Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in their margin account. Currently, margin is either determined on a trade by trade basis or is allocated within a business unit and often after the fact. Learn more about analyst research. Futures traders are traditionally placed in one of two groups: Assuming interest rates are constant the forward price of the futures is equal to the forward price of the forward contract with the same strike and maturity.
Futures Exchange-Traded Funds Futures-based ETFs: These invest in commodity futures contracts, and the requirements associated with futures (margin, expiry, etc.), but wish to benefit from.
If the margin account goes below a certain value set by the exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value since any gain or loss has already been previously settled by marking to market. Upon marketing, the strike price is often reached and creates lots of income for the "caller.
Unlike use of the term margin in equities, this performance bond is not a partial payment used to purchase a security, but simply a good-faith deposit held to cover the day-to-day obligations of maintaining the position. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss.
This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position. Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts.
Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers. Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts.
Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin. Initial margin is the equity required to initiate a futures position.
This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin.
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities' Initial Margin which is set by the Federal Reserve in the U. A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in their margin account. Margin-equity ratio is a term used by speculators , representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower.
A trader, of course, can set it above that, if he does not want to be subject to margin calls. Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract.
Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit. Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:. Expiry or Expiration in the U. For many equity index and Interest rate future contracts as well as for most equity options , this happens on the third Friday of certain trading months.
This is an exciting time for arbitrage desks, which try to make quick profits during the short period perhaps 30 minutes during which the underlying cash price and the futures price sometimes struggle to converge.
At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions.
On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour. When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. This is typical for stock index futures , treasury bond futures , and futures on physical commodities when they are in supply e.
However, when the deliverable commodity is not in plentiful supply or when it does not yet exist — for example on crops before the harvest or on Eurodollar Futures or Federal funds rate futures in which the supposed underlying instrument is to be created upon the delivery date — the futures price cannot be fixed by arbitrage.
In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.
Arbitrage arguments " rational pricing " apply when the deliverable asset exists in plentiful supply, or may be freely created. Here, the forward price represents the expected future value of the underlying discounted at the risk free rate —as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away.
We define the forward price to be the strike K such that the contract has 0 value at the present time. Assuming interest rates are constant the forward price of the futures is equal to the forward price of the forward contract with the same strike and maturity.
It is also the same if the underlying asset is uncorrelated with interest rates. Otherwise the difference between the forward price on the futures futures price and forward price on the asset, is proportional to the covariance between the underlying asset price and interest rates.
For example, a futures on a zero coupon bond will have a futures price lower than the forward price. This is called the futures "convexity correction. This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields. In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections transaction costs, differential borrowing and lending rates, restrictions on short selling that prevent complete arbitrage.
Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price. When the deliverable commodity is not in plentiful supply or when it does not yet exist rational pricing cannot be applied, as the arbitrage mechanism is not applicable.
Here the price of the futures is determined by today's supply and demand for the underlying asset in the future. In a deep and liquid market, supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship. By contrast, in a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants an illegal action known as cornering the market , the market clearing price for the futures may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.
The expectation based relationship will also hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity. The situation where the price of a commodity for future delivery is higher than the spot price , or where a far future delivery price is higher than a nearer future delivery, is known as contango.
The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation.
There are many different kinds of futures contracts, reflecting the many different kinds of "tradable" assets about which the contract may be based such as commodities, securities such as single-stock futures , currencies or intangibles such as interest rates and indexes.
For information on futures markets in specific underlying commodity markets , follow the links. For a list of tradable commodities futures contracts, see List of traded commodities. See also the futures exchange article. Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs.
Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery also called spot or cash market or for forward delivery.
These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such as grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.
Contracts on financial instruments were introduced in the s by the Chicago Mercantile Exchange CME and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in now Euronext. Today, there are more than 90 futures and futures options exchanges worldwide trading to include:.
Most futures contracts codes are five characters. The first two characters identify the contract type, the third character identifies the month and the last two characters identify the year. Futures traders are traditionally placed in one of two groups: In other words, the investor is seeking exposure to the asset in a long futures or the opposite effect via a short futures contract.
Hedgers typically include producers and consumers of a commodity or the owner of an asset or assets subject to certain influences such as an interest rate. For example, in traditional commodity markets , farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed.
