3w FinEcon 2024fall v1

Summary

The video covers key concepts related to futures markets, central counterparty mechanisms, and OTC markets. It explains how futures contracts function, particularly focusing on pricing and settlement processes. Using examples like gold, the presenter highlights the difference between spot prices and futures, and how interest rates and funding costs impact future pricing. The video also touches on the role of margins in futures trading, outlining the distinction between initial and maintenance margins and explaining how traders must maintain their margin accounts as market prices fluctuate.

Takeaways

• 📈 The session discusses the concepts of Futures, central counterparty (CCP), and OTC markets, focusing on how derivatives are settled.
• 🛡️ There are two main strategies to acquire gold in a year: buying a gold futures contract now or borrowing money to buy gold today and paying back with interest.
• ⚖️ Theoretical futures pricing is based on the relationship between the spot price and borrowing costs over time.
• 🔄 Futures prices and spot prices converge at the time of contract maturity, despite potential differences during the contract period.
• 📊 Margin requirements are essential in futures trading, with initial margin and maintenance margin protecting against potential losses.
• 💸 If the balance in the margin account falls below the maintenance margin, additional funds (variation margin) must be deposited to bring it back to the initial margin level.
• 📉 An example was given where a futures investor faced losses due to the price of gold dropping from $1,250 to $1,241, affecting the margin account balance.
• 💰 Margin accounts adjust daily, reflecting gains or losses from futures price changes.
• 🏦 Futures contracts can be traded on exchanges with underlying assets like commodities (gold, cabbage) or financial instruments.
• 📅 Futures markets can show behaviors such as prices of future contracts being higher or lower than spot prices, depending on market expectations.

Q & A

What are the two main topics covered in the session?

The two main topics covered are Futures Markets and Central Counterparties, with a focus on how futures products are settled and traded, especially in the OTC (over-the-counter) markets.

What is the difference between futures and spot pricing?

Futures pricing refers to the agreed-upon price of a commodity to be delivered at a future date, while spot pricing refers to the current price of the commodity if it were purchased immediately.

What are the two options for obtaining gold in the example provided?

The first option is buying a futures contract for gold to receive it in one year. The second option is borrowing money to buy gold at the spot price and carrying it for one year, which incurs borrowing costs.

How is the theoretical future price of gold derived?

Theoretical future price is derived by considering the spot price of gold and adding the cost of borrowing money (the funding cost) over the time period until the future delivery.

What role does supply and demand play in determining the market price of futures?

While theoretical prices are calculated based on spot prices and funding costs, market prices of futures are ultimately driven by supply and demand factors, where buyers and sellers determine the price based on market conditions.

What is a key characteristic of futures contracts related to daily settlement?

Futures contracts are settled daily, meaning gains and losses are reflected in the trader’s account at the end of each day based on price movements. Traders must either receive or pay the difference daily.

How do futures prices converge with spot prices over time?

As a futures contract approaches its maturity date, the futures price and the spot price converge, becoming equal at the point of delivery, ensuring no arbitrage opportunities exist.

What is the role of margin in futures trading?

Margin acts as a security deposit between the investor and the broker to cover potential losses. It includes initial margin (the amount required to open a position) and maintenance margin (the minimum amount that must be maintained).

What happens if the margin account falls below the maintenance margin level?

If the margin falls below the maintenance margin, the investor must provide additional funds (known as variation margin) to bring the account balance back up to the initial margin level.

How is loss calculated in futures trading based on the example provided?

Loss is calculated by multiplying the difference between the starting price and the new price (in the example, $1250 - $1241 = $9 loss) by the number of units (200 ounces of gold), resulting in a total loss of $1800.

Outlines

00:00

📊 Introduction to Futures and Central Counterparties

The speaker introduces the topic of futures markets and central counterparties. The class will cover what futures are, how these products are settled, and the distinction between OTC (over-the-counter) markets and centralized counterparties. A quick recap of the previous session on pricing futures is provided, with an emphasis on the difference between future and spot prices. Two options for acquiring gold in a year are presented: purchasing a futures contract or borrowing money to buy the gold now.

05:02

📉 Calculating Future vs Spot Prices for Gold

This section dives deeper into how futures pricing works, using gold as an example. It explains two options for obtaining one ounce of gold: either through a futures contract or by buying the gold on the spot market with borrowed money. The focus is on how the funding cost for borrowing money impacts the overall cost in both cases. Theoretical future prices are discussed, where future prices should align with spot prices plus the cost of borrowing over a year.

10:05

💰 Breakdown of Theoretical Future Price for Gold

A detailed breakdown of the theoretical pricing formula for gold futures is provided. It explains how the future price is derived based on the current spot price and the funding cost, assuming a one-year period. While theoretical prices are determined by this formula, market-driven prices are influenced by supply and demand dynamics. The speaker stresses that theoretical prices differ from actual market prices, which fluctuate based on external factors.

15:06

📦 Characteristics of Futures Contracts

This section explains the key characteristics of futures contracts, including what assets can be delivered, where and when delivery occurs, and the difference between exchange-traded futures and OTC products. The example of gold futures is extended to other commodities like cabbage, highlighting how futures can be traded for a variety of underlying assets. The final point explains that futures contracts settle daily, with gains and losses realized immediately.

20:06

🔀 Margin Requirements in Futures Trading

This paragraph discusses the margin system in futures trading. The relationship between investors, brokers, and exchanges is outlined, focusing on the role of initial and maintenance margins. Investors must deposit an initial margin to cover potential losses, and if the balance falls below a certain level, they are required to top it up to the initial margin level. The example provided involves a gold futures contract with specific margin requirements.

25:06

📉 Example of Losses in Futures Trading

The speaker uses a concrete example to explain how losses are calculated in futures trading. A trader who takes a long position on gold futures experiences a price drop, resulting in a loss. The example illustrates how the margin balance decreases as the price falls, triggering a need for the trader to top up the margin if the balance falls below the maintenance margin level. The margin system is designed to mitigate risks and ensure that losses are covered.

Keywords

💡Futures Market

The futures market is a financial market where participants trade contracts to buy or sell assets at a predetermined future date and price. In the video, this concept is introduced as part of the broader discussion on how futures products are settled and the difference between futures and OTC markets.

💡Central Counterparties (CCPs)

Central Counterparties (CCPs) are organizations that act as intermediaries between buyers and sellers in financial markets, ensuring that trades are settled even if one party defaults. The speaker mentions CCPs when discussing how derivatives are settled through a central clearing house in OTC and futures markets.

💡Spot Price

The spot price is the current market price at which an asset can be bought or sold for immediate delivery. In the script, the speaker compares spot prices to future prices, explaining how they relate to buying an ounce of gold either now or in the future.

💡Future Price

A future price refers to the agreed-upon price of an asset in a futures contract that will be delivered at a later date. The video explains how the future price of an ounce of gold differs from its spot price and how this is calculated using factors like the risk-free rate and funding costs.

💡Funding Cost

Funding cost refers to the interest or cost of borrowing money to finance an investment. The speaker uses the example of borrowing money to buy gold now and compares the overall costs to those of entering a futures contract to highlight the importance of funding costs in pricing futures.

💡Risk-Free Rate

The risk-free rate is the theoretical rate of return on an investment with zero risk, typically represented by government bonds. The video refers to the one-year risk-free rate as a component in calculating the future price of gold, contrasting it with market-driven prices.

💡Arbitrage Opportunity

An arbitrage opportunity arises when traders can profit from price differences in different markets. The speaker mentions that when spot and future prices converge at maturity, any discrepancies between them create potential arbitrage opportunities.

💡Margin Requirement

Margin requirement refers to the minimum amount of capital that must be deposited by an investor to open or maintain a futures position. In the script, the speaker explains how initial and maintenance margins work to protect brokers from losses due to investor defaults.

💡Initial Margin

Initial margin is the upfront amount that a trader must deposit when entering a futures contract. The video provides an example where an investor needs to maintain an initial margin of $6,000 per contract to buy two futures contracts for gold.

💡Maintenance Margin

Maintenance margin is the minimum balance that must be maintained in a margin account. The speaker explains how if the account balance falls below the maintenance margin level, the investor must deposit additional funds (variation margin) to bring the balance back up.

Highlights

Introduction to futures and central counterparty in the OTC market.

Comparison between futures price and spot price.

Example of pricing gold for future delivery with two approaches.

Option 1: Buy a gold future contract for delivery in one year.

Option 2: Borrow money, buy gold now, and account for funding costs.

Theoretical future price derived from spot price and borrowing costs.

Identifying the risk-free rate as a key factor in future price calculation.

Difference between theoretical and market-driven future prices.

Examples of underlying assets for futures, including gold and commodities.

Explanation of daily settlement in futures markets.

Convergence of future prices and spot prices at contract maturity.

Mechanism for calculating margin requirements in futures trading.

Initial and maintenance margin levels and their role in margin calls.

Daily price fluctuations affecting the margin balance.

Understanding long position losses and required margin top-ups in futures.

Transcripts

hello everyone we have a interesting

topic today such as a future market and

uh Central counter parties uh this class

will give you some snaps of what is

Futures and how those uh you know uh

future products are to be settled and uh

you know and OTC uh you know

Market out there and how you know

derivatives product uh can be uh SED

through our you know Central

counterparty uh in uh traded in OTC

market so those are two different uh

main uh topic

today in the previous session I mean the

last week uh we talked about how to uh

price uh future and so at the time I

didn't uh Prov provide enough uh you

know time uh for uh explanation so uh

this time again I'm going uh through uh

how to what is a future of uh price and

then how uh you know what the meaning of

future price compared to

spot uh let's uh uh suppose uh in order

to make a one o of gold ring in one year

so you like to make a one oce of gold

ring in one year then yeah you have two

option uh to have one oce of gold in one

year the the first option

is you simply buy one o of gold

future

now

and you get one

o of gold delivered in one

year this

is forse

option which

means

now just

contract that's

it one you'll get a a go one of

gold one year

one o

of

gold this is false option so which means

simply you you know you made contract as

of now but uh you uh don't have one ons

of gold in your hand second option is

this is slightly different

uh you have money so you borrow

money as much as us and buy one ounce of

gold which is

yes and paying bonding cost with 2% in

one

year what uh second option

is you have one

on

of

gold right

and you

borrow

money why

right here one

year still you have one o of

gold and what

isse you need to pay back borrow the

money as plus what funding

cost

yeah this is second

option yeah there are two uh different

uh option uh so that you can have one o

of gold in one

year yeah let me uh display uh what I uh

you know explained already so first

option

is you just in a half

contract

and in one year uh you are going to uh

get delivered one o of gold which is

which is future so now we are talking

about the uh what is price

for one o of gold

Future Let's suppose this is F this is a

future

price and second option is you

just B one o of gold with the borrow the

money and which is spot you have and

carry until one year

then and you have one of gold plus uh

funding

cost in theory in theory in one year you

have one oce of gold through

future or you have one o of gold with

spot buying and spot buying with a

borrow the

money so a

you have one o of gold and B also you

have on of gold now uh let's see you

know look at the you know what is B

B has one o of

Gold

Plus

fing

yeah it has two component one

is uh one o of gold which is which has

value

right say

s and funding cost which have

value s

times your bwing

cost one year yeah this is uh fun Cost

Plus yeah this is fun cost

yes okay in

theory A and B

equally giv you one o of uh gold in one

year then what is price of those and a

and b in terms of price should be

identical this is one way to you know

derive the theoretical uh future price

based on uh you know syic based on you

know the component of spot and the

borrow the money

okay this is what you know uh this is uh

the same uh uh things so now spot price

of gold is s and future price is uh

contract deliverable in t years AF F

this is

formula and uh let's make it simple now

T is one

year

one so where R is one

year risk free rate such

as yeah us uh in know tragedy be onee

rate previously uh you

know uh one

year riable swap rate in these days this

could

be one

year so

far

Ys right well in the varable you have we

are given you know one year risk free

rate so in uh in our

example S one of gold 1100

dollar t one year and cost

2% so that f is just like this 11 or 22

here let's break down 11 uh 2022 one is

1100

and the other one

is how much 20

two this

is equivalent of one ons of gold uh

which is

s and this is funding

cost of course we are talking about the

theoretical future price

not not you know

uh Market uh determined price because

Market determined price uh should be uh

coming

from Market which means that

is

Supply

demand so you know from from the market

and people are buying and trying to sell

Etc you know there uh that is uh you

know mechanism

uh between supply and demand finally uh

you know future price is uh you know

decided here forget about in know uh

real uh Market driven uh price we just

uh focusing on in uh theoretical price

of

gold uh which is uh you know what it

is

okay

now yeah let's uh let's go through our

future

contract available on wide range of

online whatever online uh can be can be

uh you know uh used as underline asset

for future let's say

cabbage even uh

dollar and and uh po

p

200 uh what

else

Pok and yeah and even like uh

commodity o yeah whatever

yeah you name uh whatever uh in theory

that could be you know underline asset

for

future and future uh contract exchange

traded

product exchange trading product means

it it's a different from and O

product so future is uh traded in The

Exchange Market rather than OTC market

and several specification I needed to

Define uh first one is what can be

delivered this should be specified in

future contract and where it can be uh

delivered such as commodity case there

are certain uh you know description on

delivery uh price and when can it can be

delivered like uh delivered in uh three

months delivered in 6 months or you know

deliver in one year such as and the

final uh the in know future uh f a

t on uh future

on yeah let me change like uh final uh

you know characteristic on future is

settle

daily which means like you gain uh you

know uh today and you receive today and

you lo you are make a loss today and uh

uh you uh pay out your loss today that

is s

daily

and converence of future uh to uh

spot uh

now this is spot

price time let's say one o

of

gold and this is a future price on on

one of

go

here you know we just like like let's

say uh uh the future a has

one sorry one year

maturity okay let's say this is one

year this and now you know we are

starting so uh future price on one o of

gold and also a spot price on o of gold

one o of gold it may uh you know may uh

may be different such

as and the future price uh you know

greater than uh spot price and then uh

change uh World while and Final point in

uh at one

year future price and spot price they

should be the

same have to be same

otherwise it you know it can uh you know

gave us some arit

opportunity and this this uh uh uh may

happen and uh right one this one inverse

like a future price is lower than a spot

price this can be possible yes this can

be possible and we also observe such a

uh behavior in the you know future or

Market because you know let's say uh

commodity let's say

cabbage uh now we uh now we don't have

you know much cavage that's why spot

price cavage is uh you know for one C

let's say

1,000

$1,000 and uh this one uh future price

is price of

what price

of

cabbage price

cabage that

is

deliv

sorry in one

year you don't have now

but people are

expecting

uh there are uh so much you know uh

supply of cabbage in one year then price

price uh you know they expect you know

price go down so future price uh can be

uh you know trade it uh lower than uh

spot price it can happen in the future

Market

but it doesn't matter you know uh future

price lower than uh spot but the final

point in maturity future price and spot

price they should be identical they must

be

identical okay margin what is margin now

we are talking about the future price

future is uh uh you know the future is

traded in in The Exchange Market so uh

that is margin uh requirement between

investor and the broker now you are

investor so you like to buy or

sell

through

broke finally Exchange Market such as

KX

yeah you're pricing order but the order

uh you know will be uh sent through

broker to KX

now this margin

requirement between investor and broker

this

part Marin com so Mar is cash or

marketable

Securities uh deposited by an investor

with his or her broker all right the

balance in the margin account is assed

to reflect daily uh sment let me show

you uh you know what it is and the

margin minimize the possibility of a

loss through a default on

contract this uh in uh uh margin

requirement uh should remove any uh pass

any loss from potential uh default on a

contract and retailing Trader provide

initial margin and when the balance in

the margin account Falls below

maintenance margin level we must provide

varation margin bringing bringing

balance back up to the initial margin

level well you know uh you know sentence

is not that uh clear but uh uh we can uh

you know go through the margin mechanism

uh between initial margin and

maintenance

margin all

right example of a future uh

trait retail investor takes a long

position long position means uh buy a

future in December

two this is maturity December two gold

future

contract and contract size one contract

SI is 100 of

gold

and future price is is USD in dollar

1250 po

po the value is contract uh value

is 100

times yeah this is contract value and

number of contract uh investor uh take a

buy like two contract two contract which

means against like 200 o of

gold and let's let's suppose initial

margin requirement

is

$6,000 per contract per contract

right per contract

means two

contract

right to

contract so one contract requires

$6,000 as a initial margin initial

margin the total

12,000 and maintenance margin we

suppose

$4,500 per contract so total

9,000 dollar based on this you know

example uh we see how you know a margin

uh

requirement is working uh around like a

future yeah this is possible outcome

now uh now the trade price

1250 this is starting uh

price and

uh this is end

price which

means price went

down from 12 1250 to

1241 so long I investor I will make a

loss or I will make a

gain will make a loss how

much

1,00 how you know we arrive to 1,00 loss

let's

say

1241

minus 50

times

what

20000s of

gold how

much yeah

1,00 yeah

loss uh or code to you know uh long uh

you know position

taker so again

minus

800 so margin initial margin you

deposited uh

12,000

now you paid

out your loss which

means your

margin are reduced as much as loss

so you have

10,200 in your marginal

account and next day in a settle price

also uh went down and uh you are made

additional uh loss such as so uh total

is this amount and then you know this

money uh was uh left in your marginal

account so on

yeah because every day you know future

price uh you know change it so your uh

margin uh amount in your margin account

also change it and finally see this

part in the previous uh page I what was

the what is the maintenance margin see

$9,000 maintenance margin maintenance

margin

9,000 so

now yeah six

row

still uh you

have your

margin greater than maintenance margin

such as

$9,000 you know even though you made a

loss but the next

day 7

through you made again loss and the

final uh margin in your account less

than

$9,000 then what is the mechanism over

here once your margin is lower than

maintenance margin you need to top

up so that you

should maintain initial margin such as

so which

means yeah you margin in your

account and plus you need top up how

much

finally you have

12,000

s initial margin that this is a

mechanism

so between between uh initial

margin

and maintenance

margin

so your margin amount in your account

stay between initial margin and margin

mainten maintenance margin you don't do

anything you don't need top off however

once you know you know your margin in

your margin account goes below

maintenance margin Rebels you need to

top up you make you go back to like uh

you know