2.
Mechanics of Futures Markets
FINA412: OPTIONS AND FUTURES
FALL 2025
Redacted handouts for class. Full slides posted
after class.
Overview 2
This topic provides introduction to how futures markets
work, and examines issues such as the specification of
contracts, operation of margin accounts, and the
organization of exchanges. It also presents an overview of
the regulation of markets and the treatment of futures
transactions for accounting and tax purposes.
Learning objectives 3
Describe the key features distinguishing futures
contracts from forward contracts.
Discuss the specification of a futures contract and the
way in which quotes are made.
Explain the operation of margin accounts and types of
traders / orders. Estimate margin account balances.
Describe the function of exchange clearing houses and
central counterparties (OTC).
Background information on regulation and taxation in
the area.
Foreign Exchange Quotes 5
for GBP, May 21, 2020
Bid Ask
Spot 1.2217 1.2220
1-month forward 1.2218 1.2222
3-month forward 1.2220 1.2225
6-month forward 1.2224 1.2230
Profit from a Long Forward 7
Position
Profit
Price of Underlying at
K Maturity, ST
(K= delivery price=forward price at
time contract is entered into)
Profit from a Short Forward
8
Position
Profit
Price of Underlying
K at Maturity, ST
(K= delivery price=forward price
at time contract is entered into)
9
Futures Contracts
Some futures include delivery (all commodity
futures), others are cash-settled (for example, index
futures).
Specifications of delivery-based futures:
What can be delivered
Where it can be delivered
When it can be delivered
Sample of Futures Contracts… 10
Other Key Points About Futures 12
No payment at trade time.
Positions are settled (marked to market)
daily.
Closing out a futures position involves
entering into an offsetting trade.
Most contracts are closed out before
maturity.
13
Delivery
If a delivery-based futures contract is not closed
out before maturity, it is usually settled by delivering
the assets underlying the contract.
When there are alternatives about what is
delivered, where it is delivered, and when it is
delivered, the party with the short position chooses.
For example, the seller of U.S. 10-year Treasury note futures
can deliver U.S. Treasury notes with 6.5-10 years to
maturity.
When things go wrong - Business Snapshot 2.1
Forward Contracts vs Futures 14
Contracts
FORWARDS FUTURES
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final cash Contract usually closed out
settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk
Margins 15
A margin is cash or marketable securities deposited
by an investor with his or her broker.
The broker must be a clearinghouse member or must
maintain a margin account with a clearinghouse
member.
The margin is typically 5-15% of contract value.
The balance in the margin account is adjusted to
reflect daily marking to market.
Margins minimize the possibility of default.
Example of a Futures Trade 16
An investor takes a long position in 2
December gold futures contracts on June 5:
Contract size is 100 oz.
Futures price is $800
Margin requirement is $4,000/contract ($8,000 in
total)
Maintenance margin is $3,000/contract ($6,000 in
total)
A Possible Outcome 17
Day Trade Settle Daily Cumul. Margin Margin
Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
Role of the Clearinghouse 19
The clearinghouse acts as an intermediary
between futures buyers and sellers.
Buyer and seller make payments or make delivery
to the clearinghouse.
The clearinghouse guarantees performance
of both parties in a trade
No credit risk for futures trades. If a trader fails to
meet margin calls, clearinghouse members cover
the loss.
Margin Cash Flows When Futures Price 20
Increases
Clearing House
Clearing House Clearing House
Member Member
Broker Broker
Long Trader Short Trader
21
Futures: Some Terminology
Open interest: the total number of contracts
outstanding
equal to number of long positions or number of short
positions
Settlement price: the price just before the final bell
each day
used for the daily settlement process
Volume of trading: the number of trades in one
day
22
Futures Quotes
Open High Low Prior Last Change Volume
Settle Trade
Jun 2016 44.92 45.35 43.36 44.78 43.51 −1.27 503,259
Aug 2016 46.02 46.45 44.63 45.91 44.82 −1.09 50,439
Dec 2016 47.09 47.55 45.99 47.09 46.24 −0.85 41,447
Dec 2017 48.75 49.17 47.83 48.72 48.16 −0.56 13,032
Dec 50.27 50.40 49.30 49.99 49.59 −0.40 1,618
20158
Forward Contracts Settlement 23
A forward contract is an OTC agreement to buy or
sell an asset at a certain time in the future for a
certain price.
There is no daily settlement (unless a collateralization
agreement requires it). At the end of the life of the
contract the party with the long position buys the
asset for the agreed price from the other party.
Some credit risk in forward markets
Collateralization in OTC Markets 24
It is becoming increasingly common for forward
contracts to be collateralized.
Under a collateralization agreement, if the value of the
contract moves against one of the counterparties, that
counterparty must pay collateral to the other side.
Forwards are then similar to futures contracts in that
they are settled regularly (daily or weekly).
This reduces the counterparty credit risk.
Example: Crude Oil Futures Volume and Open Interest for
March 2006 contract 25
25
26
Market vs. Limit Orders
Market orders: trade at the best price available
Take liquidity
Pay the bid-ask spread
Quick (and certain) execution
Some uncertainty about execution price (especially in open
outcry markets)
Limit orders: specify a particular price
Provide liquidity
Tend to earn the bid-ask spread
Execution may take time and is uncertain
You get your limit price or better
Types of Orders (orders executed) 27
If price falls below the If price rises above the
limit limit
Buy Limit-Buy Order Stop-Buy Order
Sell Stop-Loss Order Limit-Sell Order
Convergence of Futures to Spot 28
Futures
Spot Price
Price
Spot Price Futures
Price
Time Time
(a) (b)
Profit from a Long Futures Position 29
Profit = ST – F0
Profit
Price of Underlying
F0 at Maturity (ST)
Profit from a Short Futures Position 30
Profit Profit = F0 – ST
F0 Price of Underlying
at Maturity (ST)
31
Speculative Trading Styles
Scalpers try to profit from very short-term price
movements (a few seconds to a few minutes).
Day traders attempt to profit from price
movements that take place over one trading
day.
Position traders maintain open positions overnight.
Roles of Different Types of Traders 32
The two main economic roles of futures markets are to
serve hedgers and provide price discovery.
Profit-motivated traders (speculators and arbitrageurs)
help make futures markets more liquid and efficient.
Public benefits of liquid markets with informative prices:
Lower transaction costs
Better allocation or resources in the economy
In some cases, speculation may destabilize prices.
Regulation of Futures 33
Commodity Futures Trading Commission (CFTC)
serves as the government regulatory body for
futures markets.
Regulation is designed to protect the public interest
and make sure futures markets perform their primary
economic roles well.
Regulators try to prevent harmful trading practices
Examples: Price manipulation
Taxation of Futures Trading 34
Gains or losses are classified as capital
gains/losses or as part or ordinary income.
For a corporate taxpayer, capital gains are taxed
as ordinary income.
“60/40” rule for noncorporate taxpayers: gains
are treated as 60% long term and 40% short term.
Gains and losses from hedging trades are treated
as ordinary income.