sections:
1. Forward Contracts Versus Futures Contracts
2. Institutions Facilitating Futures Trading
3. Structure of Futures Exchanges
4. Clearinghouses’ Role in Futures Markets
5. Types of Futures Contracts
6. The Social Function of Futures Markets
7. Futures Markets’ Regulatory Framework and Taxation
Chapter 1 2
Forward Contracts
A forward contract is an agreement between two parties (counterparties) for the delivery of a physical asset (e.g., oil or gold) at a certain time in the future for a certain price that is fixed at the inception of the contract.
Forward contracts can be customized to accommodate any commodity, in any quantity, for delivery at any point in the future, at any place.
Chapter 1 3
EXAMPLE: St. Bernard Puppy
Counterparties: Buyers and Seller
Asset/Commodity: St. Bernard Pup
Delivery/Payment Time: 6 weeks
Priced Fixed: $400
Buyer: Dog Fancier has a long position
Seller: Breeder has a short position
Trading Volume: Occurs when one trader buys & another sells
Open Interest: Number of open contracts obligated for delivery
If the dog owner had completed similar contracts for six different dogs, the open interest would be 6.
Chapter 1 4
Future Contracts
Futures contracts are highly uniform and well-specified commitments for a carefully described good (quantity and quality of the good) to be delivered at a certain time and place (acceptable delivery date) and in a certain manner (method for closing the contract) and the permissible price fluctuations are specified (minimum and maximum daily price changes).
Chapter 1 5
Forward Versus Futures
COMPARISON FORWARD FUTURES
Trade on organized exchanges No Yes
Use standardized contract terms No Yes
Use associate clearinghouses to guarantee contract fulfillment No Yes
Require margin payments and daily settlements No Yes
Close easily No Yes
Regulated by identifiable agencies No Yes
Any quantity Yes No
Any product Yes No
Chapter 1 6
Futures Contract Standardized Terms
1. Quantity
2. Quality
3. Expiration months
4. Delivery terms
5. Delivery differentials
6. Delivery dates
7. Minimum price fluctuation
8. Daily price limits
9. Trading days and hours
Chapter 1 7
CBOT Wheat Futures Contract
Quantity: 5,000 bushels per contract.
Quality: No. 2 Soft Red, No. 2 Hard Red Winter No. 2 Dark Northern Spring, or No. 1 Northern Spring.
There are two types of organizations that facilitate futures trading:
Exchange
Exchanges are non-profit or for-profit organizations that offer standardized futures contracts for physical commodities, foreign currency and financial products.
Clearinghouse
A clearinghouse is agency associated with an exchange, which settles trades and regulates delivery. Clearinghouses guarantee the fulfillment of futures contract obligations by all parties involved.
Chapter 1 9
The Organized Exchange
Not-for-Profit Organization Structure
Members hold exchange memberships or seats that allow them to:
1. Trade on the exchange
2. Have a voice in the exchange’s operation
For-Profit Organization Structure
Members receive shares or stocks.
Demutualize
Conversion of an exchange from not-for-profit to for-profit.
Chapter 1 10
Organized Exchange: Trading Systems
Futures contracts trade by two systems:
Open Outcry
Open outcry is a trading room where traders literally “cry out” their bids to locate another trader who is willing to trade with them.
Electronic Trading Platforms
Contracts are traded through electronic computer networks. Electronic trading represents over 50% of futures contracts trading.
Chapter 1 11
Organized Exchange: Trading Players
Speculator
A trader who enters the futures market in pursuit of profit, accepting risk in the endeavor.
Hedger
A Trader who enters the futures market to reduce some pre-existing risk exposure.
Broker
An Individual or firm acting as an intermediary by conveying customers’ trade instructions. Account executives or floor brokers are examples of brokers.
