Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 1

Chapter 8: The Structure of Forward and Futures Markets

Futures traders tend to be superstitious—when on a good Futures traders tend to be superstitious—when on a good run they are reluctant to change their mojo, this includes run they are reluctant to change their mojo, this includes washing their jackets. Traders will wear their lucky jackets washing their jackets. Traders will wear their lucky jackets until they fall apart or their luck runs out. Some traders until they fall apart or their luck runs out. Some traders have even been buried in their lucky jackets, reflecting a have even been buried in their lucky jackets, reflecting a hope that the good luck their jackets provided in the trading hope that the good luck their jackets provided in the trading pits on Earth could be retained for eternity in that Great pits on Earth could be retained for eternity in that Great Trading Pit in the sky.Trading Pit in the sky.

Jim OverdahlJim Overdahl

FuturesFutures Fall Special Issue 2005, p. 14 Fall Special Issue 2005, p. 14

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 2

Important Concepts in Chapter 8 Definitions and examples of forward and futures contractsDefinitions and examples of forward and futures contracts Institutional characteristics of forward and futures marketsInstitutional characteristics of forward and futures markets Futures contracts available for tradingFutures contracts available for trading Placing an order, margins, daily settlementPlacing an order, margins, daily settlement The role of the clearinghouseThe role of the clearinghouse Accessing futures price quotationsAccessing futures price quotations Magnitude and effects of transaction costsMagnitude and effects of transaction costs

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 3

Development of Forward and Futures Markets

Chicago Futures MarketsChicago Futures Markets Development of Financial FuturesDevelopment of Financial Futures Development of Options on Futures MarketsDevelopment of Options on Futures Markets Parallel Development of Over-the-Counter MarketsParallel Development of Over-the-Counter Markets

interbank marketinterbank market growth of forward marketsgrowth of forward markets

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 4

Over-the-Counter Forward Market

customizedcustomized privateprivate essentially unregulatedessentially unregulated credit riskcredit risk market size: $64 trillion face value, $840 billion market market size: $64 trillion face value, $840 billion market

value at year-end 2007value at year-end 2007

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 5

Organized Futures Trading Contract DevelopmentContract Development Contract Terms and ConditionsContract Terms and Conditions

contract sizecontract size quotation unitquotation unit minimum price fluctuationminimum price fluctuation contract gradecontract grade trading hourstrading hours

Delivery TermsDelivery Terms delivery date and timedelivery date and time delivery or cash settlementdelivery or cash settlement

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 6

Organized Futures Trading (continued)

Daily Price Limits and Trading HaltsDaily Price Limits and Trading Halts limit moveslimit moves circuit breakerscircuit breakers

Other Exchange ResponsibilitiesOther Exchange Responsibilities minimum financial responsibility requirementsminimum financial responsibility requirements position limitsposition limits rules governing the trading floorrules governing the trading floor

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 7

Futures Exchanges

See Table 8.1 for list of exchanges.See Table 8.1 for list of exchanges. Global and after-hours tradingGlobal and after-hours trading Estimated world-wide volume in 2007 was 7.0 billion Estimated world-wide volume in 2007 was 7.0 billion

contracts.contracts.

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 8

Futures Traders

General Classes of Futures TradersGeneral Classes of Futures Traders futures commission merchantsfutures commission merchants localslocals dual tradingdual trading

Classification by Trading StrategyClassification by Trading Strategy hedger/speculatorhedger/speculator spreaderspreader arbitrageurarbitrageur

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 9

Futures Traders (continued) Classification by Trading StyleClassification by Trading Style

scalpersscalpers day tradersday traders position tradersposition traders

Off-Floor Futures TradersOff-Floor Futures Traders individualsindividuals institutionsinstitutions Others: Introducing Broker (IB), Commodity Trading Others: Introducing Broker (IB), Commodity Trading

Advisor (CTA), Commodity Pool Operator (CPO), Advisor (CTA), Commodity Pool Operator (CPO), Associated Person (AP)Associated Person (AP)

