Futures Market

A futures market is an auction market in which participants buy and sell commodity and futures contracts for delivery on a specified future date. Futures are exchange-traded derivatives contracts that lock in future delivery of a commodity or security at a price set today.

Examples of futures markets are the New York Mercantile Exchange (NYMEX), the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBoT), the Cboe Options Exchange (Cboe), and the Minneapolis Grain Exchange.

In this Wiki, we will take a look at what a futures contract is and

Futures Market

What is a Futures Contract?

A futures contract is a legally binding agreement to buy or sell a standard quantity of an underlying asset, at a future date, and at a price agreed upon at the time of the trade. Basically, it’s a contract to trade something in the future where you agree on the price today. The underlying asset of the future could be an interest rate, bond, currency, commodity or equity index, to name a few. All futures are traded on an exchange which means that they are centralized instruments that can only be traded on the exchange they belong to and nowhere else.

The thing to keep in mind is that the underlying asset could literally be on anything you can think of from cheese to baby diapers to gold bars. Even recently we have seen cryptocurrency futures which are something I never thought I would see in my lifetime. I mean, it’s future of a digital global currency that has been associated with criminal activity in its early days. Times are really changing!

Buying a futures contract is also known as “going long.” The buyer of the future has two choices:

1. Take physical delivery of the product at the end of the contract. The end of the contract is called the expiry.
2. Sell the contract before it expires for a profit or a loss. This is the case for the majority of futures traded.

Selling the futures contract is also known as “going short.” The seller of the future has two choices:

1. Deliver whatever the underlying asset of the future is to the buyer.
2. Buy back the contract before it expires for a profit or a loss.

It’s important to note that the ease with which futures contracts can be bought, sold, and exchanged is one of the main advantages of the futures market. It’s really efficient because of the vast amount of liquidity that is available which makes the futures market a go-to source for speculators. Liquidity is king in all modern markets.

Economic Functions of the Futures Market

The futures market provides two vital economic functions:

1. Risk Transfer

The first economic function is that of risk transfer. This is more commonly known as hedging. Hedging is one of the biggest and most important reasons that the futures markets exist. It means that the buying and selling various futures contracts can offset the risks of fluctuating prices in other certain underlying assets.

So why would you want to offset the risks of fluctuating prices you ask? Well, price risk exists in virtually every type of business you can think of. For example, the prices of crops might fluctuate in relation to factors with what the weather is doing or costs associated with transporting the crops. Let’s say there is a major drought and a large portion of corn crops are lost, while at the same time, the cost of gasoline is going up. In this scenario you might pretty easily come to the conclusion that corn prices are going to go up because the supply of corn has gone down due to the drought and the transportation costs are going up because gasoline prices are rising. If we have less supply but the demand remains constant then prices will rise and find a new fair value to continue to meet the existing demand.

To take this concept even further, manufacturing is at risk for labor supply and costs or even tax code changes. Financial institutions are at risk of price fluctuations in the assets that they hold in their portfolios whether they pay a yield or not. Those portfolios are at further risk because the value of equities and bonds are constantly reacting to the forces of supply and demand and so on. There is literally no limit to the various ways that any business could have price risks.

The people and institutions that are hedging using futures are able to easily and efficiently transfer the risks specific to their businesses to speculators with their hedge positions. Think about that, speculators make it easy for businesses to pass on their risk in an efficient manner. It’s really starting to seem like speculators are good for the markets isn’t it?

To illustrate hedging an example, we can use a pension fund based in the United States with a large position in European equities. Let’s suppose this pension fund has fears that there may be a short term economic downturn in Europe. They quite literally have billions of dollars under management. The sheer size of their holdings doesn’t allow them to simply unwind or sell out of their positions. This is because it would have the potential to greatly impact the markets and consequently negatively impact the cash value of their portfolio while they are selling. Obviously this is not something they want to do.

In order to counter this kind of risk they can simply enter a calculated short position on a carefully selected combination of European Indexes such as the FTSE, DAX and CAC futures. This short position in equity index futures will provide a short term hedge against the potential downturn in the share prices of European equities. If the pension fund is correct and the European equities market does indeed have a downturn then they would make up an equal amount of money on their hedge position that they lost on their equities portfolio. By doing this the pension fund potentially saved hundreds of millions of dollars for their investors. If the European equities markets did not have a downturn then the pension fund would have paid a small premium for the right to have protected their large holdings of equities.

