A futures contract is an agreement to make delivery (to sell) or to take delivery (to buy) a specified amount and specific grade or quality of a commodity at a set price at a future date.
<ul>
	<li>For example, you’ve header of Treasury futures, gold and silver futures, corn futures, pork bellies, etc.</li>
</ul>
<ul>
	<li>Futures contracts are basically used for two broad purposes:
<ul>
	<li>Hedging</li>
	<li>Speculating</li>
</ul>
</li>
</ul>
<ul>
	<li>Hedging is taking a temporary position in the futures market to offset a cash market position in order to minimize loss due to price fluctuation.
<ul>
	<li>This risk transfer mechanism allows hedgers to control costs and protect their profit margins.</li>
	<li>The parallel movement (in opposite directions), will not exact, is close enough to make it possible to minimize risk by hedging.</li>
	<li>Hedging is the primary justification of the futures market.</li>
</ul>
</li>
	<li>Speculators assume the risk transferred to them by the hedgers.
<ul>
	<li>Motive to profit.</li>
	<li>They provide an essential element to market-place and that is liquidity.</li>
</ul>
</li>
</ul>
<h3>How futures work?</h3>
Futures contracts are standardized. All contract features are established. For example, in a US T-bond future, the yield, maturity, quantity, delivery dates, etc., are established.

The only negotiable variable is price, which is determined by open outcry on organized and regulated markets or electronically matched on systems.

When entering into a futures contract, you must post an initial margin, which is like a security deposit to ensure performance.
<ul>
	<li>Initial margin is generally 3% to 10% of the contract value.</li>
</ul>
<ul>
	<li>All futures contracts are marked to market, with gains and losses settled daily.</li>
</ul>
<ul>
	<li>If losses deplete the initial margin below a certain point, you may be required to post a variation margin to bring your deposit back up to the original predetermined level.</li>
</ul>
To enter into a futures contract, you would place an order (and margin deposit) with a brokerage house or futures commission merchant, who also posts margin with the exchange and executes the order on the exchange through a floor trader.

Foor traders give complete orders to clearing firms who are members of the exchange’s clearing house or clearing corporation.
<h3>Role of the clearing house</h3>
The clearing house provides several functions:
<ul>
	<li>It matches all orders and interposes itself between each buyer and seller, which guarantees the integrity and performance of all contracts.</li>
</ul>
<ul>
	<li>It balances its books to zero, settling all gains and losses. Each day begins with no money owed and no money due.</li>
</ul>
<ul>
	<li>It future positions are still open at expiration and physical delivery is to occur, the clearing house assigns delivery to the clearing member having the oldest position. For example, if a short position is open and the short seller indicates its intention to deliver a security rather than close out its contract, the clearing house will determine the buyer based on the oldest long position in that contract.</li>
</ul>

How Interest Rate Futures Work?

Treasury bond futures and Treasury note futures traded on the CBOT have the following standard features:

T-bonds deliverable grade

<ul>
	<li>US Treasury bonds with maturity (or call date) atleast 15 years from delivery date, with an 8% coupon</li>
	<li>Other T-bonds delivered are converted to the equivalent of the above</li>
</ul>
T-notes deliverable grade

US Treasury notes with a maturity of between 6-1/2 to 10 years from delivery date, with an 8% coupon.

Again, an equivalent amount of other T-notes may be delivered.

Other specifications

Other contract specifications which are the same for T-bond and T-note futures are:

Size: Size is $100,000 face value.

Price quotation: In points ($1,000) and thirty seconds of a point; for example, 92-16 equals 92-16/32.

Minimum price fluctuation: One thirty second of a point, or $31.25 (one tick) per contract.

Daily trading limits: Three points ($3,000) per contract above or below the previous day’s settlement price.

Months traded: March, June, September, and December

Last trading day: Seven business days prior to the last business day of the month.

Last delivery day: Last business day of the month.

Delivery method: Federal Reserve book entry wire transfer system.

Margin requirements: Initial margin $1,500 a contract; maintenance margin $1,000 a contract.