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 10

Futures Traders (continued)

The Cost and Profitability of Exchange MembershipThe Cost and Profitability of Exchange Membership seatsseats See Figure 8.1 for history of CME seat prices.See Figure 8.1 for history of CME seat prices. leasing a seat at around 1.0 - 1.5 %/mo. of seat priceleasing a seat at around 1.0 - 1.5 %/mo. of seat price profitability of membershipprofitability of membership

Forward Market TradersForward Market Traders over-the-counterover-the-counter primarily institutionsprimarily institutions

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 11

Mechanics of Futures Trading

Placing an OrderPlacing an Order pitpit open outcryopen outcry electronic systemselectronic systems

The Role of the ClearinghouseThe Role of the Clearinghouse See Figure 8.2.See Figure 8.2. margin depositsmargin deposits

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 12

Mechanics of Futures Trading (continued)

Daily SettlementDaily Settlement initial margininitial margin maintenance marginmaintenance margin concept of “margin” vs. performance bondconcept of “margin” vs. performance bond settlement pricesettlement price variation marginvariation margin See Table 8.2 for example.See Table 8.2 for example. open interestopen interest

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 13

Mechanics of Futures Trading (continued)

Delivery and Cash SettlementDelivery and Cash Settlement three-day delivery processthree-day delivery process alternative deliverable gradesalternative deliverable grades offsettingoffsetting exchange for physicalsexchange for physicals forward market proceduresforward market procedures

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 14

Futures Price Quotations

Newspapers and web sitesNewspapers and web sites

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 15

Types of Futures Contracts

Agricultural CommoditiesAgricultural Commodities Natural ResourcesNatural Resources Miscellaneous CommoditiesMiscellaneous Commodities Foreign CurrenciesForeign Currencies Federal funds and EurodollarsFederal funds and Eurodollars Treasury Notes and BondsTreasury Notes and Bonds EquitiesEquities Managed FundsManaged Funds Hedge FundsHedge Funds Options on FuturesOptions on Futures

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 16

Transaction Costs in Forward and Futures Trading

CommissionsCommissions Bid-Ask SpreadBid-Ask Spread Delivery CostsDelivery Costs

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 17

Regulation of Futures Markets

Regulation is nearly always at the federal level; e.g.,Regulation is nearly always at the federal level; e.g., Commodity Futures Trading Commission (U.S.)Commodity Futures Trading Commission (U.S.) Financial Services Authority (U.K.)Financial Services Authority (U.K.) Financial Services Agency (Japan)Financial Services Agency (Japan)

Objective of most federal regulationObjective of most federal regulation ensuring public information availableensuring public information available authorization and licensing of contracts and authorization and licensing of contracts and

exchangesexchanges contract approvalcontract approval market surveillancemarket surveillance

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 18

Regulation of Futures Markets (continued)

Arbitration of disputes is sometimes done through the Arbitration of disputes is sometimes done through the federal government and the courts but often through self-federal government and the courts but often through self-regulatory organizations such as the National Futures regulatory organizations such as the National Futures Association in the U. S.Association in the U. S.

Note: Forward markets are regulated only indirectly and, Note: Forward markets are regulated only indirectly and, thus, are largely unregulated.thus, are largely unregulated.

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 19

Summary

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 20

Appendix 8: Taxation of Futures Contracts

Treated as 60 % capital gains and 40 % ordinary income.Treated as 60 % capital gains and 40 % ordinary income. Capital gains subject to 28 % maximum.Capital gains subject to 28 % maximum. Must be marked to market at year end.Must be marked to market at year end. New single stock futures are taxed the same as individual New single stock futures are taxed the same as individual

stocks.stocks. Hedge transactions covered in Chapter 11.Hedge transactions covered in Chapter 11.

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 21

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 22

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 23

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Chance/Brooks An Introduction to Derivatives and Risk Management, 8th ed. Ch. 8: 24

(Return to text slide)

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