may well have closed out his or her position by trading with investor C,investor C may have closed out his or her position by trading with investor D, and so on. The usualrule chosen by the exchange is to pass the notice of intention to deliver on to the party with the oldestoutstanding long position. Parties with long positions must accept delivery notices. However, if thenotices are transferable, long investors have a short period of time, usually half an hour, to findanother party with a long position that is prepared to accept the notice from them.
In the case of a commodity, taking delivery usually means accepting a warehouse receipt inreturn for immediate payment. The party taking delivery is then responsible for all warehousingcosts. In the case of livestock futures, there may be costs associated with feeding and looking afterthe animals. In the case of financial futures, delivery is usually made by wire transfer. For allcontracts the price paid is usually the settlement price immediately preceding the date of the noticeof intention to deliver. Where appropriate, this price is adjusted for grade, location of delivery, andso on. The whole delivery procedure from the issuance of the notice of intention to deliver to thedelivery itself generally takes two to three days.
There are three critical days for a contract. These are the first notice day, the last notice day, andthe last trading day. The first notice day is the first day on which a notice of intention to makedelivery can be submitted to the exchange. The /ast notice day is the last such day. The dast tradingday is generally a few days before the last notice day. To avoid the risk of having to take delivery,an investor with a long position should close out his or her contracts prior to the first notice day.
Cash Settlement
Some financial futures, such as those on stock indices, are settled in cash because it is inconvenientor impossible to deliver the underlying asset. In the case of the futures contract on the S&P 500,for example, delivering the underlying asset would involve delivering a portfolio of 500 stocks.When a contract is settled in cash, it is simply marked to market on the last trading day, and allpositions are declared closed. To ensure that the futures price converges to the spot price, thesettlement price on the last trading day is set equal to the spot price of the underlying asset ateither the opening or close of trading on that day. For example, in the S&P 500 futures contracttrading on the Chicago Mercantile Exchange final settlement is based on the opening price of theindex on the third Friday of the delivery month.
2.8 TYPES OF TRADERS
 
 
 
 
aaaiccinn brokers and Incale SospailectanMimission brokers and lOCalS. Cortiniis stora
commission for doing so. Locals
ae of tes
There are two main types OL traders executing trades: cobrokers are following the instructions of their clients and chargeare trading on their own account.
Individuals taking positions, whether locals or the clients of commission brokers, can becategorized as hedgers, speculators, or arbitrageurs, as discussed in Chapter 1. Speculators canbe classified as scalpers, day traders, or position traders. Scalpers are watching for very short termtrends and attempt to profit from small changes in the contract price. They usually hold theirpositions for only a few minutes. Day traders hold their positions for less than one trading day.Mechanics of Futures Markets 33
They are unwilling to take the risk that adverse news will occur overnight. Position traders holdtheir positions for much longer periods of time. They hope to make significant profits from majormovements in the markets.
Orders
The simplest type of order placed with a broker is a market order. It is a request that a trade becarried out immediately at the best price available in the market. However, there are many othertypes of orders. We will consider those that are more commonly used.
A limit order specifies a particular price. The order can be executed only at this price or at onemore favorable to the investor. Thus, if the limit price is $30 for an investor wanting to take a longposition, the order will be executed only at a price of $30 or less. There is, of course, no guaranteethat the order will be executed at all, because the limit price may never be reached.
A stop order or stop-loss order also specifies a particular price. The order is executed at the bestavailable price once a bid or offer is made at that particular price or a less-favorable price. Supposea stop order to sell at $30 is issued when the market price is $35. It becomes an order to sell whenand if the price falls to $30. In effect, a stop order becomes a market order as soon as the specifiedprice has been hit. The purpose of a stop order is usually to close out a position if unfavorableprice movements take place. It limits the loss that can be incurred.
A stop-limit order is a combination of a stop order and a limit order. The order becomes a limitorder as soon as a bid or offer is made at a price equal to or less favorable than the stop price. Twoprices must be specified in a stop-limit order: the stop price and the limit price. Suppose that at thetime the market price is $35, a stop—limit order to buy is issued with a stop price of $40 and a limitprice of $41. As soon as there is a bid or offer at $40, the stop—limit becomes a limit order at $41. Ifthe stop price and the limit price are the same, the order is sometimes called a stop-and-limit order.
A market-if-touched (MIT) order is executed at the best available price after a trade occurs at aspecified price or at a price more favorable than the specified price. In effect, an MIT orderbecomes a market order once the specified price has been hit. An MIT order is also known as aboard order. Consider an investor who has a long position in a futures contract and is issuinginstructions that would lead to closing out the contract. A stop order is designed to place a limit onthe loss that can occur in the event of unfavorable price movements. By contrast, an MIT order isdesigned to ensure that profits are taken if sufficiently favorable price movements occur.
A discretionary order or market-not-held order is traded as a market order except that executionmay be delayed at the broker’s discretion in an attempt to get a better price.
Some orders specify time conditions, Unless otherwise stated, an order is a day order and expiresat the end of the trading day. A time-of-day order specifies a particular period of time during theday when the order can be executed. An open order or a good-till-canceled order is in effect untilexecuted or until the end of trading in the particular contract. A fill-or-kill order, as its nameimplies, must be executed immediately on receipt or not at all.
2.9 REGULATION
 
