Chapter 23 Swap Contracts, Convertible Securities, and Other Embedded
21.1 A N O VERVIEW OF F ORWARD AND F UTURES T RADING
Historically, forward contracts are agreements negotiated directly between two parties in the OTC (i.e., nonexchange-traded) markets. A typical participant in a forward contract is a commercial or investment bank that, serving the role of the market maker, is contacted directly by the customer.
Forward contracts can be tailored to the specific needs of the ultimate end user. Futures contract- ing, on the other hand, is somewhat more complicated. An investor wishing either to buy or to sell in the futures market gives his order to a broker (afutures commission merchant), who then passes it to a trader on the floor of an exchange (thetrading pit) or through an electronic trading network. After a trade has been agreed on, details of the deal are passed to theexchange clearing- house, which catalogs the transaction. The ultimate end users in a futures contract never deal with each other directly, but transact with the clearinghouse, which is also responsible for over- seeing the delivery process, settling daily gains and losses, and guaranteeing the overall transac- tion. Exhibit 21.1 highlights the differences in how these contracts are created.1
As an example, consider the agricultural commodity futures that have been traded for more than 160 years beginning with the creation of the Chicago Board of Trade (CBT), the world’s oldest derivatives exchange. Futures contracts based on a wide array of commodities and
Exhibit 21.1H i s t o r i c a l F o r w a r d a n d F u t u r e s T r a d i n g M e c h a n i c s
Customer (Long)
A. Forward Contracts
Market Maker
Customer (Short)
Brokerage Firm
Brokerage Firm
Exchange Clearinghouse
• Guarantor
• Oversees Delivery
• Bookkeeper
• Settlement Treasurer B. Futures Contracts
Customer (Long)
Customer (Short)
Pit Traders/
Computer Network
1For a more detailed discussion of the historical futures trading process, see Clarke (1992); some of this discussion is based on his book.
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securities have been created and now trade on over 100 exchanges worldwide. Exhibit 21.2 lists the leading futures exchanges in the United States and the world, ranked by trading volume.
Notice that three of the top ten exchanges in the world are located in the United States.
Additionally, Exhibit 21.3 shows price and trade activity data for a representative sample of com- modity futures contracts; financial futures will be described in detail later in the chapter. Each of these commodity contracts is standardized in terms of the amount and type of the commodity involved and the available dates on which it can be delivered. As we will see, this standardization can lead to an important source of risk that may not exist in forward contracts.
21.1.1 Futures Contract Mechanics
To interpret the display in Exhibit 21.3, consider the gold futures contract traded on the Commod- ity Exchange (CMX), a division of the CME Group, on March 2, 2011. Each contract calls for the long position to buy, and the short position to sell, 100 troy ounces of gold in the appointed months. With commodity futures, it usually is the case that delivery can take place any time during the month at the discretion of the short position. Contracts are available with settlement dates ev- ery other month for the next five years, although only the next two contracts are shown. An inves- tor committing on this particular date to a long position in the June 2011 contract is obligated to buy 100 ounces of gold four months later for the contract price of $1,432.10 per ounce. Open interest—the total number of outstanding contracts—was 68,083 for this expiration date.2
Exhibit 21.2L e a d i n g F u t u r e s E x c h a n g e s b y T r a d i n g V o l u m e ( M i l l i o n s o f C o n t r a c t s )
A. U.S. Futures Exchanges (January–June 2010 Data)
Exchange Name & Abbreviation Trading Volume
CME Group: Chicago Mercantile (CME) 875.1
CME Group: Chicago Board of Trade (CBT) 443.3
CME Group: New York Mercantile Exchange (NYM) 252.9
ICE Futures U.S. (ICE) 54.9
B. International Futures Exchanges & Groups (January–June 2010 Data)
Exchange & Country Trading Volume
Korea Exchange, Korea 1,781.5
EUREX, Germany & Switzerland 1,485.5
National Stock Exchange, India 783.9
BM&FBovespa, Brazil 728.0
LIFFE, Belgium, France, Netherlands, UK, Portugal 723.2
Shanghai Futures Exchange, China 300.4
Russian Trading Systems Stock Exchange, Russia 280.8
Multi Commodity Exchange of India, India 246.1
Zhengzhou Commodity Exchange, China 226.7
Dalian Commodity Exchange, China 145.0
ICE Futures Europe 106.0
Source:Futures Industry Association, FI Online (September 2010). Reprinted with permission.
2New contracts are created when a new customer comes to the exchange at a time when no existing contract holder wishes to liquidate his position. On the other hand, if an existing customer wants to close out her short position and there is not a new customer to take her place, the contract price will be raised until an existing long position is en- ticed to sell back his agreement, thereby canceling the contract and reducing open interest by one.
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Exhibit 21.3C o m m o d i t y F u t u r e s Q u o t a t i o n s
Metal & Petroleum Futures
Contract Contract
Open High hi lo Low Settle Chg
Open
Interest Open High hi lo Low Settle Chg
Open Interest Copper-High (CMX)–25.000 lbs.; cents per lb. Cattle-Feeder (CME)–50,000 lbs.; cents per lb.
