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short. The clearinghouse, bound to perform on its side of each contract, is the only party that
two traders.
can be hurt by the failure of any trader to observe the obligations of the futures contract. This
arrangement is necessary because a futures contract calls for future performance, which can-
not be as easily guaranteed as an immediate stock transaction.
Figure 16.4 illustrates the role of the clearinghouse. Panel A shows what would happen in
the absence of the clearinghouse. The trader in the long position would be obligated to pay the
futures price to the short position trader, and the trader in the short position would be obligated
to deliver the commodity. Panel B shows how the clearinghouse becomes an intermediary, act-
ing as the trading partner for each side of the contract. The clearinghouse™s position is neutral,
as it takes a long and a short position for each transaction.
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

16 Futures Markets


Long Short
position position


Money Money

Long Short
position position

Commodity Commodity

F I G U R E 16.4
A. Trading without the clearinghouse
B. Trading with a clearinghouse

The clearinghouse makes it possible for traders to liquidate positions easily. If you are cur-
rently long in a contract and want to undo your position, you simply instruct your broker to
enter the short side of a contract to close out your position. This is called a reversing trade.
The exchange nets out your long and short positions, reducing your net position to zero. Your
zero net position with the clearinghouse eliminates the need to fulfill at maturity either the
original long or reversing short position.
The open interest on the contract is the number of contracts outstanding. (Long and short po-
sitions are not counted separately, meaning that open interest can be defined as either the num-
ber of long or short contracts outstanding.) The clearinghouse™s position nets out to zero, and
so it is not counted in the computation of open interest. When contracts begin trading, open in-
terest is zero. As time passes, open interest increases as progressively more contracts are en-
tered. Almost all traders, however, liquidate their positions before the contract maturity date.
Instead of actually taking or making delivery of the commodity, virtually all market partic-
ipants enter reversing trades to cancel their original positions, thereby realizing the profits or
losses on the contract. The fraction of contracts that result in actual delivery is estimated to
range from less than 1% to 3%, depending on the commodity and the activity in the contract.
The image of a trader awakening one delivery date with a mountain of wheat in the front yard
is amusing, but unlikely.
You can see the typical pattern of open interest in Figure 16.2. In the silver contract, for ex-
ample, the January delivery contracts are close to maturity, and open interest is relatively
small; most contracts have been reversed already. The next few maturities have significantly
greater open interest. Finally, the most distant maturity contracts have little open interest, as
they have been available only recently, and few participants have yet traded.

Marking to Market and the Margin Account
Anyone who saw the film “Trading Places” knows that Eddie Murphy as a trader in orange
juice futures had no intention of purchasing or delivering orange juice. Traders simply bet on
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

574 Part FIVE Derivative Markets

the futures price of juice. The total profit or loss realized by the long trader who buys a con-
tract at time 0 and closes, or reverses, it at time t is just the change in the futures price over the
period, Ft F0. Symmetrically, the short trader earns F0 Ft .
The process by which profits or losses accrue to traders is called marking to market. At
marking to
initial execution of a trade, each trader establishes a margin account. The margin is a security
account consisting of cash or near-cash securities, such as Treasury bills, that ensures the
The daily settlement
trader will be able to satisfy the obligations of the futures contract. Because both parties to the
of obligations on
futures contract are exposed to losses, both must post margin. If the initial margin on corn, for
futures positions.
example, is 10%, the trader must post $1063.75 per contract for the margin account. This is
10% of the value of the contract ($2.1275 per bushel 5,000 bushels per contract).
Because the initial margin may be satisfied by posting interest-earning securities, the re-
quirement does not impose a significant opportunity cost of funds on the trader. The initial
margin is usually set between 5% and 15% of the total value of the contract. Contracts written
on assets with more volatile prices require higher margins.
On any day that futures contracts trade, futures prices may rise or fall. Instead of waiting
until the maturity date for traders to realize all gains and losses, the clearinghouse requires all
positions to recognize profits as they accrue daily. If the futures price of corn rises from 2123„4
to 2143„4 cents per bushel, for example, the clearinghouse credits the margin account of the
long position for 5,000 bushels times 2 cents per bushel, or $100 per contract. Conversely, for
the short position, the clearinghouse takes this amount from the margin account for each
contract held. Therefore, as futures prices change, proceeds accrue to the trader™s account
Although the price of corn has changed by only 0.94% (i.e., 2/212.75), the percentage re-
turn on the long corn position on that day is 10 times greater: The $100 gain on the position is
9.4% of the $1,063.75 posted as margin. The 10-to-1 ratio of percentage changes reflects the
leverage inherent in the futures position, since the corn contract was established with an ini-
tial margin of 1/10th the value of the underlying asset.

