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3.4. An example

The above definitional section may be rendered more meaningful if an example of a futures transaction is introduced at this stage (see Box 1). This is an actual deal supplied by an exchange [the Johannesburg Securities Exchange (JSE); hence the use of the currency ZAR, reduced to "R", in the example] (names are fictitious in the interests of confidentiality).

Member (of the exchange) ABCM bought one Dec 2012 ALSI futures contract at the price 29490. It is a notional contract with the underlying "asset" being the ALSI index, and it expires at 12 noon on 1 December 2012. It can therefore not be delivered by the seller to the buyer and will be settled in cash. The counterparty (seller) to the deal is member (of the exchange) PQRM: he sold the contract at price 29490. Both parties dealt 29490, i.e. the agreed price (i.e. the price at which willing buyer and willing seller were prepared to deal), which is the "trading" (or market) price of the ALSI at the time (let's assume 10 am) on the date of purchase / sale (let's assume 3 January 2012). (Note that the trading / market price is different, but related, to the actual index value.) If these were naked positions (i.e. not hedged), they indicated:

• The buyer expected the ALSI to increase.

• The seller expected the ALSI to decline.

example of futures deal

Box 1: example of futures deal

At 3 pm on 3 January 2012 both parties "closed out" their positions at the trading price of the future: 29510. Members ABCM and PQRM each did an equal and opposite trade to their original trade, and therefore made a profit or a loss. This indicates an important point on the nature of the futures market (and indeed of the derivatives market in general): it is a zero-sum market: for every buyer there is a seller (in equal amounts) and for every profit there is an equal-sized loss.

Thus, in the above example member ABCM made a profit of R20, while member PQRM made a loss of R20. Note that this assumes the "nominal" is 1 (we did this to keep it simple). In reality the nominal is 10, i.e. the contract size / value = 10 x the market prices dealt at. Thus, when the trade was opened, both parties had an exposure to the ALSI market of 10 x R29 490 = R290 490, and when the trade was closed out the profit / loss was R200.

It is a feature of futures markets that no money changes hands when a deal is struck. However, both buyer and seller are required to make a "good faith" deposit - termed the "margin" (note: this was the origin of the margin, but it is now part of the risk management procedures of the exchange). This deposit is made with the broker who, in turn, passes it on to the exchange.

In conclusion, it is important to again point out that the exchange interposes itself between the buyer and the seller and guarantees the transaction. For each buy-deal the exchange creates a sell-deal, and for the opposite deal (the sell-deal) the exchange creates a buy-deal. Thus, the counterparty to each leg of a deal is the exchange.

3.5. Futures trading price versus spot price

It should be clear at this stage that buyers and sellers of futures contracts trade at the market prices for the relevant futures, i.e. at the prices established in the market by the interplay of supply of and demand for the futures contracts. It is also apparent that these prices are different from the spot prices of the underlying assets, but that the prices of futures are closely related to the spot prices of the underlying assets. An example is required.

The example in the Figure 2 depicts the life of a three-month future (assume it is a share index future) created on 31 March and expiring on 30 June. It will be evident that the buyer of the future on 31 March who holds it to expiry on 30 June profits (and the seller loses of course). She bought the future at 110 when the spot price was 100 and it "closed out" at 132. Similarly, the buyer of the future on 30 April at 122 (when the spot price was 112) also profits, but to a lesser extent. The buyer of the future on 31 May at 138 (when the spot price was 124), held to expiry, however, makes a loss because the futures price declined to 132 on expiry date (= spot price).

example of a 3-month future (index)

Figure 2: example of a 3-month future (index)

As noted earlier, the price of a future always converges upon the spot (cash market) price as the expiry date gets closer. The reason is that the so-called basis (which is similar to net carry cost - see below) becomes smaller with the passage of time. On expiry date the basis (and net carry cost) is zero.

Table 1 tracks the life of a fictitious March 2011 All Share Index (ALSI) future as at month-ends. As noted above, "spot" refers to the value of the index on the particular dates, while market rate refers to the price for the future established in the market, i.e. the price at which the future traded on the relevant dates. This is also illustrated in the Figure 3.

It can be seen that the future traded above the spot price for the entire life of the contract. This is not always the case, however. At times the future can trade at a discount to the spot price. Also clear from the above is that the difference between the two prices is not consistent. This is because expectations play a major role in the determination of the futures price.

Value of index (spot rate)

Market rate (price / value) of future (mark-to-market)

2009

March

13535

13665

April

13733

13860

May

13992

14120

June

14054

14223

July

14177

14525

August

14011

14282

September

13792

14030

October

13916

14252

November

14183

14425

December

14889

15415

2010

January

14754

15262

February

14846

15235

March

14939

15185

April

15357

15870

May

15396

15865

June

15404

15515

July

15651

15865

August

15833

15948

September

15676

15712

October

15724

15862

November

15756

15840

2011

December

15860

15965

January

15054

15165

February

15147

15173

March (15th)

Table 1: March 2011 all share index futures contract

Two examples may be useful (the numbers are from the Table 1):

• A buyer of 10 contracts (one contract = LCC10 x market price) of the March 2011 ALSI on 30 April 2009 would have "bought" an exposure in the share market (ALSI) to the value of LCC1 386 000 (10 x LCC10 x 13860). If this position were held until "close out", i.e. 15 March 2011, the buyer would have profited to the extent of LCC141 700 [LCC1 527 700 (10 x LCC10 x 15277) - LCC1 386 000]. The seller of the contract would of course have lost this amount (if she held the contract until expiry).

• A buyer of the 10 contracts on 30 July 2010 would have bought exposure to the ALSI of LCC1 586 500 (10 x LCC10 x 15865). If she held the future until expiry, she would have made a loss LCC58 800 [LCC1 527 700 (10 x LCC10 x 15277) - LCC1 586 500].

March 2011 all share index (ALSI) future

Figure 3: March 2011 all share index (ALSI) future

 
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