Chapter 1 12
Major Futures Exchange
Table 1.6
Major Futures Exchanges in the World for 2003 EXCHANGE
2003 Volume (Futures Only)
Top 20 % Volume
Eurex (Germany) Chicago Mercantile Exchange (USA)
668,650,028 530,989,007
24.55 19.49
Chicago Board of Trade (USA) Euronext-Liffe (Netherlands) Mexican Derivatives Exchange (Mexico)
373,,669,290 273,121,004 173,820,944
13.72 10.03 6.38
Bolsa de Mercadorias e Futuros (Brazil) New York Mercantile Exchange (USA)
113,895,061 111,789,658
4.18 4.10
Tokyo Commodity Exchange (Japan)
87,252,219
3.20 London Metals Exchange (UK).
68,570,154
2.52
Korea Stock Exchange (South Korea)
62,204,783
2.28 Sydney Futures Exchange (Australia)
41,831,862
1.54
National Stock Exchange of India (India)
36,141,561
1.33 SIMEX (Singapore)
35,356,776
1.30
International Petroleum Exchange (UK) OM Stockholm (Sweden) Tokyo Grain Exchange (Japan) New York Board of Trade (USA) Bourse de Montreal (Canada) MEFF Renta Variable (Spain) Tokyo Stock Exchange (Japan)
1. Guarantee that the traders will honor their obligations (solves issues of trust).
2. Each trader has obligations only to the clearinghouse, not to other traders.
3. Each exchange uses a futures clearinghouse.
4. Clearinghouses may be part of a futures exchange (division), or a separate entity.
5. Due to 2000 CFMA, clearing arrangements vary across industries.
6. Clearinghouses are “perfectly hedged” by maintaining no futures market position of their own.
Chapter 1 14
The Function of Clearinghouses in Futures Markets
Obligations without a clearinghouse
Buyer
SellerBuyer
Seller
Clearing-house
Obligations with a clearinghouse
Chapter 1 15
Major Futures Clearing Organizations
Table 1.7
Major Futures Clearing Organizations Clearinghouse
Affiliated Exchanges
The Clearing Corporation (CCorp)
US Futures Exchange and the Merchants Exchange of St. Louis
Chicago Mercantile Exchange Clearinghouse
Chicago Mercantile exchange With clearing link to CBOT
Kansas City Board of Trade Clearing Corporation
Kansas City Board of Trade
Energy Clear Corporation
Exempt Commercial Markets
MGE Clearinghouse
Minneapolis Grain Exchange
NYMEX Clearinghouse
New York Mercantile Exchange
New York Clearing Corporation The Options Clearing Corporation The London Clearinghouse
New York Board of Trade OneChicago, NQLX, & option exchanges Exempt Commercial Markets and OTC markets
Sources: The CFTC web site, www.cftc.gov.
Chapter 1 16
Margin and Daily Settlement
Margin A good-faith deposit (or performance bond) made by a prospective trader with a broker. Margin can be posted in cash, bank letter of credit or short-term U.S. Treasury instruments.
Daily Settlement
Process by which traders are required to realize any losses in cash immediately (marked-to-the-market). The losses are usually deducted from the margin deposit.
Chapter 1 17
TYPES OF MARGIN
There are 3 types of margin:
1. Initial Margin
Deposit that a trader must make before trading any futures.
2. Maintenance Margin
When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin.
3. Variation Margin
Additional margin required to bring an account up to the required level.
Chapter 1 18
Futures Market Obligations
Table 1.2
Futures Market Obligations The oat contract is traded by the Chicago Board of Trade. Each contract is for 5,000 bushels, and prices are quoted in cents per bushel. (a) Party 1
Party 2
Buys 1 SEP contract for oats at 171 cents per bushel
Sells 1 SEP contract for oats at 171 cents per bushel
(b) Party 1 Clearinghouse
Buys 1 SEP contract for oats at 171 cents per bushel
Agrees to delivery to Party 1 a SEP contract for oats at a price of 171 cents per bushel
(c) Party 2 Clearinghouse
Sells 1 SEP contract for oats at 171 cents per bushel
Agrees to receive from Party 2 1 SEP contract for oats and to pay 171 cents per bushel
Table 1.2 shows a typical trading situation.
Chapter 1 19
Futures Market Obligations
Based on Table 1.2, a trader purchases an oat Contract at 171 cents/ bushel at the close of day 0. The initial margin is $1,400.
Notice that very few contracts are delivered or settled in cash.
Chapter 1 25
Delivery Differential
Sometimes the quantity and quality do not exactly match the quantity and quality specified in the contract. In these cases, shorts are given the option of delivering non-standard commodities at non-standard delivery points. However, they may have to pay a surcharge or “delivery differential” relative to standard terms of the futures contracts.
There are 2 types of delivery differential:
1. Quality Differentials
2. Location Differential
Chapter 1 26
Delivery Differential
Example: CBOT Corn Contract
Quality differentialGrade differential based on the standard “par” delivery grade.
Location differential Based relative to the standard delivery point or points specified in the futures contracts.
