3: Futures Markets & Central Counterparties∗
Dr. Bhanu Pratap Singh†
IIM Sirmaur, 2025
Learning Objectives
• Specification of a futures contract.
• Convergence of futures price to spot price.
• The operation of margin accounts.
• OTC markets.
Introduction
• Futures and forward contracts are agreements to buy or sell an asset at a future time for a
certain price.
• A futures contract is traded on an exchange, and the contract terms are standardized by
that exchange.
• A forward contract is traded in the over-the counter market and can be customized to meet
the needs of users.
Introduction
Example
• On June 5, a trader call a broker with instructions to buy 5,000 bushels of corn for delivery
in September.
– Long position in one September corn contract. (Each corn contract is for 5,000 bushels.)
• At about the same time, another trader might instruct a broker to sell 5,000 bushels of corn
for September delivery.
– Short position in one corn contract.
• A price would be determined and the deal would be done.
– The price agreed to is the current futures price for September corn.
• Under the traditional open outcry system, floor traders representing each party would
physically meet to determine the price.
• With electronic trading, a computer matches the traders.
Introduction
Closing Out Positions
• The vast majority of futures contracts do not lead to delivery.
∗ Reference: Options, Futures, & Other Derivatives, Hull & Basu, Chapter 2
† [Link]@[Link]
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– Most traders close out their positions prior to the delivery period specified in the contract.
• Closing out a position means entering into the opposite trade to the original one.
• Trader’s total gain or loss is determined by the change in the futures price.
Specification of a Futures Contract
• In a new contract, the exchange must specify the exact nature of the agreement between the
two parties.
• The asset, the contract size, where delivery can be made, and when delivery can be made.
Specification of a Futures Contract
The Asset
• When the asset is a commodity, exchange stipulate the grade/grades of the commodity that
are acceptable.
• The financial assets in futures contracts are generally well defined and unambiguous.
Specification of a Futures Contract
The Contract Size
• It specifies the amount of the asset that has to be delivered under one contract.
– This is an important decision for the exchange: Too small or too large.
• The correct size for a contract depends on the likely user.
Specification of a Futures Contract
Delivery Arrangements
• The place where delivery will be made must be specified by the exchange.
• This is particularly important for commodities that involve significant transportation costs.
Specification of a Futures Contract
Delivery Months
• A futures contract is referred to by its delivery month.
• The exchange must specify the precise period during the month when delivery can be made.
– For many futures contracts, the delivery period is the whole month.
• The exchange specifies when trading for a contract will begin & end.
– It generally ceases a few days before the last day on which delivery can be made.
Specification of a Futures Contract
Price Quotes
• The exchange defines how prices will be quoted.
– For example, crude oil futures prices are quoted in dollars and cents.
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Specification of a Futures Contract
Price Limits and Position Limits
• For most contracts, daily price movement limits are specified by the exchange.
• If the price moves down by the daily price limit, the contract is said to be limit down.
• If it moves up by the limit, it is said to be limit up.
• A limit move is a move in either direction equal to the daily price limit.
• Normally, trading ceases for the day once the contract is limit up or limit down.
• The purpose is to prevent large price movements from occurring because of speculative
excesses.
• Position limits are the maximum number of contracts that a speculator may hold.
– Purpose is to prevent speculators from exercising undue influence on the market.
Convergence of Futures Price to Spot Price
• As the delivery period is approached, the futures price converges to the spot price of the
underlying asset.
• Suppose that the futures price is above the spot price during the delivery period.
• Traders then have a clear arbitrage opportunity:
– Sell (i.e., short) a futures contract.
– Buy the asset.
– Make delivery.
– As traders exploit this arbitrage opportunity, the futures price will fall.
• If the futures price is below the spot price , it is attractive to enter into a long futures
contract.
– The futures price will tend to rise.
Convergence of Futures Price to Spot Price
The Operation of Margin Accounts
Daily Settlement
• Consider a trader who takes a long position in two December gold futures contracts.
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– Current futures price is $1,750 per ounce (200 ounces at this price).
• The trader has to keep funds in what is known as a margin account.
– Initial margin: Amount that must be deposited at the time the contract is entered.
– Suppose this is $6,000 per contract, or $12,000 in total.
• At the end of each trading day, the margin account is adjusted to reflect the trader’s gain or
loss.
– This practice is referred to as daily settlement or marking to market.
• Maintenance margin.
– This is somewhat lower than the initial margin.
– If the balance in the margin account falls below the maintenance margin, the trader
receives a margin call and is expected to top up the margin account to the initial margin
level.
• This daily flow of funds between traders to reflect gains and losses is known as variation
margin.
The Operation of Margin Accounts
OTC Markets
• Markets where companies agree to derivatives transactions without involving an exchange.
– Credit risk has traditionally been a feature of OTC derivatives markets.
• To reduce credit risk, the OTC market has borrowed some ideas from exchange-traded
markets.
• Central Counterparties.
– Clearing houses for standard OTC transactions.
– Perform much the same role as exchange clearing houses.
– Members of the CCP have to provide both initial margin and daily variation margin.
• Bilateral Clearing
– Those OTC transactions that are not cleared through CCPs are cleared bilaterally.
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– Parties enter into a master agreement covering all their trades including collateral
requirement.
Questions
• Suppose that you enter into a short futures contract to sell July silver for $17.20 per ounce.
The size of the contract is 5,000 ounces. The initial margin is $4,000, and the maintenance
margin is $3,[Link] change in the futures price will lead to a margin call?What happens
if you do not meet the margin call?
• A trader buys two July futures contracts on frozen orange juice concentrate. Each contract
is for the delivery of 15,000 pounds. The current futures price is 160 cents per pound, the
initial margin is $6,000 per contract, and the maintenance margin is $4,500 per contract.
What price change would lead to a margin call? Under what circumstances could $2,000 be
withdrawn from the margin account?