2. Price Discovery

The second vital economic function that futures provide is that of price discovery. A futures market provides an essential forum for the exchange of risk at agreed upon prices. Whether the futures trades are executed on a computer screen via an electronic exchange or through the old style of trading pits in an open outcry environment, the concept is the same, which is the exchange of a standardized risk at an agreed upon price. This price then becomes the benchmark for all previous and all subsequent transactions for that futures contract. This also provides an easily accessible and understandable way to price the underlying asset at a given time of day in a given quantity.

Said another way, contract size and pricing are set by the exchange and not by some outside body. This means that if the exchange has set rules that say the smallest amount of a particular futures contract that can be traded is 1,000 units then you can’t come in and expect to purchase 47 units when the minimum quantity is 1,000 units. This makes trading in this particular market very efficient and easy to understand for all participants. If you can only afford 47 units, well then you can’t trade in this hypothetical market and you will have to move on to another market.

Price itself becomes a valuable piece of information giving insight into the future expectations, hopes, and fears of the collective market participants. For example, a Eurodollar is a futures contract for interest rates. This is not to be confused for the EURUSD currency pair which is also referred to as the Euro Dollar. Interest rate futures are a way for companies and banks to lock in interest rates today for money that it will be borrowing or lending out later in the future. This is a very common practice amongst large financial firms.

The price of the Eurodollar is determined by the markets forecast for the 3 month Libor interest rate. A price of 95 implies an interest rate of 5% because the benchmark price is always 100. What we do is simply subtract whatever the current price the market is quoting from 100 and the remainder is what the market expects the Federal Reserve’s interest rate to be in 3 months’ time.

One thing that I want to say here is that you don’t need to get confused with all these new terms. If you want you can head to Investopedia.com and punch in the term and get an excellent definition. For our purpose here I am merely exposing you to the jargon used in the markets. I will define everything that will be relevant for you as a Forex trader but here we are just broadly overviewing the futures market for basic understanding of how markets are connected.

However, I will take a moment here to complicate things a bit. Don’t worry if you struggle with this, it will work itself out by the end of the training. In a hypothetical scenario, the current interest rate as set by the Federal Reserve is 3.5%. The September 2015 Eurodollar is trading at a price of 96.50, the December 2015 is trading at 96.25 and the March 2016 is trading at 96.00. Given that the cash price should be roughly 96.50, the futures prices of later Eurodollar contracts tell us that rate rises are expected by the market and that price action in the futures has accounted for these rate hike expectations. By December 2015 the price is telling us that the Fed is expected to raise its trades to 3.75% (100 – 96.25). By March 2016 the market expectation of the Fed is to have interest rates raised to 4.00% (100 – 96.00). The true futures prices are not as exact as these prices are but this is just meant to be a simplified example.

I would say not to worry too much if you don’t exactly understand what I was trying to get at in how the futures pricing works. Not understanding this will not make or break you as a trader by any means. What I would say is that you will come across these terms in your daily trading and over time things will start to make more sense than they may at this moment in time.

As I will always encourage, you can find a lot of great information for free online that will help to fill in any of the gaps on the academic things that we have looked at so far. Self-study is a great habit to form early in your trading career. My goal with this beginners training is to give you a basic understanding and then build on that knowledge throughout the rest of the program.

Buyers and Sellers as Speculators

Every transaction involves a buyer and a seller. There would be no possible way to make a trade if it did not. Each transaction price is the result of two different traders with opposing views that the current price is a good reason to place a trade. This is important to bear in mind when you are thinking about entering a trade. Do you really think that it’s a good and reasonable price based on your overall view of the market? Do you have really smart and well thought out reasons for taking this particular trade? It’s interesting when you think about it because the other person obviously thinks your assessment is wrong and thinks that he or she will be the one to make a profit from the trade, not you.

Speculators fulfil several important functions because they are basically making a market when they trade in futures. Speculators are not the ones creating risks in the markets. Rather, they actually assume the risk from hedgers and other market participants. They do this in the hope of making a profit from the future price fluctuations. Without speculators those hedgers would have a hard time getting fair prices to offset their risks. This goes back to the concept of speculators adding massive amounts of liquidity, which as we have learned, is the most important thing to any modern market.

For example, a large bank (bank A) has 50 Eurodollar contracts to sell in order to cover some risk on their outstanding debt. They are only prepared to sell at a price of 94.25. Bank B wants to buy 50 Eurodollar contracts but is only willing to pay 94.15. What we have here is a 10 basis point spread between the buyers and the sellers. Speculator X thinks that the Fed will be cutting interest rates in the near term so he is prepared to pay 94.20 for the Eurodollar contracts. Meanwhile, speculator Y is convinced that there are no rate cuts coming anytime soon and so he is willing to sell Eurodollar contracts at 94.22.