Features of T-bond Futures and T-note Futures

Options on interest rate futures have the following characteristics:
<ul>
	<li>The right, but not the obligation, to buy or sell a specific commodity or financial instrument at a specified price for a specified period or on a specified date.</li>
	<li>When hedging, purchased options provide “insurance” against adverse price movements but offer the flexibility to benefit from favourable price movements.</li>
	<li>Option sellers (or writers) receive a fixed premium upfront and in return are obligated to buy or sell the underlying item at specified prices if the option is exercised against the writer. Thus, option writers are exposed to unlimited liability.</li>
</ul>
There are two types of options:

Call option: Gives the buyer the right to buy a specific number of futures contracts at a pre-determined price within a specified period of time.

Put option: Gives the buyer the right to sell the futures contracts as described above.

For example, an investor may buy December T-bond calls with a strike price of 96. If the market price of December T-bond futures increase to 100, the call enables the option holder to purchase futures at 96 for a profit of four. If the market price falls to 90, the holder is not obligated to purchase the futures contracts and loses only the premium paid for the option.
<h3>How options on interest rate futures work?</h3>
The specific commodity underlying the option is identified. As we know, the exchange traded interest rate futures are standardized.

The strike price is determined.

The exercise period is determined.

The price or option premium is then determined on the exchange floor.

The buyer of the option may exercise the option on any business day prior to expiration by giving notice to the exchange. The notice is then randomly assigned to an option seller. However, most options are closed rather than exercised.
<h3>Standard contract features - Options on US Treasury bond and US Treasury note futures</h3>
Trading unit: $100,000 face amount of a futures contract of a specified delivery month

Price quotations: In points and 64ths of a point

Daily trading limits: Three points per contract above or below the previous day’s settlement price

Strike prices: Set in integral multiples of two points per futures contract to bracket the current futures price (i.e., if the futures price is 85, the strike prices would be 80, 82, 84, 86, 88, 90).

Months traded: March, June, September and December

Last trading day: The second to last Friday of the month prior to the delivery date of the underlying futures

How Options on Interest Rate Futures Work?

As we know, options on interest rate futures provide the right, but not the obligation, to buy or sell a specific number of futures contracts at a pre-determined price within a specified period of time.

We will now learn about some uses of these contracts:

Covered Call Writing

An investor holding T-bonds or T-notes whose concern is rising interest rates may wish to protect the value of an investment and also enhance the yield by selling calls. If the value of the investment decreases, the call will expire (worthless to the holder) and the option writer will keep the premium. The investment yield is enhanced is enhanced through receipt of premium. Alternatively, if the value of the T-notes increases, the option will be exercised and the writer will deliver their investment to the call option holder, producing a limited profit from the sale plus keeping the premium.

Hedging a Firm Commitment

A company expects to receive $5,000,000 on the sale of a asset which it wishes to invest in t-bonds. The company expects a decrease in interest rates before the money is received. The company purchases a T-bond futures call option, thereby fixing the maximum price to be paid for the futures contract. If rates do fall, the lower yield from investing the $5,000,000 can be offset by a gain on the futures contract.

Buying Puts

Investors can buy puts to protect against downside risk of holding interest sensitive assets. For example, if interest rates decline so the yield on interest sensitive assets also declines , gains from the put options can make up for this shortfall.

Selling Naked Puts

To capture premium (i.e., generate revenue) during a market that is relatively stable or declining modestly. This, however, exposes the writer to huge losses if the market turns against them.

Spreading

Relies on the premise that, given equal fluctuations, the price of long-term debt instruments will move more sharply than prices of intermediate-term debt; therefore, when prices are advancing, sell notes and but bonds and vice versa.