Premium Location: 2 cents/bushel for delivery at terminals between Lockport & Seneca, Illinois
Par Location: Terminals between Chicago & Burns Harbor, Indiana
Chapter 1 27
Closing a Futures Position: Offset or Reversing Trade
If you previously sold a futures contract, you can close out your position by purchasing an identical futures contract. The exchange will cancel out your two positions. Table 1.4 illustrates a reversing trade.
Table 1.4
The Reversing Trade
Party 1's Initial Position
Party 2
May 1 Bought 1 SEP contract for oats at 171 cents per bushel
Sold 1 SEP contract for oats at 171 cents per bushel
Party 1's Reversing Trade
Party 3
May 10 Sells 1 SEP contract for oats at 180 cents per bushel
Buys 1 SEP oats contract at 180 cents per bushel
Chapter 1 28
Closing a Futures Position: Exchange-for-Physicals (EFP)
Two traders agree to a simultaneous exchange of a cash commodity and futures contracts based on that cash commodity. Table 1.5 illustrates a EFP transaction.
Table 1.5
An Exchange-for-Physicals Transaction Before the EFP
Trader A
Trader B Long 1 wheat futures Wants to acquire actual wheat
Short 1 wheat futures Owns wheat and wishes to sell
EFP Transaction Trader A
Trader B
Agrees with Trader B to purchase wheat and cancel futures Receives wheat; pays Trader B Reports EFP to exchange; exchange a-djusts books to show that Trader A is out of the market
Agrees with Trader A to sell wheat and cancel futures Delivers wheat; receives payment from Trader A Reports EFP to exchange; exchange adjusts books to show that Trader B is out of the market
Chapter 1 29
Types of Futures Contracts
In this section, we will examine the following types of futures contracts:
• Physical Commodity
• Foreign Currency
• Interest-Earning Asset
• Index (Stock Index)
• Individual Stocks
Chapter 1 30
Future Contracts: Physical Commodity
Contracts on physical commodities include:
1. Agricultural contracts
2. Metallurgical contracts
3. Energy contracts
These commodities, excluding electricity, are physically settled and are highly storable.
Futures Contracts: Foreign Currency and Interest-Earning Asset
Foreign Currency Interest-Earning Assets
Australian dollar
Brazilian Real
Russian Ruble
New Zealand dollar
Swedish Krona
South African Rand
Norwegian Krone
British pound
Canadian dollar
Japanese yen
Swiss franc
Mexican peso
Euro
Treasury bills
Notes
Bonds
Eurodollar deposits
Interest rate swaps
Fed funds
Municipal bonds
Chapter 1 33
Futures Contracts: Index Based
Traders must fulfill their obligation by reversing trade or cash settlement at the end of trading.
EXAMPLE OF INDEX BASED CONTRACTS
US Exchanges Foreign Exchanges
Broad-Based stock indexes
S&P 500
Dow Jones Industrial Average
Russell 2000
NASDAQ 100
Style-Based Indexes
S&P Barra Growth
S&P Barra Value
Foreign Stock Indexes
British FTSE 100
French CAC 40
Dow Jones Euro Stoxx 50
German DAX
Brazillian Bovespa stock
Japanese Nikkei 225
Korean KOSPI 200
Chapter 1 34
Future Contracts on Individual Stocks
Permitted for trade in United States after the passage of the Commodity Futures Modernization Act of 2000 (CFMA).
Also called “single stock futures” in the United States and “universal futures” in Great Britain.
Chapter 1 35
Relative Importance of Commodity Types
INSERT FIGURE 1.5 HERE
Chapter 1 36
Changing Commodity Trading Volume
INSERT FIGURE 1.6 HERE
Chapter 1 37
Social Function of Futures Markets
Futures markets meet the needs of three groups of users:
1. Those who wish to discover information about future prices of commodities
2. Those who wish to speculate
3. Those who wish to hedge
There are two main social functions of futures markets:
1. Price discovery
2. Hedging
Speculation is not regarded as a social function by itself, but it may have socially useful by-products.
Chapter 1 38
Social Function of Futures Markets
PRICE DISCOVERY
Futures market information helps people make better estimates of future prices.
Futures market information helps people with their production or consumption decisions.
Example: silver Mine
HEDGING
Hedging is the prime social rationale for futures trading.
Hedgers have a pre-existing risk exposure that leads them to use futures transactions as a substitute for a cash market transaction. By doing so, they are able to reduce or eliminate their risk.
