ACCA AFM Syllabus E. Treasury And Advanced Risk Management Techniques - Futures - Notes ^{4 / 5}

Ticks

A tick is the minimum price movement permitted by the exchange on which the future contract is traded. 

Ticks are used to determine the profit or loss on the futures contract. 

The significance of the tick is that every one tick movement in price has the same money value.

Example 1

If the price of a sterling futures contract changes from $1.3523 to $1.3555, then price has risen by $0.0032 or 32 ticks.

If you entered/bought into 50 contracts the profit on the futures contract will be calculated as:

Number of contracts x ticks x tick value
50 x 32 x $6.25 = $10,000

Ticks are used to calculate the value of a change in price to someone with a long or a short position in futures.

If someone has a long position, a rise in the price of the future represents a profit, and a fall in price represents a loss.

If someone has a short position, a rise in the price of the future represents a loss, and a fall represents a profit.

Margins

When a deal has been made both buyer and seller are required to pay margin to the clearing house. 

This sum of money must be deposited and maintained in order to provide protection to both parties.

• Initial margin

  Initial margin is the sum deposited when the contract is first made.

  This is to protect against any possible losses on the first day of trading. 

  The value of the initial margin depends on the future market, risk of default and volatility of interest rates and exchange rates.

• Variation margin

  Variation margin is payable or receivable to reflect the day-to-day profits or losses made on the futures contract. 

  If the future price moves adversely a payment must be made to the clearing house, whilst if the future price moves favourably variation margin will be received from the clearing house. 

  This process of realising profits or loss on a daily basis is known as “marking to market”.

  This implies that margin account is maintained at the initial margin as any daily profit or loss will be received or paid the following morning. 

  Default in variation margins will result in the closure of the futures contract in order to protect the clearing house from the possibility of the party providing cash to cover accumulating losses.

Example 2

Required:

Calculate the cash flow if the future price moves to in day one $1.3700 and 1.3450 day two (variation margin). Assume a short position.

Solution 2

1. Day One

   Selling price 1.3545
   Buying price 1.3700
   Loss 0.0155 = 155 ticks

   Variation margin = payment of the loss 
   = 155 x 50 x $6.25 = $48,437

2. Day 2

   Selling price 1.3700 
   Buying price 1.3450 
   Profit 0.025  = 250 ticks

   Variation margin = receipt of the profit
   = 250 x 50 x $6.25 = $78,125

Basis and basis risk

Basis is the difference between the futures price and the current cash market price of the underlying security. 

In the case of exchange rates, basis is the difference between the current market price of a future and the current spot rate of the currency. 

At final settlement date itself, the futures price and the market price of the underlying item ought to be the same otherwise speculators would be able to make an instant profit by trading between the futures market and spot cash market.

Most futures positions are closed out before the contract reaches final settlement, hence a difference between the close out future price and the current market price of the underlying item.

Basis risk may arise from the fact that the price of the futures contract may not move as expected in relation to the value of the underlying item which is being hedged.

Futures hedge

Hedging with a future contract means that any profit or loss on the underlying item will be offset by any loss or profit made on the future contract. 

A perfect hedge is unlikely because of:

• Basis risk.

• The “round sum” nature of futures contracts, which can only be bought or sold in whole number.