Chapter 2 Derivatives

[Ayushi Arora]

Hi,
Can you help me with the following:
Q1: Can you please explain the working of futures market with a small numerical example covering every concept stated in core reading like initial margin, variation margin, price limits, Close out prior to delivery, normal delivery, and marking to market?

Q2: How the future trading process differs from options trading process with numerical example comparing the example used in Q1?

Q3: Can you please mention exhaustive list how Over the counter market place different from Exchange?

Q4: There is a practice question which asks to state maximum/ minimum profit from selling a future, In the solution following lines are mentioned -

"The maximum loss is unlimited. (Although note that if the seller owns the underlying asset, then the unlimited loss on the future will be matched by an unlimited profit from the underlying asset.)". Can you please explain these lines?

Q5: In the below practice question :

"An investor takes out a long position in five equity index futures, at 12 noon on 6thJanuary, when the futures price is 9,600. The index futures is traded on the basis of $10 per index point and the initial margin payment is set at 10% of the contract value of each future.

Complete the table below showing how the investor’s margin account balance will vary subsequently......"

The solution calculates initial margin as 5 contracts × 9,600 points per contract × $10 per point × 10%= $48,000
I am not clear where in the question it is mentioned that a futures contract has 9600 equity indexes, it simply mentions the price as 9600. Can you please explain this?

 

[Joe Hook]

1) Let's say I am buying 1 future with a delivery price of 6,000 with delivery set for 1 years time and the contracts are valued at £10 per index point ie for each movement of 1 in the index I make a profit or loss of £10. The initial margin is set by the exchange and so let's say I need to deposit £5,000 initially. A party on the other side of the transaction (selling a future with delivery price 6,000) would also need to deposit margin so that the exchange is protected from price movements in either direction).

After day 1 the index drops to 5,998. As I have a long position in the future, a fall in the index represents a loss. Therefore, I need to deposit a further £20 with the exchange (£10 * (6,000 - 5,998)). This process of recognising profit or loss on a daily basis through the topping up or release of margin is known as marking-to-market.

Let's say the exchange has a price limit of 5%. This means that the market is suspended if the index rises or falls by 5% over a single day. Large movements in the index lead to increased exposure for the exchange to the party making a loss. The market can therefore be suspended for a period of time to allow the exchange to collect the margin. So if at lunchtime on day 2 the index has dropped to 5,500 (a fall of 8.3%) the market could be suspended and we would have to deposit further margin of (£10 * (5,998 - 5,500)) = £4,980.

If we hold on to the future for the full year this would be classed as normal delivery. On the final day our margin account would be adjusted for gains or losses on that day and we would be able to withdraw our initial margin and any profits that we have made. If we want to close out our position prior to expiry, we would need to go short in 1 future with a delivery price of 6,000 with the same delivery time as above. Any further gains/losses on our original contract would be offset with losses/gains on the short contract and so we have pretty much removed our exposure (with some small remaining counterparty risk).

2) Note that option trading is not core reading and so is not examinable. As stated in the course notes, the difference between options and futures is the fact that losses accrue to only one party under an option. The buyer pays a premium up front for the option but makes no further loss (the option is either exercised for a positive payoff or expires worthless).

3) Sorry I can't add anything here to the points mention in the course notes.

4) When you take up a long position in a future, e.g the one we used as an example above, you make the maximum loss if the index drops to 0. The loss in that case would be £10 * (6,000 - 0) = £60,000. If you take up a short position you make losses when the index rises. In theory, there's no cap on the value that the index could take so it could increase to let's say 500,000 and you'd make a loss equal to £10 * (500,000 - 6,000) = £4,940,000. However, if I had that short position but I also held the underlying asset (e.g. I held all of the index constituents in correct proportions and the value of that portfolio were the same initially as my index position (£60,000)) then if the market rises I make a loss on my short position in the future but a corresponding profit on my asset.

5) As above the delivery price affects the value of the contract. The initial value is index value * $ per point (you can think of it as the maximum loss you can make from a long position in the contract). So if the initial margin is set at 10% of the value we need to be incorporating the initial index value within our formula.

Hope this helps.

Joe