What has happened in this hypothetical scenario is that there was previously a wide market, i.e. 94.15 buy price and 94.25 sell price. But thanks to the speculators the prices are now 94.20 to buy and 94.22 to sell. Both the hedging banks have had significant improvement in the price gaps when they would have otherwise been forced to take a much worse deal. Once again, from all of us speculators, you’re welcome! What the speculator has done is provide crucial liquidity to the market as a whole. In this overly simplistic example the spread went from being 10 basis points wide and thanks to speculators it became much better and more efficient at 2 basis points. In reality, most futures markets are extremely liquid and there is very little difference between the bid ask spread under normal trading conditions. Sometimes the spread will get larger on days like major holidays but that is quite rare.

In a market without these risk takers, called speculators, it would be almost impossible for other participants to agree on a price that was cost efficient and take place in a timely manner. This is because sellers want the highest price and buyers obviously want the lowest price. It would not be cost or time efficient to find offsetting hedges and the system would become useless to anyone seeking to use it to offset their risks. Speculators bridge this gap between bids and offers making the market much more efficient and competitive.

In short, speculators increase the numbers of readily available buyers and sellers so that the market can operate at maximum efficiency and keep everyone happy. So the next time you hear the talking heads on the television or politicians demonizing speculators you can simply shake your head and have full confidence that they have no idea what they are talking about. You know the real truth now and you can take pride in being someone who supports the financial stability of the global financial markets.

Liquidity

We have already touched on liquidity but let's go into a bit more depth here. The term liquidity refers to how easy or difficult it is to trade a particular market without changing the price significantly and in a quantity that suites your purpose. A liquid market has large numbers of buyers and sellers and a very small difference between the bid ask spreads. A smaller spread between the best price you can buy and the best price that you can sell makes it more efficient for all market participants to trade. This makes it easy for traders to get in and out of positions in a relatively short period of time and at good prices.

Liquidity in a market can change for various reasons and can do so very quickly in extreme cases. For example, on holidays many traders and speculators are away from their trading desks which can create a low liquidity environment. This in turn makes the price much more volatile and the spreads higher when compared to more normal trading days.

The reason prices can be more volatile in a low liquidity environment is because small orders can move the price much more than they normally would be able to when compared to a higher liquidity environment. If you are trying to sell 100,000 units and it takes 10 price levels to fill that order then you are going to clear those 10 price level to get what you need whereas in a normal liquidity environment you might be able to get the same 100,000 units on just 1 price level. It’s always best to trade at times when you know the chances are good that the liquidity is high which we will cover later on.

We sometimes can encounter a low liquidity situation called a liquidity vacuum. There are a lot of ways that people define liquidity vacuums but for the sake of simplicity I am just going to say that it is a place in price where there is just no liquidity. If someone wants to trade around that area or if price moves aggressively into the liquidity vacuum then there is a spot where there are just no bids or offers to hit. This means price will move very fast as the orders seek to find the first available liquidity. Sometimes these vacuums can be fairly small or they can be quite large if the trading session is particularly illiquid. Don't worry too much about this happening all the time. I am just making you aware of these concepts. We are going to focus our trading on the 8 major currencies which have huge liquidity at virtually all price levels.

In FX, high impact news events create a similar environment as many traders sit on the sidelines waiting for the release. This is why if you watch the spread around a large news event it will tend to widen up quite a bit as the market participants digest the news in order to make their next trading decision.

Understanding liquidity and why it’s important will protect you from entering the market at dangerously illiquid times when you are unlikely to get the price you want and will pay a far higher spread. We will talk at great lengths the best times to trade later on in this training.

Contracts and Lots

When trading in the futures market, and many other markets as well, you will do so and execute your trades with something called contracts. Each market and exchange designs these contracts to meet the overall average needs of the market participants. This means that for a futures contract to trade successfully and entice many traders to trade it then it must appeal to a broad range of market participants such as institutions, individuals, hedgers and speculators. The terms of each futures contract is set by the exchange at suitable levels to generate interest in the product with the hope of adding as much liquidity as possible. That’s right, the futures exchanges want as much liquidity as they can get so that means they want us speculators to come and play!

The main thing to concern yourself with in futures is the tick value of the contract that you are trading. For example, at the time creating this training the minimum tick value for the S&P 500 mini futures contract is $12.50 per tick and there are 4 ticks per point. Some futures contracts will have higher or lower tick values. If you are interested in trading futures then you need to consult with your broker to determine the trading conditions they have.

