10.3 Futures Markets

Futures Markets

FMP–7 is the market microstructure and contract-design reading that makes later hedge-ratio math usable. If you cannot read a contract spec, explain convergence, or contrast mark-to-market futures with forward settlement, hedging vignettes become guesswork.

Contract Specifications

A futures contract is a standardized agreement to buy or sell an asset (or settle to a price) at a future date on exchange terms. Spec sheets typically fix:

Worked tick P&L

An equity-index futures multiplies by $50 per index point. Tick = 0.25 index points → tick value = 0.25 × $50 = $12.50 per contract. A long who gains 4.00 index points earns 4 × $50 = $200 per contract (before fees).

Convergence

As a contract approaches delivery (or final settlement), the futures price and the spot price of the deliverable (or the cash-settlement reference) are forced together by arbitrage. Otherwise traders would buy the cheap leg and sell the rich leg and hold to delivery/settlement.

Basis = Spot − Futures (some texts reverse the sign—always follow the definition in the question). For a physical delivery contract on the standard grade at the delivery location, basis tends toward zero at delivery. Cash-settled contracts converge to the agreed fixing (for example, an equity index settlement price), not necessarily to a single cash market quote if the index is a basket.

Frictions—storage, transportation, grade differences, delivery options—can leave small residual basis even near expiry.

Role of the Exchange

Exchanges (and their clearinghouses):

• Design and list contracts
• Provide a central limit order book or other matching
• Set margin parameters (often jointly with the CCP)
• Publish settlement prices for mark-to-market
• Enforce position limits and conduct rules

The exchange is a market organizer and rule-setter. Through the CCP, it becomes the legal counterparty chain—but economically, gains and losses still transfer between longs and shorts via VM. The exchange organization itself is not “taking the other side” as a proprietary directional bet when you buy a futures (except insofar as affiliated market-makers might).

Delivery Versus Cash Settlement

Physical delivery: short delivers the asset (or cheapest-to-deliver eligible grade); long pays and takes delivery. Most financial futures traders close out before delivery, but the delivery option disciplines pricing.

Cash settlement: no asset changes hands; final mark settles to a reference price (index, survey, auction). Common for equity indices, some interest-rate products, and weather/other underlyings that are hard to deliver.

Cheapest-to-deliver (CTD) options in bond futures create delivery optionality that affects the futures price relative to any single bond’s forward.

Order Types

Risk managers care because stops in illiquid markets can gap through triggers, realizing worse prices than the stop level—especially in overnight commodity sessions.

Marking to Market and Hedge Accounting

Futures are marked to market daily: VM is exchanged so the futures position’s carrying value resets near zero each day while cumulative P&L is realized in the margin account. That is a core difference from a classic forward, which often has a large unpaid MTM until expiry (unless collateralized).

Worked marking-to-market path

Long 1 gold futures (100 oz) at $2,000/oz. IM = $8,000.

Daily P&L day 1 = 100 × (2,010 − 2,000) = $1,000, and so on. Economically the trader is long gold; operationally cash flows daily.

Hedge accounting (under accounting standards such as IFRS 9 / ASC 815) can allow qualifying hedges to recognize futures gains/losses in a way that matches the hedged item’s accounting, reducing earnings volatility from hedges that are economically sound. FRM does not require accountant-level journal entries, but you should know why firms care: daily VM creates P&L noise versus accrual accounting on the underlying exposure unless hedge accounting (or economic explanation to stakeholders) bridges the gap.

Forwards Versus Futures

Pricing relationship (cost-of-carry intuition, investment asset):

F ≈ (S − I) e^(rT), where I is the present value of income (dividends/coupons) paid over the contract's life, or with a continuous yield q: F ≈ S e^((r − q)T)

For commodities the carry flips sign: storage is a cost, not income, so with PV of storage U the relation becomes F ≈ (S + U) e^(rT), or with continuous storage u and convenience yield y, F ≈ S e^((r + u − y)T). You need the intuition for exam comparisons: higher rates lift futures on investment assets; dividends/convenience yield pull futures down relative to spot.

Worked forward vs futures credit sketch

Two parties enter a 1-year forward on an equity index at forward price 5,000. After six months the mark is +$2 million to Party A. In an uncollateralized forward, A has $2 million counterparty exposure to B. An otherwise similar exchange futures would already have transferred much of that value through VM, leaving exposure dominated by IM shortfalls and gap risk—not a $2 million unpaid invoice.

Putting Futures Markets Together

Read the contract: size, tick, settlement month, delivery vs cash. Trace convergence as expiry nears. Map cash flows through daily settlement. Contrast with a bespoke forward that may fit the hedge better but reintroduces credit and liquidity frictions. That triad—spec, convergence, mark-to-market—is FMP–7’s core.