Benefits of Options on Futures Contracts
<ul>
	<li>A potentially large profit from a relatively small cash outlay (buyer).</li>
	<li>The buyer of an option knows in advance that the maximum loss that can be incurred is the price paid for the option, yet, upside potential is unlimited.</li>
	<li>An opportunity for writers of options to increase the income derived from their investments.</li>
	<li>The protection they offer against a possible decline in the market value of owned investments.</li>
	<li>Liquidity: Positions can be liquidated in the event of a change in the investor’s circumstances.</li>
</ul>
Downside of Options on Futures Contracts
<ul>
	<li>The premium is paid by the buyer up front and can be sizable.</li>
	<li>The writer has unlimited risk of loss.</li>
	<li>The seller of an option (if not covered) must post margin.</li>
</ul>

Options on Interest Rate Futures – Uses and Benefits

Forward Rate Agreements (FRA’s) are similar to over-the-counter futures contracts (but there is no margin) or single-period swaps.

One party contracts with another for a fixed rate that applies to a future period. The buyer receives a payment if market rates exceed the contract rate, but must pay the seller if market rates fall below the contract rate.

For example, hedging a six-month period, that will commence in three months from the contract date, is called a “three against nine” FRA, or 3x9 FRA. In three months, the payment is determined by comparing the contract rate to current market rates.

Unlike swaps and caps, where the payment is determined at the outset of each period but settled in arrears, FRA payments are discounted and paid at the beginning of the period.

The payment ends up compensating for any change in interest rates since the contract date.

FRA’s are generally used to lock in an interest rate for transactions that will take place in the future. For example, a bank that plans to issue or roll over certificates of deposit, but anticipates that interest rates are headed upward, can lock in today’s rate by purchasing FRA. If rates do rise, then the payment received on the FRA should offset the increased interest cost on the CDs. If rates fall, the bank pays out

Under the FRA but has a lower cost on its debt. In either case, the all-in cost of the CDs is relatively the same. The same example holds true for a corporation that plans to issue or roll over commercial paper.

The above example demonstrated how FRA’s were used to lock in an interest rate or debt cost. FRA’s can also be used to lock in the price of a short-term security to be taught or sold in the near future.
<ul>
	<li>If the investment is being purchased, you can hedge the risk that interest rates may fall (which would increase the price of the investment) by selling the FRA.</li>
	<li>If the investment is being sold, you can hedge against the risk of rates rising (which would depress the sales price of the security) by buying the FRA.</li>
</ul>
Benefits of FRAs
<ul>
	<li>Used similar to futures</li>
	<li>But, no margin and no daily settlements</li>
	<li>Flexible</li>
</ul>
Shortcomings of FRAs
<ul>
	<li>Credit risk of counterparty</li>
	<li>Short-term nature</li>
</ul>

Introduction to Forward Rate Agreements

When a futures trader takes a position (long or short) in a futures contract, he can settle the contract in three different ways.

Closeout: In this method, the futures trader closes out the futures contract even before the expiry. If he is long a futures contract, he can take a short position in the same contract. The long and the short position will be off-set and his margin account will be marked to marked and adjusted for P&amp;L. Similarly, if he is short a futures contract, he will take a long position in the same contract to closeout the position.

Physical Delivery: If the futures trader does not closeout the position before expiry, and keeps the position open and allows it to expire, then the futures contract will be settled by physical delivery or cash settlement (discussed below). This will depend on the contract specifications. In case of the physical delivery, the clearinghouse will select a counterparty for physical settlement (accept delivery) of the futures contract. Typically the counterpart selected will be the one with the oldest long position. So, at the expiry of the futures contract, the short position holder will deliver the underlying asset to the long position holder.

Cash Settlement: In case of cash settlement (in case the contract has expired), there is no need for physical delivery of the contract. Instead the contract can be cash-settled. This can be done only if the contract specifies so. If a contract can be cash settled, the trader need not closeout the position before expiry, He can just leave the position open. When the contract expires, his margin account will be marked-to market for P&amp;L on the final day of the contract. Cash settlement is a preferred option for most traders because of the savings in transaction costs.

Let's take an example to compare the working of the three methods.

Assume a trader buys a futures contract at $100.

<img class="aligncenter size-full wp-image-4044" title="Futures Contracts Settlement" src="https://financetrain.com/wp-content/uploads/2012/01/Screen-Shot-2012-01-10-at-12.22.38-PM.png" alt="" width="631" height="746" />

Settlement of Futures Contracts

Futures and Forwards

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Futures and Forwards

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