Lesson Objective: To understand the mechanics of futures contracts, margin requirements, and the pricing of futures.

In-Depth Notes:

1. Futures Contracts:
Futures are standardized contracts traded on regulated exchanges that obligate the buyer to purchase, and the seller to sell, an underlying asset at a specified price on a specified future date. Futures are exchange-traded derivatives, meaning they are standardized, centrally cleared, and subject to strict regulatory oversight.

  • Key Characteristics:

    • Standardization: Contracts have standardized terms (size, maturity, delivery date, settlement method). This standardization makes futures highly liquid.

    • Central Clearing: All futures trades are cleared through a Central Counterparty (CCP), eliminating counterparty credit risk.

    • Mark-to-Market: Futures positions are marked-to-market daily. Gains and losses are settled in cash on a daily basis.

    • Margin Requirements: Both buyers and sellers of futures must post initial margin (collateral) and maintain maintenance margin. If the margin account falls below the maintenance margin, a margin call is triggered.

    • Delivery: Futures can be settled by physical delivery (the seller delivers the underlying asset) or by cash settlement (the difference between the contract price and the settlement price is paid in cash).

2. Futures Pricing:
The price of a futures contract is determined by the spot price of the underlying asset, the risk-free rate, and the cost of carry (storage costs, interest, and dividends).

  • The Cost of Carry Model: The fair value of a futures contract is: Futures Price = Spot Price × (1 + Risk-Free Rate)^t - Dividends (or Yield)

  • Interpretation: The futures price is the spot price plus the cost of holding the asset until delivery, minus any income (dividends) earned on the asset.

3. Basis and Basis Risk:

  • Basis: The difference between the spot price and the futures price: Basis = Spot Price - Futures Price.

  • Basis Risk: The risk that the basis changes between the time a hedge is established and the time it is lifted. Basis risk is an inherent risk in futures hedging.

4. Applications of Futures:

  • Hedging: Using futures to reduce or eliminate risk. For example, an airline can hedge against rising fuel prices by buying oil futures.

  • Speculation: Using futures to profit from anticipated price movements.

  • Arbitrage: Exploiting price discrepancies between related instruments.

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