The futures market (part 3)

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The Futures market (part3)

In the last editorial I said:  I will today describe the difference between hedging and speculating in the futures market.

In part 3 I will describe the main features of a futures market.  First thing first.  Futures are exchanged traded contracts.  They are standardised, so all participants know exactly the size of the contract, the delivery date, and all the information that make up the contract.

A futures contract will need to specify the following (the elements of the standard)

  • Whether you are a buyer or a seller, you will therefore state if you are buying or selling
  • What commodity, or instrument you are entering into
  • The delivery month
  • Any price restrictions that you wish your order to have (a market order or a limit order)
  • A time limit for the execution of the order

The order is then matched between you (the buyer) and the opposite side (the seller), you will be a seller and the opposite side a buyer if you are going the other way. If your order is first in line, your order will be executed first.  If you are not, you will need to wait until all the orders before you get filled.

Let us take an example where you will enter a 10 year treasury bond futures contract.  The transaction is completed when the electronic trading system matches the bid (buy) with the offer (sell).  The price of the transaction is based on the yield of the contract.  The contract is quoted as an index figure (100 minus the yield0.  The treasury bond futures contract is quoted to three decimal places. If you entered into a contract at a yield of 7.25% per annum, the contract will be quoted as 92.750.

If the contract is to be closed later when the yield is 6.5%, we will calculate the difference between 92.750 and 93.500 and the transaction is in profit.

Tomorrow I will talk about margins taken in futures contracts