Trading in Financial Markets
5.5 Plain Vanilla Derivatives
5.5.2 Futures Contracts
to sell 1 million pounds for an exchange rate of 1.2889 in one year. If the spot exchange rate applicable to the bank rose to 1.5000, at the end of the year the forward contract leads to 1 million pounds being sold by the bank at an exchange rate of 1.2889 rather than at the spot exchange rate of 1.5000. This costs the bank $211,100. If the exchange rate falls to 1.1000 by the end of the year, the forward contract leads to 1 million pounds being sold by the bank at an exchange rate of 1.2889 rather than 1.1000. This is worth $188,900 to the bank. The payoff is the agreed delivery price for the assets underlying the forward contract minus the spot price and is shown in Figure 5.2(b). The valuation of forward contracts and the determination of forward prices are discussed in Appendix C.
BUSINESS SNAPSHOT 5.1
The Unanticipated Delivery of a Futures Contract
This story (which may well be apocryphal) was told to the author of this book many years ago by a senior executive of a financial institution. It concerns a new employee of the financial institution who had not previously worked in the financial sector. One of the clients of the
financial institution regularly entered into a long futures contract on live cattle for hedging purposes and issued instructions to close out the
position on the last day of trading. (Live cattle futures contracts trade on the Chicago Mercantile Exchange and each contract is on 40,000
pounds of cattle.) The new employee was given responsibility for handling the account.
When the time came to close out a contract, the employee noted that the client was long one contract and instructed a trader at the exchange go long (not short) one contract. The result of this mistake was that the financial institution ended up with a long position in two live cattle futures contracts. By the time the mistake was spotted, trading in the contract had ceased.
The financial institution (not the client) was responsible for the mistake.
As a result it started to look into the details of the delivery arrangements for live cattle futures contracts—something it had never done before.
Under the terms of the contract, cattle could be delivered by the party with the short position to a number of different locations in the United States during the delivery month. Because it was long, the financial institution could do nothing but wait for a party with a short position to issue a notice of intention to deliver to the exchange and for the
exchange to assign that notice to the financial institution.
It eventually received a notice from the exchange and found that it would receive live cattle at a location 2,000 miles away the following Tuesday. The new employee was dispatched to the location to handle things. It turned out that the location had a cattle auction every Tuesday.
The party with the short position that was making delivery bought cattle at the auction and then immediately delivered them. Unfortunately, the cattle could not be resold until the next cattle auction the following
Tuesday. The employee was therefore faced with the problem of making arrangements for the cattle to be housed and fed for a week. This was a great start to a first job in the financial sector!
Most futures contracts trade actively with the futures price at any given time being determined by supply and demand. If there are more buyers than sellers at a time when the September 2019 future price of gold is $1,280 per ounce, the price goes up. Similarly, if there are more sellers than buyers, the price goes down.
One of the attractive features of exchange‐traded contracts such as futures is that it is easy to close out a position. If you buy (i.e., take a long position in) a September 2019 gold futures contract on March 5, 2019, you can exit on June 5, 2019, by selling (i.e., taking a short position in) the same contract.
Closing out a position in a forward contract is not as easy as closing out a position in a futures contract. As a result, forward contracts usually lead to final delivery of the underlying assets, whereas futures contracts are usually closed out before the delivery month is reached. Business Snapshot 5.1 is an amusing story showing that the assets underlying futures contracts do get delivered if mistakes are made in the close out.
The futures price of an asset is usually very similar to its forward price.
Appendix C at the end of the book gives the relationship between the futures or forward price of an asset and its spot price. One difference between a futures and a forward contract is that a futures is settled daily whereas a forward is settled at the end of its life. For example, if a futures price increases during a day, money flows from traders with short positions to traders with long positions at the end of the day. Similarly, if a futures price decreases during a day, money flows in the opposite direction.
Because a futures contract is settled daily whereas a forward contract is settled at the end of its life, the timing of the realization of gains and losses is different for the two contracts. This sometimes causes confusion, as indicated in Business Snapshot 5.2. Table 5.3 summarizes the difference between forward and futures contracts.
Table 5.3 Comparison of Forward and Futures Contracts
Forward Futures
Private contract between two parties Traded on an exchange
Not standardized Standardized contract
Usually one specified delivery date Range of delivery dates Settled at end of contract Settled daily
Delivery or final cash settlement usually takes place
Contract is usually closed out prior to maturity
Some credit risk Virtually no credit risk
BUSINESS SNAPSHOT 5.2 A Software Error?
A foreign exchange trader working for a bank enters into a long forward contract to buy 1 million pounds sterling at an exchange rate of 1.3000 in three months. At the same time, another trader on the next desk takes a long position in 16 three‐month futures contracts on sterling. The futures price is 1.3000 and each contract is on 62,500 pounds. The sizes of the positions taken by the forward and futures traders are therefore the same. Within minutes of the positions being taken, the forward and the futures prices both increase to 1.3040. The bank's systems show that the futures trader has made a profit of $4,000 while the forward trader has made a profit of only $3,900. The forward trader immediately calls the bank's systems department to complain. Does the forward trader have a valid complaint?
The answer is no! The daily settlement of futures contracts ensures that the futures trader realizes an almost immediate profit corresponding to the increase in the futures price. If the forward trader closed out the position by entering into a short contract at 1.3040, the forward trader would have contracted to buy 1 million pounds at 1.3000 in three
months and sell 1 million pounds at 1.3040 in three months. This would lead to a $4,000 profit—but in three months, not in one day. The
forward trader's profit is the present value of $4,000.
The forward trader can gain some consolation from the fact that gains and losses are treated symmetrically. If the forward/futures prices dropped to 1.2960 instead of rising to 1.3040, the futures trader would take a loss of $4,000 while the forward trader would take a loss of only
$3,900. Also, over the three‐month contract life, the total gain or loss from the futures contract and the forward contract would be the same.
Futures are cleared on an exchange clearing house. The clearing house stands between the two sides and is responsible for ensuring that required payments are made. The clearing house has a number of members. If a
trader or broker is not a member of the exchange clearing house, it must arrange to clear trades through a member.
The clearing house requires initial margin and variation margin from its members. The variation margin for a day may be positive or negative and covers the gains and losses during the day. The initial margin is an extra amount held by the exchange that provides protection to the exchange in the event that the member defaults. In addition, the exchange clearing house requires default fund (also known as a guaranty fund) contributions from its members. This provides additional protection to the exchange. If a member defaults and its initial margin and default fund contributions are not enough to cover losses, the default fund contributions of other members can be used.
Exchange clearing house members require margin from brokers and other traders when they agree to clear their trades and brokers require margin from their clients. Typically the relationship between broker and client involves the posting of initial margin (greater than the initial margin applicable to a member). When the balance in the client's margin account (adjusted for daily gains and losses) falls below a maintenance margin level, the client is required to bring the balance back up to the initial margin level.