682 Part Eight Risk Management
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In addition, futures contracts are marked to market. This means that each day any profits or
losses on the contract are calculated; you pay the exchange any losses and receive any profits. For
example, suppose that in September Arctic Fuels buys one million gallons of January heating-
oil futures contracts at a futures price of $2.40 per gallon. The next day the price of the January
contract increases to $2.44 per gallon. Arctic now has a profit of $.04 × 1,000,000 = $40,000.
The exchange’s clearinghouse therefore pays $40,000 into Arctic’s margin account. If the price
then drops back to $2.42, Arctic’s margin account pays $20,000 back to the clearing house.
Of course Northern Refineries is in the opposite position. Suppose it sells one million gal-
lons of January heating-oil futures contracts at a futures price of $2.40 per gallon. If the price
increases to $2.44 cents per gallon, it loses $.04 × 1,000,000 = $40,000 and must pay this
amount into the clearinghouse. Notice that neither the distributor nor the refiner has to worry
about whether the other party will honor the other side of the bargain. The futures exchange
guarantees the contracts and protects itself by settling up profits or losses each day. Futures
trading eliminates counterparty risk.
Now consider what happens over the life of the futures contract. We’re assuming that Arc-
tic and Northern take offsetting long and short positions in the January contract (not directly
with each other, but with the exchange). Suppose that a severe cold snap pushes the spot price
of heating oil in January up to $2.60 per gallon. Then the futures price at the end of the con-
tract will also be $2.60 per gallon.^12 So Arctic gets a cumulative profit of (2.60 − 2.40) ×
1,000,000 = $200,000. It can take delivery of one million gallons, paying $2.60 per gallon,
or $2,600,000. Its net cost, counting the profits on the futures contract, is $2,600,000 −
200,000 = $2,400,000, or $2.40 per gallon. Thus it has locked in the $2.40 per gallon price
quoted in September when it first bought the futures contract. You can easily check that Arc-
tic’s net cost always ends up at $2.40 per gallon, regardless of the spot price and ending futures
price in January.(^12) Recall that the spot price is the price for immediate delivery. The futures contract also calls for immediate delivery when the contract
ends in January. Therefore, the ending price of a futures or forward contract must converge to the spot price at the end of the contract.
Future Exchange Future Exchange
U.S. Treasury bonds CBOT Euroyen deposits CME, SGX, TFX
U.S. Treasury notes CBOT
German government bonds (bunds) Eurex S&P 500 Index CME
Japanese government bonds (JGBs) CME, SGX, TSE French equity index (CAC) LIFFE
British government bonds (gilts) LIFFE German equity index (DAX) Eurex
U.S. Treasury bills CME Japanese equity index (Nikkei) CME, OSE, SGX
U.K. equity index (FTSE) LIFFE
LIBOR CME Euro CME
EURIBOR LIFFE Japanese yen CME
Eurodollar deposits CME
❱ TABLE 26.2^ Some important financial futures and some of the exchanges on which they are traded.
CBOT Chicago Board of Trade
CME Chicago Mercantile Exchange
Eurex Eurex Exchange
LIFFE ICE LIFFE
OSE Osaka Securities Exchange
SGX Singapore Exchange
TFX Tokyo Financial Futures Exchange
TSE Tokyo Stock Exchange
Key to abbreviations: