3w FinEcon 2024fall v1
Summary
TLDRThe 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
- π The session discusses the concepts of Futures, central counterparty (CCP), and OTC markets, focusing on how derivatives are settled.
- π‘οΈ 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.
- βοΈ Theoretical futures pricing is based on the relationship between the spot price and borrowing costs over time.
- π Futures prices and spot prices converge at the time of contract maturity, despite potential differences during the contract period.
- π Margin requirements are essential in futures trading, with initial margin and maintenance margin protecting against potential losses.
- πΈ 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.
- π 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.
- π° Margin accounts adjust daily, reflecting gains or losses from futures price changes.
- π¦ Futures contracts can be traded on exchanges with underlying assets like commodities (gold, cabbage) or financial instruments.
- π 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 traderβs 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
π 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.
π 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.
π° 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.
π¦ 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.
π 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.
π 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.
Mindmap
Keywords
π‘Futures Market
π‘Central Counterparties (CCPs)
π‘Spot Price
π‘Future Price
π‘Funding Cost
π‘Risk-Free Rate
π‘Arbitrage Opportunity
π‘Margin Requirement
π‘Initial Margin
π‘Maintenance Margin
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
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