2. What must be the net inflow or outlay from marking to market for the clearing-
If a trader accrues sustained losses from daily marking to market, the margin account may
fall below a critical value called the maintenance margin. Once the value of the account falls
below this value, the trader receives a margin call. For example, if the maintenance margin on
corn is 5%, then the margin call will go out when the 10% margin initially posted has fallen
An established value
about in half, to $532 per contract. (This requires that the futures price fall only about 11 cents,
below which a
as each 1 cent drop in the futures price results in a loss of $50 to the long position.) Either new
trader™s margin may
not fall. Reaching the funds must be transferred into the margin account or the broker will close out enough of the
maintenance margin trader™s position to meet the required margin for that position. This procedure safeguards the
triggers a margin call.
position of the clearinghouse. Positions are closed out before the margin account is ex-
hausted”the trader™s losses are covered, and the clearinghouse is not put at risk.
Marking to market is the major way in which futures and forward contracts differ, besides
contract standardization. Futures follow this pay- (or receive-) as-you-go method. Forward
contracts are simply held until maturity, and no funds are transferred until that date, although
the contracts may be traded.
It is important to note that the futures price on the delivery date will equal the spot price
of the commodity on that date. As a maturing contract calls for immediately delivery, the fu-
tures price on that day must equal the spot price”the cost of the commodity from the two
competing sources is equalized in a competitive market.2 You may obtain delivery of the

Small differences between the spot and futures prices at maturity may persist because of transportation costs, but this
is a minor factor.
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

16 Futures Markets

commodity either by purchasing it directly in the spot market or by entering the long side of
a futures contract.
A commodity available from two sources (the spot and futures markets) must be priced
identically, or else investors will rush to purchase it from the cheap source in order to sell it in
the high-priced market. Such arbitrage activity could not persist without prices adjusting to
eliminate the arbitrage opportunity. Therefore, the futures price and the spot price must con-
verge at maturity. This is called the convergence property. convergence
For an investor who establishes a long position in a contract now (time 0) and holds that property
position until maturity (time T), the sum of all daily settlements will equal FT F0, where FT The convergence of
stands for the futures price at contract maturity. Because of convergence, however, the futures futures prices and
price at maturity, FT, equals the spot price, PT, so total futures profits also may be expressed spot prices at the
maturity of the
as PT F0. Thus, we see that profits on a futures contract held to maturity perfectly track
futures contract.
changes in the value of the underlying asset.

Assume the current futures price for silver for delivery five days from today is $5.10 per
ounce. Suppose that over the next five days, the futures price evolves as follows:
Marking to
Day Futures Price
Market and
0 (today) $5.10 Futures Contract
1 5.20 Profits
2 5.25
3 5.18
4 5.18
5 (delivery) 5.21

The spot price of silver on the delivery date is $5.21: The convergence property implies that
the price of silver in the spot market must equal the futures price on the delivery day.
The daily mark-to-market settlements for each contract held by the long positions will be
as follows:

Day Profit (loss) per Ounce 5,000 Ounces/Contract Daily Proceeds

1 $5.20 $5.10 $ 0.10 $ 500
2 5.25 5.20 0.05 250
3 5.18 5.25 0.07 350
4 5.18 5.18 0 0
5 5.21 5.18 0.03 150

Sum $ 550

The profit on day 1 is the increase in the futures price from the previous day, or ($5.20
$5.10) per ounce. Because each silver contract on the Commodity Exchange calls for purchase
and delivery of 5,000 ounces, the total profit per contract is 5,000 times $0.10, or $500. On
day 3, when the futures price falls, the long position™s margin account will be debited by $350.
By day 5, the sum of all daily proceeds is $550. This is exactly equal to 5,000 times the differ-
ence between the final futures price of $5.21 and the original futures price of $5.10. Thus, the
sum of all the daily proceeds (per ounce of silver held long) equals PT F0.
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

576 Part FIVE Derivative Markets

Cash versus Actual Delivery
Most futures markets call for delivery of an actual commodity, such as a particular grade of
wheat or a specified amount of foreign currency, if the contract is not reversed before matu-
rity. For agricultural commodities, where quality of the delivered good may vary, the exchange
sets quality standards as part of the futures contract. In some cases, contracts may be settled
with higher or lower grade commodities. In these cases, a premium or discount is applied to
the delivered commodity to adjust for the quality differences.
Some futures contracts call for cash delivery. An example is a stock index futures contract
cash delivery
where the underlying asset is an index such as the Standard & Poor™s 500 index. Delivery of
The cash value of the
every stock in the index clearly would be impractical. Hence, the contract calls for “delivery”
underlying asset
of a cash amount equal to the value that the index attains on the maturity date of the contract.
(rather than the asset
itself) is delivered to The sum of all the daily settlements from marking to market results in the long position real-
satisfy the contract. izing total profits or losses of ST F0, where ST is the value of the stock index on the maturity
date T, and F0 is the original futures price. Cash settlement closely mimics actual delivery, ex-
cept the cash value of the asset rather than the asset itself is delivered by the short position in
exchange for the futures price.
More concretely, the S&P 500 index contract calls for delivery of $250 times the value of
the index. At maturity, the index might list at 1,200, a market value-weighted index of the
prices of all 500 stocks in the index. The cash settlement contract calls for delivery of $250
1,200, or $300,000 cash in return for 250 times the futures price. This yields exactly the same
profit as would result from directly purchasing 250 units of the index for $300,000 and then
delivering it for 250 times the original futures price.

Futures markets are regulated by the Commodities Futures Trading Commission (CFTC), a fed-
eral agency. The CFTC sets capital requirements for member firms of the futures exchanges, au-
thorizes trading in new contracts, and oversees maintenance of daily trading records.
The futures exchange may set limits on the amount by which futures prices may change
from one day to the next. For example, if the price limit on silver contracts is $1, and silver fu-
tures close today at $5.10 per ounce, trades in silver tomorrow may vary only between $6.10
and $4.10 per ounce. The exchange may increase or reduce these price limits in response to


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