Chapter 2: Futures Markets and Central Counterparties

Background

Futures exchanges have existed since the 1840s when the Chicago Board of Trade (CBOT) was formed. The first futures-like contract was the to-arrive contract — an agreement to deliver grain at a future date. The Chicago Mercantile Exchange (CME) followed in 1919. Today, the CME Group is the world's largest futures exchange.

Specification of a Futures Contract

When an exchange develops a new futures contract, it must specify:

The party with the short position (seller) has delivery options — choosing the exact delivery date within the delivery month, delivery location, and sometimes the grade of the commodity.

Convergence of Futures Price to Spot Price

As the delivery month approaches, the futures price converges to the spot price. If $F>S$, arbitrageurs can short futures, buy the asset, and deliver — making a risk-free profit. This arbitrage forces convergence at maturity: $F_T=S_T$.

Operation of Margin Accounts

Margin is crucial to the functioning of futures markets. There are two types:

Initial Margin

The amount that must be deposited at the time the contract is entered. Typically set at a level to cover the maximum likely daily price movement.

Variation Margin (Maintenance Margin)

If the balance in the margin account falls below the maintenance margin, a margin call is issued and the investor must top up the account to the initial margin level.

Example of Marking to Market: Suppose you go long one gold futures contract (100 oz) at $1,750/oz.Theinitialmarginis$6,000 and maintenance margin is $4,500.

At the end of day 2, the balance of $3,800isbelow$4,500 maintenance margin, triggering a margin call of $2,200tobringitbackto$6,000.

Note: Variation margin for futures does not earn interest (unlike OTC collateral). In OTC markets cleared through CCPs, daily variation margin earns interest.

Central Counterparties (CCPs)

A CCP stands between the two sides of a transaction, becoming the buyer to every seller and the seller to every buyer. This transforms the credit risk situation from a complex web of bilateral exposures to a hub-and-spoke model.

Benefits:

• Mutualized default risk
• Reduced systemic risk
• Simplified credit risk management

Risks:

• CCPs become "too big to fail"
• Concentration of risk
• Requires careful regulation

After the 2008 financial crisis, G20 nations agreed that standardized OTC derivatives should be cleared through CCPs.

Forward vs. Futures Contracts

When interest rates are constant (or uncorrelated with futures prices), forward and futures prices are equal. When interest rates are uncertain, the daily settlement of futures creates a difference.

Types of Orders