 
Futures markets in the United States are currently regulated federally by the Commodity FuturesTrading Commission (CFTC, www.cfte.gov), which was established in 1974. This body isresponsible for licensing futures exchanges and approving contracts. All new contracts and changesto existing contracts must be approved by the CFTC. To be approved, the contract must have some34 CHAPTER 2
useful economic purpose. Usually this means that it must serve the needs of hedgers as well asspeculators.
The CFTC looks after the public interest. It is responsible for ensuring that prices arecommunicated to the public and that futures traders report their outstanding positions if theyare above certain levels. The CFTC also licenses all individuals who offer their services to the publicin futures trading. The backgrounds of these individuals are investigated, and there are minimumcapital requirements. The CFTC deals with complaints brought by the public and ensures thatdisciplinary action is taken against individuals when appropriate. It has the authority to forceexchanges to take disciplinary action against members who are in violation of exchange rules.
With the formation of the National Futures Association (NFA, www.nfa.futures.org) in 1982,some of responsibilities of the CFTC were shifted to the futures industry itself. The NFA is anorganization of individuals who participate in the futures industry. Its objective is to prevent fraudand to ensure that the market operates in the best interests of the general public. The NFA requiresits members to pass an exam. It is authorized to monitor trading and take disciplinary action whenappropriate. The agency has set up an efficient system for arbitrating disputes between individualsand its members.
From time to time other bodies such as the Securities and Exchange Commission (SEC,www.sec.gov), the Federal Reserve Board (www.federalreserve.gov), and the U.S. Treasury Depart-ment (www.treas.gov) have claimed jurisdictional rights over some aspects of futures trading. Thesebodies are concerned with the effects of futures trading on the spot markets for securities such asstocks, Treasury bills, and Treasury bonds. The SEC currently has an effective veto over theapproval of new stock or bond index futures contracts. However, the basic responsibility for allfutures and options on futures rests with the CFTC.
Trading Irregularities
Most of the time futures markets operate efficiently and in the public interest. However, from timeto time, trading irregularities do come to light. One type of trading irregularity occurs when aninvestor group tries to “corner the market”.’ The investor group takes a huge long futures positionand also tries to exercise some control over the supply of the underlying commodity. As thematurity of the futures contracts is approached, the investor group does not close out its position,so that the number of outstanding futures contracts may exceed the amount of the commodityavailable for delivery. The holders of short positions realize that they will find it difficult to deliverand become desperate to close out their positions. The result is a large rise in both futures and spotprices. Regulators usually deal with this type of abuse of the market by increasing marginrequirements, imposing stricter position limits, prohibiting trades that increase a speculator’s openposition, and forcing market participants to close out their positions.
Other types of trading irregularities can involve the traders on the floor of the exchange. Thesereceived some publicity early in 1989 when it was announced that the FBI had carried out a two-year investigation, using undercover agents, of trading on the Chicago Board of Trade and theChicago Mercantile Exchange. The investigation was initiated because of complaints filed by alarge agricultural concern. The alleged offenses included overcharging customers, not payingcustomers the full proceeds of sales, and traders using their knowledge of customer orders totrade first for themselves.
' Possibly the best known example of this involves the activities of the Hunt brothers in the silver market in 1979-80.Between the middle of 1979 and the beginning of 1980, their activities led to a price rise from $9 per ounce to $50 perounce.Mechanics of Futures Markets 35
2.10 ACCOUNTING AND TAX
 
 
The full details of the accounting and tax treatment of futures contracts are beyond the scope ofthis book. A trader who wants detailed information on this should consult experts. In this sectionwe provide some general background information.
Accounting
Consider a trader who in September 2002 takes a long position in a March 2003 corn futurescontract and closes out the position at the end of February 2003. Suppose that the futures pricesare 150 cents per bushel when the contract is entered into, 170 cents per bushel at the end of 2002,and 180 cents per bushel when the contract is closed out. One contract is for the delivery of 5,000bushels. If the trader is a speculator, the gains for accounting purposes are
5,000 x $0.20 = $1,000in 2002 and
5,000 x $0.10 = $500in 2003.
If the trader is hedging the purchase of 5,000 bushels of corn in February 2003, hedge accountingcan be used, The entire $1,500 gain then appears in the 2003 income statement. In general, hedgeaccounting allows the profit/loss from a hedging instrument to be recognized at the same time asthe profit/loss from the item being hedged.
In June 1998, the Financial Accounting Standards Board issued FASB Statement No. 133,Accounting for Derivative Instruments and Hedging Activities (FAS 133). FAS 133 applies to alltypes of derivatives (including futures, forwards, swaps, and options). It requires all derivatives tobe included on the balance sheet at fair market value.” It increases disclosure requirements. It alsogives companies far less latitude in using hedge accounting. For hedge accounting to be used, thehedging instrument must be highly effective in offsetting exposures and an assessment of this
effectiveness is required every three months. FAS 133 is effective for all fiscal years beginning afterJune 15, 2000.
Tax
Under the U.S. tax rules, two key issues are the nature of a taxable gain or loss and the timing ofthe recognition of the gain or loss. Gains or losses are either classified as capital gains/losses or aspart of ordinary income.
‘For a corporate taxpayer, capital gains are taxed at the same rate as ordinary income, and theability to deduct losses is restricted. Capital losses are deductible only to the extent of capital gains.A corporation may carry back a capital loss for three years and carry it forward for up to five years.
Tor a noncorporate taxpayer, short-term capital gains are taxed at the same rate as ordinaryincome, but long-term capital gains are taxed at a lower rate than ordinary income. (Long-termcapital gains are gains from the sale of a capital asset held for longer than one year: short termcapital gains are the gains from the sale of a capital asset held less than one year.) The TaxpayerRelief Act of 1997 widened the rate differential between ordinary income and long-term capitalgains. For a noncorporate taxpayer, capital losses are deductible to the extent of capital gains plusordinary income up to $3,000 and can be carried forward indefinitely.
? Previously the attraction of derivatives in some situations was that they were “‘off-balance-sheet” items.36 CHAPTER 2
Generally, positions in futures contracts are treated as if they are closed out on the last day of thetax year. Gains and losses are capital. For the noncorporate taxpayer they are considered 60% longterm and 40% short term.
Hedging transactions are exempt from this rule. The definition of a hedge transaction for taxpurposes is different from that for accounting purposes. The tax regulations define a hedgingtransaction as a transaction entered into in the normal course of business primarily for one of thefollowing reasons:
1. To reduce the risk of price changes or currency fluctuations with respect to property that isheld or to be held by the taxpayer for the purposes of producing ordinary income
2. To reduce the risk of price or interest rate changes or currency fluctuations with respect toborrowings made by the taxpayer :
Gains or losses from hedging transactions are treated as ordinary income. The timing of therecognition of gains or losses from hedging transactions generally matches the timing of therecognition of income or deduction from the hedged items.
Special rules apply to foreign currency futures transactions. A taxpayer can make a bindingelection to treat gains and losses from ail futures contracts in all foreign currencies as ordinaryincome, regardless of whether the contracts is entered into for hedging or speculative purposes. If ataxpayer does not make this election, then foreign currencies futures transactions are treated in thesame way as other futures transactions.
2.11 FORWARD CONTRACTS vs. FUTURES CONTRACTS
 
 
The main differences between forward and futures contracts are summarized in Table 2.3. Bothcontracts are agreements to buy or sell an asset for a certain price at a certain future time. Aforward contract is traded in the over-the-counter market and there is no standard contract size orstandard delivery arrangements. A single delivery date is usually specified and the contract isusually held to the end of its life and then settled. A futures contract is a standardized contracttraded on an exchange. A range of delivery dates is usually specified. It is settled daily and usuallyclosed out prior to maturity.
Suppose that the sterling exchange rate for a 90-day forward contract is 1.4381 and that this rateis also the futures price for a contract that will be delivered in exactly 90 days. What is thedifference between the gains and losses under the two contracts?
Table 2.3. Comparison of forward and futures contracts
 
Forward Futures
Traded on over-the-counter market Traded on an exchange
Not standardized Standardized contractUsually one specified delivery date Range of delivery datesSettied at end of contract Settled daily
Delivery or final cash settlement Contract is usually closed out
usually takes place prior to maturityMechanics of Futures Markets 37
Under the forward contract, the whole gain or loss is realized at the end of the life of thecontract. Under the futures contract, the gain or loss is realized day by day because of the dailysettlement procedures. Suppose that investor A is long £1 million in a 90-day forward contract andinvestor B is long £1 million in 90-day futures contracts. (Because each futures contract is for thepurchase or sale of £62,500, investor B must purchase a total of 16 contracts.) Assume that the spotexchange rate in 90 days proves to be 1.4600. Investor A makes a gain of $21,900 on the 90th day.Investor B makes the same gain—but spread out over the 90-day period. On some days investor Bmay realize a loss, whereas on other days he or she makes a gain. However, in total, when lossesare netted against gains, there is a gain of $21,900 over the 90-day period.
Foreign Exchange Quotes
Both forward and futures contracts trade actively on foreign currencies. However, there is adifference in the way exchange rates are quoted in the two markets. Futures prices are alwaysquoted as the number of U.S. dollars per unit of the foreign currency or as the number ofU.S. cents per unit of the foreign currency. Forward prices are always quoted in the same wayas spot prices. This means that for the British pound, the euro, the Australian dollar, and the NewZealand dollar, the forward quotes show the number of U.S. dollars per unit of the foreigncurrency and are directly comparable with futures quotes. For other major currencies, forwardquotes show the number of units of the foreign currency per U.S. dotlar (USD). Consider theCanadian dollar (CAD). A tutures price quote of 0.7050 USD per CAD corresponds to a forwardprice quote of 1.4184 CAD per USD (1.4184 = 1/0.7050).
SUMMARY
 
 
 
In futures markets, contracts are traded on an exchange, and it is necessary for the exchange todefine carefully the precise nature of what is traded, the procedures that will be followed, and theregulations that will govern the market. Forward contracts are negotiated directly over thetelephone by two relatively sophisticated individuals. As a result, there is no need to standardizethe product, and an extensive set of rules. and procedures is not required.
Avery high proportion of the futures contracts that are traded do not lead to the delivery of theunderlying asset. They are closed out before the delivery period is reached. However, it is thepossibility of final delivery that drives the determination of the futures price. For each futurescontract, there is a range of days during which delivery can be made and a well-defined deliveryprocedure. Some contracts, such as those on stock indices, are settled in cash rather than bydelivery of the underlying asset.
The specification of contracts is an important activity for a futures exchange. The two sides toany contract must know what can be delivered, where delivery can take place, and when deliverycan take place. They also need to know details on the trading hours, how prices will be quoted,maximum daily price movements, and so on. New contracts must be approved by the CommodityFutures Trading Commission before trading starts.
Margins are an important aspect of futures markets. An investor keeps a margin account with hisor her broker. The account is adjusted daily to reflect gains or losses, and from time to time thebroker may require the account to be topped up if adverse price movements have taken place. Thebroker either must be a clearinghouse member or must maintain a margin account with aclearinghouse member. Each clearinghouse member maintains a margin account with the exchange38 CHAPTER 2
clearinghouse. The balance in the account is adjusted daily to reflect gains and losses on thebusiness for which the clearinghouse member is responsible.
Information on futures prices is collected in a systematic way at exchanges and relayed within amatter of seconds to investors throughout the world, Many daily newspapers such as the WallStreet Journal carry a summary of the previous day’s trading.
Forward contracts differ from futures contracts in a number of ways. Forward contracts areprivate arrangements between two parties, whereas futures contracts are traded on exchanges.There is generally a single delivery date in a forward contract, whereas futures contracts frequently_ involve a range of such dates. Because they are not traded on exchanges, forward contracts neednot be standardized. A forward contract is not usually settled until the end of its life, and mostcontracts do in fact lead to delivery of the underlying asset or a cash settlement at this time.
In the next few chapters we will look at how forward and futures prices are determined. We willalso examine in more detail the ways in which forward and futures contracts can be used for hedging.
SUGGESTIONS FOR FURTHER READING
 