March 448.60 450.20 443.05 449.05 1.25 7,405 March 130.150 130.350 128.125 128.900 −1.175 11,226
May 449.95 452.50 444.85 450.95 1.30 97,904 Aug 132.750 133.400 131.300 132.200 −.900 12,650
Gold (CMX)–100 troy oz., $ per troy oz. Cattle-Live (CME)–40,000 lbs.; cents per lb.
March 1415.30 1434.40 1415.30 1450.70 21.40 180 April 112.975 113.350 111.350 111.400 −1.500 152,499
April 1411.60 1435.60 1409.80 1431.20 21.30 325,453 June 114.700 115.100 113.200 113.600 −1.050 102,468
June 1413.30 1437.10 1411.30 1432.70 21.40 68,083 Hogs-Lean (CME)–40,000 lbs.; cents per lb.
Aug 1415.50 1438.60 1415.40 1434.10 21.50 22,941 April 88.850 89.550 87.750 88.100 −.700 86,006
Dec 1417.00 1441.30 1417.00 1436.90 21.50 27,444 June 100.225 100.800 99.175 99.925 −.275 71,159
Dec’12 l446.00 1455.00 1445.80 1454.40 21.90 12,218 Pork Bellies (CME)–40,000 lbs.; cents per lb.
Platinum (NYM)–50 troy oz.; $ per troy oz. March … … … 116.500 … 1
March … … … 1845.10 35.90 15 Lumber (CME)–110,000 bd. ft., $ per 1,000 bd. ft.
April 1812.40 1846.70 1806.00 1845.10 35.90 35,814 March 291.10 292.60 285.10 288.00 −.90 1,560
Silver (CMX)–5,000 troy oz.; cots per troy oz. May 309.20 309.90 305.50 309.20 .80 5,756
March 3388.5 3469.0 3382.5 3441.6 61.2 2,833 Milk (CME)–200,00 lbs.; cents per lb.
May 3390.0 3472.0 3379.0 3442.7 60.7 84,753 Feb 17.05 17.10 17.05 17.80 .03 5,069
Crude Oil, Light Sweet (NYM)–1,000 bbls.; $ per bbl. March 19.16 19.48 19.16 19.44 .25 6,533
April 96.97 100.69 96.37 99.63 2.66 287,572 Cocoa (ICE-US)–10 metric tans; $ per ton.
May 98.64 102.43 98.07 101.40 2.76 208,207 March 3,755 3,755 3,578 3,660 −97 74
June 99.35 103.07 98.94 102.17 2.73 137,512 May 3,695 3,712 3,400 3,620 −75 74,119
July 100.09 103.51 100.00 102.75 2.64 76,035 Coffee (ICE-US)–37,500 lbs.; cents per lb.
Dec 101.39 104.42 101.01 103.92 2.45 183,080 March 273.70 274.90 265.55 269.30 −2.40 .687
Dec’12 100.10 102.12 99.89 101.80 1.73 129,747
May 271.90 275.10 265.55 269.30 −2.40 78,169
Heating Oil No.2 (NYM)–42,000 gal,; $ per gal. Sugar-World (ICE-US)–112,000 lbs.; cents per lb.
April 2.9357 3.0572 2.9315 3.0235 .0846 97,386 May 29.45 29.45 28.58 29.26 −.19 235,653
June 2.9696 3.0787 2.9673 3.0504 .0808 46,004 July 27.15 27.15 26.39 26.93 −.33 171,840
Gasoline-NY RBOB (NYM)–42,000 gal.; $ per gal. Sugar-Domestic (ICE-US)–112,000 lbs.; cents per lb.
April 2.8944 3.0179 2.8900 2.9834 .0907 90,944 May 39.50 39.50 39.50 39.69 −.23 1,644
May 2.970 3.0250 2.9070 2.9962 .0871 58,135 Jan’12 35.50 35.50 35.50 35.99 … 1,586
Natural Gas (NYM)–10,000 MMBtu.; $ per MMBtu. Cotton (ICE-US)–50,000 lbs.; cents per lb.
April 4.050 4.056 3.854 3.873 −.164 215,596 March 205.77 209.50 190.00 195.87 −9.27 412
May 4.122 4.123 3.931 3.950 −.160 224,583 May 198.23 198.23 191.57 193.60 2.37 71,607
June 4.173 4.182 3.999 4.015 −.158 75,336 Orange Juice (ICE-US)–15,000 lbs.; cents per lb.
July 4.241 4.242 4.067 4.084 −.151 62,371 March 180.95 182.15 180.00 180.65 .70 2,027
Oct 4.329 4.329 4.165 4.176 −.146 73,537 May 174.65 176.45 173.70 175.25 .60 23,954
Jan’12 4.902 4.912 4.766 4.782 −.123 57,961
Agriculture Futures
Corn (CBT)–5,000 bu.; cents per bu.