Example: wheat Farmer
Chapter 1 39
Regulation of Futures Markets
CEA
Grain Futures Act of 1922, superseded by the Commodity Exchange Act (CEA) of 1936.
The CEA was last amended by the Commodity Futures Modernization Act of 2000 (CFMA).
CFMA
Promotes competition and innovation in futures markets.
Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform (the three P’s).
Chapter 1 40
The CFMA’s Three Tiers of Regulation
First Tier- Agricultural Commodities
Futures on commodities (agricultural commodities) that Congress judged to be potentially susceptible to manipulation and that are offered to members of the public.
Second Tier- Exempt Futures Contracts
Futures contracts on metals and energy that are judged to be less susceptible to manipulation.
Third Tier- Trade Principal to Principal Basis
Contracts on financial products (swaps) that are privately-negotiated between large, sophisticated contract counterparties.
Chapter 1 41
Futures Markets Levels of Regulation (Market Regulators)
1. Brokers
2. Exchanges and clearinghouses
3. National Futures Association (NFA), industry self-regulatory body
4. Commodity Futures Trading Commission (CFTC), federal governmental agency
Chapter 1 42
Market Regulators: Brokers
The Broker is responsible for:
1. Knowing the customer's position and intentions.
2. Ensuring that the customer does not disrupt the market or place the system in jeopardy.
3. Keeping the customer's trading activity in line with industry regulations and legal restrictions.
Chapter 1 43
Market Regulators: Exchange & Clearinghouses
Futures exchanges and clearinghouses formulate and enforce rules to:
1. Prohibit fraud
2. Prohibit dishonorable conduct
3. Prevent defaulting on contract obligations
Chapter 1 44
Abusive Trading Practices
Table 1.8
Abusive Trading Practices Pre-arranged trading
Agreeing to some aspect of a transaction before it is openly executed on the exchange floor.
Accommodation trading Entering transactions to assist another floor partici-pant in accomplishing improper trading objectives.
Trading before custom-ers orders, front running
Trading for one's personal account or an account in which one has an interest, while having in hand any executable customer order in that contract.
Bucketing Failing to introduce an order to the marketplace, traditionally occurring when a broker noncompeti-tively takes the other side of a customer order to the detriment of the customer or other members.
Wash trading Entering transactions to provide the appearance of trading activity without resulting in a change in market position.
Curb trading Trading after the official close of trading.
Source: Government Accounting Office, “Automation Can Enhance Detection of Trade Abuses but Introduces New Risks,” September 1989.
Chapter 1 45
Market Regulators: National Futures Association (NFA)
The NFA seeks to prevent fraudulent and manipulative acts by:
1. Screening and test applicants for registration.
2. Requiring members who handle customer funds to maintain adequate capital.
3. Requiring members to keep accurate trading records.
CFTC protects market participants from manipulation, abusive trading practices, and fraud by enforcing regulatory oversight of:
1. Futures exchanges
2. Futures clearinghouses
3. NFA
The heart of the CFTC’s market surveillance is its large-trader electronic reporting system. This reporting system helps identify potential concentrations of market power within a market and to enforce speculative position limits.
Chapter 1 47
Insert figure 1.7 here
Figure 1.7 shows the place of the CFTC in the regulatory structure of the futures industry in the United States.
Insert Figure 1.7 here
Chapter 1 48
Recent Regulatory Initiatives
FASB ACCOUNTING RULES
In 1998, The FASB adopted new rules for disclosure of risk positions in firms’ derivatives positions.
CFMA 2000
Allows futures trading on individual stocks and narrow-based stock indexes.
Clarifies the legal status of privately-negotiated swap transactions.
Provides a predictable and calibrated regulatory structure tailored to the product, the participant, and the trading platform.
Allows exchanges to bring new contracts to market without prior regulatory approval.
Establishes a set of standards, that permit futures exchanges and clearinghouses to use different methods to achieve federal requirements.
Gives the CFTC clear authority to stop certain illegal, foreign exchange transactions aimed at defrauding small investors.
Gives the CFTC separate oversight authority with respect to clearinghouse organizations.
Chapter 1 49
Recent Regulatory Initiatives
TAXATION OF FUTURES TRADING
1981 LAWFutures positions must be marked-to-market at the end of the year.
ACT of 1986Stipulates that short-term and long-term capital gains will be taxed at one rate.