Basics Of Futures Contracts

•'Typically, account must be made for other details For example, interest rates for fixed payments are usually quoted on the basis of 365 days per year, whereas for floating rates they are quoted on the basis of 360 days per year prices and provides convenience and security because individuals do not themselves need to find an appropriate counterparty and need not face the risk of counterparty default Individual contracts are made with the exchange, the exchange itself being the counterparty for both long and short traders But standardization presents an interesting challenge. Consider the likely mechanics of forward contract trading on an exchange. It is a relatively simple matter to standardize a set of delivery dates, quantities to be delivered, quality of delivered goods, and delivery locations (although there are some subtleties even in these items) But standardization of forward prices is impossible. To appreciate the issue, suppose that contracts were issued today at a delivery price of F0 The exchange would keep track of all such contracts Then tomorrow the forward price might change and contracts initiated that day would have a different delivery price Ft. In fact, the appropriate delivery price might change continuously throughout the day The thousands of outstanding forward contracts could each have a different delivery price, even though all other terms were identical This would be a bookkeeping nightmare

The way that this has been solved is through the brilliant invention of a futures market as an alternative to a forward market Multiple delivery prices are eliminated by revising contracts as the price environment changes Consider again the situation where contracts are initially written at Fq and then the next day the price for new contracts is F\ At the second day, the clearinghouse associated with the exchange revises all the earlier contracts to the new delivery price F\ To do this, the contract holders either pay or receive the difference in the two prices, depending on whether the change in price reflects a loss or a gain. Specifically, suppose F\ > F() and I hold a one-unit long position with price Fq- My contract price is then changed to F[ and I receive Fj ~ Fo from the clearinghouse because I will later- have to pay F\ rather than Fo when I receive delivery of the commodity

The process of adjusting the contract is called marking to market In more detail it works like this: An individual is required to open a margin account with a broker . This account must contain a specified amount of cash for each futures contract (usually on the order of 5-10% of the value of the contract). All contract holders, whether short or long, must have such an account. These accounts are marked to market at the end of each trading day If the price of the futures contract (the price determined on the exchange) increased that day, then the long parties receive a profit equal to the price change times the contract quantity This profit is deposited in their margin accounts The short parties lose the same amount, and this amount is deducted from their margin accounts Hence each margin account value fluctuates from day to day according to the change in the futures price, With this procedure, every long futures contract holder has the same contract, as does every short contract holder At the delivery date, delivery is made at the futures contract price at that time, which may be quite different from the futures price at the time the contract was first purchased

Actually, delivery of commodities under the terms of a futures contract is quite rare; over 90% of all parties close out their positions before the delivery date, Even commercial organizations that need the commodity for production frequently close out their long positions and purchase the commodity from their conventional suppliers on the spot market.

10 6 BASICS OF FUTURES CONTRACTS 277

GRAINS AND OILSEEDS

Lifetime

Open High Low Settle Change High Low CORN (CBT) 5,000 bu ; cents per bu.

Open Interest

GRAINS AND OILSEEDS

Lifetime

Open High Low Settle Change High Low CORN (CBT) 5,000 bu ; cents per bu.

Open Interest

Dec

336

337

32614

327/,

- 3%

339

235X

162,928

Mr96

344

344

333*

334*

- 3 %

344'/.

249*

215,702

May

344Vs

345

333*

334

~ 4*

345

259*

36,974

July

342

342

331

331%

~ 4Y,

342

254

47,422

Sept

299

299

294*

295

- VA

300

260

8,173

Dec

284

284'A

280*

281

~ %

284%

239

23,244

Mr97

289*

289%

286*

286%

~ 1%

289%

279'/.

796

Jly

292

293%

290

290

- 1%

293%

284

176

Dec

272

273

271

271 *

-

273

249%

325

Est vol 100,000; vol Wd 85,650; open int 495,740, + 145

FIGURE 10.3 Corn futures quotations. Contracts for various delivery dates are shown Source: The Wall Street journal, November 10, 1995

Est vol 100,000; vol Wd 85,650; open int 495,740, + 145

Futures prices are listed in financial newspapers such as The Wall Sli ce! Journal An example listing for corn futures is shown in Figure 10.3 The heading explains that a standard contract for com is for 5,000 bushels, and that prices are quoted in cents per bushel. The first column of the table lists the delivery dates for the various contracts, with the earliest date being first The next columns indicate various prices for the previous trading day: Open, High, Low, Settle, and Change, followed by Lifetime High and Low. The last column is Open Interest, which is the total number of contracts outstanding (Both the long and short positions are counted, so open interest really reflects twice the number of contracts committed.) Delivery of the commodity may be made anytime within the specified month

Margin accounts not only serve as accounts to collect or pay out daily profits, they also guarantee that contract holders will not default on their obligations Margin accounts usually do not pay interest, so the cash in these accounts is, in effect, losing money, However, many brokers allow Treasury bills or other securities, as well as cash, to serve as margin, so interest can be earned indirectly If the value of a margin account should drop below a defined maintenance margin level (usually about 75% of the initial margin requirement), a margin call is issued to the contract holder, demanding additional margin Otherwise the futures position will be closed out by taking an equal and opposite position

Example 10,7 (Margin) Suppose that Mr. Smith takes a long position of one contract in corn (5,000 bushels) for March delivery at a price of $2.10 (per bushel). And suppose the broker requires margin of $800 with a maintenance margin of $600.

The next day the price of this contract drops to $2 07 This represents a loss of .0.3x5, 000 = $150, The broker will take this amount from the margin account, leaving a balance of $650. The following day the price drops again to $2,05. This represents an additional loss of $100, which is again deducted from the margin account At this point the margin account is $550, which is below the maintenance level. The broker calls Mr Smith and tells him that he must deposit at least $50 in his margin account, or his position will be closed out, meaning that Mr. Smith will be forced to give up his contract, leaving him with $550 in his account

10.7

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Lessons From The Intelligent Investor

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