In modern financial markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap. Those that buy or sell commodity futures need to be careful. If a company buys contracts hedging against price increases, but in fact the market price of the commodity is substantially lower at time of delivery, they could find themselves disastrously non-competitive for example see: Speculators typically fall into three categories: With many investors pouring into the futures markets in recent years controversy has risen about whether speculators are responsible for increased volatility in commodities like oil, and experts are divided on the matter.
This gains the portfolio exposure to the index which is consistent with the fund or account investment objective without having to buy an appropriate proportion of each of the individual stocks just yet.
When it is economically feasible an efficient amount of shares of every individual position within the fund or account can be purchased , the portfolio manager can close the contract and make purchases of each individual stock.
The social utility of futures markets is considered to be mainly in the transfer of risk , and increased liquidity between traders with different risk and time preferences , from a hedger to a speculator, for example. In many cases, options are traded on futures, sometimes called simply "futures options". A put is the option to sell a futures contract, and a call is the option to buy a futures contract.
For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. Futures are often used since they are delta one instruments. Calls and options on futures may be priced similarly to those on traded assets by using an extension of the Black-Scholes formula , namely the Black—Scholes model for futures. For options on futures, where the premium is not due until unwound, the positions are commonly referred to as a fution , as they act like options, however, they settle like futures.
Investors can either take on the role of option seller or "writer" or the option buyer. Futures ETFs are primarily commodity products that include oil, natural gas, agricultural products, and precious metals like gold, silver, platinum, and palladium. Here are a few examples Futures ETFs:. More varieties are available to investors looking for exposure in higher proportions through leveraged ETFs two times, three times or inverse. Futures ETFs offer an additional security class for individual investors to add diversification to their holdings.
Commodity ETFs provide an efficient mode of investing and trading commodities and come in three flavors: Such funds invest directly in physical commodities like gold, crude oil, or grains, while bearing the additional cost of transport, storage, and security.
Such ETFs avoid the hassles of commodity storage and operational issues. However, they carry stock-specific and overall market risks. These invest in commodity futures contracts , along with a pre-selected portfolio of money market instruments.
Such futures-based ETFs never take possession of the physical commodity, but keep the capital moving from one basket of futures contracts to another. Since futures have expiry dates, futures rollover is an integral part of the business. We are going to focus on this last type of commodity ETF. Futures ETFs Almost all commodity-based futures ETFs have capital invested in futures contracts, with a smaller portion going into a portfolio of money market securities.
Here are the different streams that contribute to returns for an ETF: The surplus capital including those sourced from margin receivables gets invested in short- to mid-term money market instruments that earn applicable secure interest rates, leading to money market yields. The movement in underlying spot price of the commodity will generate intrinsic returns for the ETF. Positive return is available during the rollover cycle due to backwardation effect explained in next section.
Since futures ETF hold futures contracts that are bound by expiry dates, they need to rollover to new contracts as existing ones come to expiry. If a futures price is lower than the spot price the backwardation effect , the ETF benefits by purchasing lower-priced long-dated futures contracts during the time of rollover.
The price of existing futures, which are about to expire and are to be sold, becomes similar to those of spot prices. This leads to squaring off existing positions at near about spot at-par prices, and taking new long-term contracts at lower prices.
Commodities are considered to be a good option to hedge against inflation. Futures ETFs offer investors another alternative for investments beyond the traditional assets like stocks and bonds and funds based on them. As ETFs offer the best of both money management of funds and real-time trading, they let investors add commodity exposure to their portfolios without the hassles of daily price tracking and trading expertise.
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CFA Level 1 - Futures Markets Margin. Learn how investors use margin accounts to create more leverage. Exchange Traded Options; Interest Rate Options vs. FRAs; Futures (which. Variation margin is the payment made on a daily or intraday basis by a clearing member based on price movement in positions carried by the customer. Equity-style Margin. Futures-style margin options behave in a manner somewhat analogous to that of a futures contract. The trade of the option itself does not result in any cash flow as the. Margin collateral reflecting the maximum expected fluctuations of the underlying is required for both options and futures. The required margin is called initial margin because it needs to be put up before (inital) entering into a position.