March 722.00 727.75 717.25 727.25 4.75 34,712
May 730.50 736.25 725.25 735.50 4.50 726,111
Ethanol (CBT)–29,000 gal.; $ per gal.
March 2.620 2.620 2.5830 2.595 .003 319
July 2.582 2.594 2.575 2.588 .008 1,237
Oats (CBT)–5,000 bu.; cents per bu.
March 369.25 369.25 365.00 380.00 8.75 126
May 379.75 389.50 373.75 389.50 8.50 8,935
Soybeans (CBT)–5,000 bu.; cents per bu.
March 1360.00 1369.00 1347.25 1367.50 10.25 15,315
May 1368.00 1376.50 1353.75 1375.25 10.50 250,970
Soybean Meal (CBT)–100 tons; $ per ton.
March 356.40 359.50 351.40 358.00 1.60 6,689
May 361.80 364.00 356.60 363.40 1.50 92,033
Soybean Oil (CBT)–60,000 lbs.; cents per lb.
March 56.80 57.23 56.57 57.07 .30 10,964
May 57.30 57.81 57.04 57.60 .27 177,152
Rough Rice(CBT)–2,000cwt.; cents per cwt.
March 1394.00 1400.00 1382.00 1385.00 … 872
May 1427.50 1441.50 1411.00 1417.00 −4.00 16,403
Wheat (CBT)–5,000 bu,: tents per bu.
March 784.50 784.75 766.00 775.75 −6.75 3,495
May 819.50 823.25 797.25 810.25 −6.75 200,452
Wheat (KC)–5,000 bu.; cents per bu.
March 902.00 907.00 886.00 902.00 −.50 2,364
May 915.00 918.00 895.75 912.00 −.50 89,350
Wheat (MPL5)–5,000 bu.; cents per bu.
March 929.50 936.25 926.25 931.50 .75 437
May 943.00 948.25 928.00 939.50 −1.50 23,479
Source:Reprinted with permission ofThe Wall Street Journal, March 2, 2011. Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved Worldwide.
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Another important difference between forward and futures contracts is how the two types of agreements account for the possibility that a counterparty will fail to honor its obligation.
Forward contracts may not require either counterparty to post collateral, in which case each is exposed to the potential default of the other during the entire life of the contract. In con- trast, the futures exchange requires each customer to post an initialmargin account in the form of cash or government securities when the contract is originated. (The futures exchange, as a well-capitalized corporation, does not post collateral to protect customers from its poten- tial default.) This margin account is then adjusted, or marked to market, at the end of each trading day, according to that day’s price movements. All outstanding positions are adjusted to thesettlement price, which is set by the exchange after trading ends to reflect the midpoint of the closing price range.
The marked-to-market process effectively credits or debits each customer’s margin account for daily trading gains or losses as if the customer had closed out her position, even though the contract remains open. For example, Exhibit 21.3 indicates that the settlement price of the March 2011 gold contract increased by $21.40 per ounce from the previous trading day. This price increase benefits the holder of a long position by $2,140 (= 21.40 per ounce × 100 ounces).
Specifically, if she had entered into the contract yesterday, she would have a commitment to buy gold for $1,411.30, which she could now sell for $1,432.70. Accordingly, her margin account will be increased by $2,140. Conversely, any party who is short February gold futures will have his margin account reduced by $2,140 per contract. To ensure that the exchange always has enough protection, collateral accounts are not allowed to fall below a predeterminedmaintenance level, typically about 75 percent of the initial level. If this $2,140 adjustment reduced the short posi- tion’s account beneath the maintenance margin, he would receive amargin calland be required to restore the account to its full initial level or face involuntary liquidation.
21.1.2 Comparing Forward and Futures Contracts
To summarize, the main trade-off historically between forward and futures contracts isdesign flexibilityversuscredit and liquidity risks, as highlighted by the following comparison:
F u t u r e s F o r w a r d s
Design flexibility: Standardized Can be customized Credit risk: Clearinghouse risk Counterparty risk Liquidity risk: Depends on trading Negotiated exit
These differences represent extremes; some forward contracts are quite standard and liquid, while some futures contracts now allow for greater flexibility in the terms of the agreement.
Also, forwards have historically required less managerial oversight and intervention—especially on a daily basis—because of the lump-sum settlement at delivery (i.e., no margin accounts or marked-to-market settlement), a feature that is often important to unsophisticated or infre- quent users of these products.
One interesting development that resulted from the global capital market decline in 2008–2009 was the increased scrutiny that OTC derivatives received from regulators. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was adopted by the U.S. Congress in 2010, contains several provisions that change the nature of the way some OTC derivatives can be created and traded. In particular, the Act (1) provides the Security Ex- change Commission (SEC) and Commodity Futures Trading Commission (CFTC) with the authority to regulate OTC derivative transactions in an attempt to create more transparency in the financial system, and (2) requires central clearing and exchange trading for derivative positions that can be cleared. Thus, under these new statutes, it is likely that forward contracts will begin to look more like futures contracts in form and function, which will reduce signifi- cantly the differences implied by the preceding trade-off comparison.
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