Chance, D., An Introduction to Derivatives, 4th edn., Dryden Press, Orlando, FL, 1997.Duffie, D., Futures Markets, Prentice Hall, Upper Saddle River, NJ, 1989.
Hicks, J.R., Value and Capital, Clarendon Press, Oxford, 1939.
Horn, F.F., Trading in Commodity Futures, New York Institute of Finance, New York, 1984.Keynes, J.M., 4 Treatise on Money, Macmillan, London, 1930.
Kolb, R., Futures, Options, and Swaps, 3rd edn., Blackwell, Oxford, 2000.
Schwager, J.D., 4 Complete Guide to the Futures Markets, Wiley, New York, 1984.
Teweles, R.J., and F.J. Jones, The Futures Game, McGraw-Hill, New York, 1987.
QUESTIONS AND PROBLEMS(ANSWERS IN SOLUTIONS MANUAL)
 
2.1. Distinguish between the terms open interest and trading volume.2.2. What is the difference between a local and a commission broker?
2.3. Suppose that you enter into a short futures contract to sell July silver for $5.20 per ounce on theNew York Commodity Exchange. The size of the contract is 5,000 ounces. The initial margin is$4,000, and the maintenance margin is $3,000. What change in the futures price will lead to amargin call? What happens if you do not meet the margin call?
2.4. Suppose that in September 2002 you take a long position in a contract on May 2003 crude oilfutures. You close out your position in March 2003. The futures price (per barrel) is $18.30 whenyou enter into your contract, $20.50 when you close out your position, and $19.10 at the end ofDecember 2000. One contract is for the delivery of 1,000 barrels. What is your total profit? Whenis it realized? How is it taxed if you are (a) a hedger and (b) a speculator? Assume that you have aDecember 31 year-end.
2.5. What does a stop order to sell at $2 mean? When might it be used? What does a limit order to sellat $2 mean? When might it be used?Mechanics of Futures Markets 39
2.6.
2.7.
2.8.
2.9.
2.10.2.411.
2.12.
2.13.2.14.2.15,
2.17.
2.22.
2.23.
What is the difference between the operation of the margin accounts administered by aclearinghouse and those administered by a broker?
What differences exist in the way prices are quoted in the foreign exchange futures market, theforeign exchange spot market, and the foreign exchange forward market?
The party with a short position in a futures contract sometimes has options as to the precise assetthat will be delivered, where delivery will take place, when delivery will take place, and so on. Dothese options increase or decrease the futures price? Explain your reasoning.
What are the most important aspects of the design of a new futures contract?Explain how margins protect investors against the possibility of default.
An investor enters into two long futures contracts on frozen orange juice. Each contract is for thedelivery 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 wouldlead to a margin call? Under what circumstances could $2,000 be withdrawn from the marginaccount?
Show that if the futures price of a commodity is greater than the spot price during the deliveryperiod there is an arbitrage opportunity. Does an arbitrage opportunity exist if the futures price is
lace than the enot orice? Uxolain vour anewe
less than the spot pricc? Explain your answer.Explain the difference between a market-if-touched order and a stop order.
Explain what a stop-limit order to sell at 20.30 with a limit of 20.10 means.
At the end of one day a clearinghouse member is long 100 contracts, and the settlement price is$50,000 per contract. The original margin is $2,000 per contract. On the following day themember becomes responsible for clearing an additional 20 long contracts, entered into at a price
of $51,000 per contract. The settlement price at the end of this day is $50,200. How much does themember have to add to its margin account with the exchange clearinghouse?
. On July 1, 2002, a company enters into a forward contract to buy 10 million Japanese yen on
January |, 2003. On September !, 2002, it enters into a forward contract to sell 10 miilionJapanese yen on January 1, 2003. Describe the payoff from this strategy.
The forward price on the Swiss franc for delivery in 45 days is quoted as 1.8204. The futures pricefor a contract that will be delivered in 45 days is 0.5479. Explain these two quotes. Which is morefavorable for an investor wanting to sell Swiss francs?
. Suppose you call your broker and issue instructions to sell one July hogs contract. Describe what
happens.
. “Speculation in futures markets is pure gambling. It is not in the public interest to allow
speculators to trade on a futures exchange.” Discuss this viewpoint.
. Identify the contracts with the highest open interest in Table 2.2. Consider cach of the following
sections separately: grains and oilseeds, livestock and meat, food and fiber, and metals andpetroleum.
. What do you think would happen if an exchange started trading a contract in which the quality of
the underlying asset was incompletely specified?
“When a futures contract is traded on the floor of the exchange, it may be the case that the openinterest increases by one, stays the same, or decreases by one.” Explain this statement.
Suppose that on October 24, 2002, you take a short position in an April 2003 live-cattle futurescontract. You close out your position on January 21, 2003. The futures price (per pound) is61.20 cents when you enter into the contract, 58.30 cents when you close out your position,40
CHAPTER 2
 
2.24,
and 58.80 cents at the end of December 2002. One contract is for the delivery of 40,000 pounds ofcattle. What is your total profit? How is it taxed if you are (a) a hedger and (b) a speculator’?A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live-cattlefutures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds ofcattle. How can the farmer use the contract for hedging? From the farmer’s viewpoint, what arethe pros and cons of hedging?
. It is now July 2002. A mining company has just discovered a small deposit of gold. It will take six
months to construct the mine. The gold will then be extracted on a more or less continuous basisfor one year. Futures contracts on gold are available on the New York Commodity Exchange.There are delivery months every two months from August 2002 to December 2003. Each contractis for the delivery of 100 ounces. Discuss how the mining company might use futures markets forhedging.
ASSIGNMENT QUESTIONS
 
2.28.
. A company enters into a short futures contract to sell 5,000 bushels of wheat for 250 cents per
bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price change
wouid fead to a margin cali? Under what circumstances couid $1,500 be withdrawn from themargin account?
. Suppose that on March 15, 2001, speculators tonded to be short Sugar-World futures and hedgers
tended to be long Sugar-World futures, What does the Keynes and Hicks argument imply aboutthe expected future price of sugar? Use Table 2.2. Explain carefully what is meant by the expectedprice of a commodity on a particular future date.
Suppose that corn can be stored for 20 cents per bushel per year and the risk-free interest rate is5% per year, How could you make money in the corn market on March 15, 2001, by trading theMay 2001 and May 2002 contracts? Use Table 2.2.
. The author’s Web page www.rotman.utoronto.ca/"hull contains daily closing prices for the
December 2001 crude oil futures contract and the December 2001 gold futures contract. (Bothcontracts are traded on NYMEX.) You are required to download the data and answer thefollowing:
a. How high do the maintenance margin levels for oi] and gold have to be set so that there is a1% chance that an investor with a balance slightly above the maintenence margin level onaparticular day has a negative balance two days later (i.e., one day after a margin call). Howhigh do they have to be for a 0.1% chance. Assume daily price changes are normallydistributed with mean zero.
b. Imagine an investor who starts with a long position in the oil contract at the beginning ofthe period covered by the data and keeps the contract for the whole of the period of timecovered by the data. Margin balances in excess of the initial margin are withdrawn. Use themaintenance margin you calculated in part (a) for a 1% risk level and assume that themaintenance margin is 75% of the initial margin. Calculate the number of margin calls andthe number of times the investor has a negative margin balance and therefore an incentive towalk away. Assume that all margin calls are met in your calculations. Repeat thecalculations for an investor who starts with a short position in the gold contract. 
CHAPTER 3