As an example in Forex, a standard contract or “lot”, as we call it in FX, is 100,000 units of whatever currency pair you are trading. This can be broken down further in the spot market into units of 10,000 and 1,000.

100,000 units are called a standard lot, 10,000 units are called a mini lot and 1,000 units is a micro lot. This has been broken down in this way to accommodate a growing number of smaller self-directed retail traders who may not have the necessary capital to trade with the traditional standard lot sizes of 100,000 units.

In the Forex market most retail brokers will let you trade with pretty much any size you want. So if you would like to buy 47,000 units of the EURUSD currency pair then this will most likely be possible with your current broker. Some brokers will even let you trade with units smaller than 1,000 which really lowers the barriers to entry to almost everyone to try their hand at Forex trading. You can literally start trading a live Forex account with as little as $50.

Ticks and Pips

In futures and other markets the minimum fluctuation in price is called a tick. A tick represents the minimum up or down movement that can be traded on a specific futures contract. The FX markets use a term called pip which stands for “percentage in point” which is a different word for basically describing the same thing as a tick. We Forex traders like to have our own club and be fancy with the terms we use.

As an example of a futures contract, the FTSE, which is the equity index for the London Stock Exchange, the minimum tick size is 0.5 of an index point. This means that if we have a price of 5452.0 it can only be followed by 5452.5 for a move higher or 5451.5 for a move lower. This is because it can only move in its minimum tick size of 0.5 of one index point. It can move more than that but never less than that.

As another example, the minimum tick size for the S&P 500 equity index out of the United States is 0.25 or a quarter of one index point. This means that you have 4 ticks per index point. Therefore, a price of 2100 can be only be followed by 2100.25 for an uptick or 2099.75 for a downtick and so on.

The tick value is the monetary value assigned to a tick by each respective futures exchange. The profit or loss on any futures contract is translated by the movement in ticks multiplied by the tick value. For example, the minimum tick value for one S&P500 e-mini contract is $12.50 for one contract and there are 4 ticks for every one point. This means that if you buy one contract each point of movement will be worth $50 US dollars ($12.50 x 4 ticks = $50 per point).

As an example in Forex, a pip value on a standard EURUSD contract, which is 100,000 units of currency, is roughly $10. If you buy 1 standard contract of EURUSD and you make a 50 pips profit then this equates to roughly $500 in profit. The same is true on the flip side; if you lose 50 pips then you will have a loss of $500.

The pip value for each currency pair will differ depending on what your account base denomination is. For most of the examples in this course I will use US Dollars as examples because it is the most widely recognized currency on the planet. If you want to get more exact on the value of pips on certain currency pairs in your home currency denomination then do a quick search on Google for currency pip value calculators and you will be sure to find something free and easy to use.

What is a Pip?

A pip is the smallest unit of price for any currency pair in the spot Forex market. Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit. For example, EURUSD might equal 1.1138. In this instance, a single pip equals the smallest change in the fourth decimal place which in this case is 0.0001. So if the EURUSD pair goes up 1 pip the value would go from 1.1138 to 1.1139. Therefore, if the quote currency in any pair is USD, then one pip always equal 1/100 of a cent. Said another way, 100 pips is the equivalent of one cent worth of price movement.

However, with the Japanese yen a pip equals 0.01 and is typically quoted in 2 decimal places instead of 4. For example, the USDJPY pair might be priced a 115.50. One pip of price movement would be equal to 0.01 in this case. So if the USDJPY went up 1 pip the price would move from 115.50 to 115.51.

What is a Pipette?

Now this is where things can get a little bit tricky. Because the spot Forex market has become so competitive over the years almost all retail Forex brokers have gone to a 5 decimal point system in order to increase efficiency and offer more competitive pricing. This is where a new term called pipette comes into play.

A pipette is one-tenth of a traditional pip. For example, if the EURUSD pair moved from 1.11380 to 1.11381, it moved 1 pipette or a tenth of a pip. If you had a position of one standard lot of 100,000 units in the EURUSD currency pair then a 1 pipette move would be worth approximately $1 while a 1 pip move would be worth about $10.

This concept of a pipette applies to Yen pairs as well. For Example, if the USDJPY has moved from 115.500 to 115.501 then it has moved 1 pipette or one-tenth of a pip.

There is no need to get too hung up on how every pip is calculated because it’s the job of the broker to make that easy and do it for you. The trading software has become so technologically advanced in recent years that you don't really need to concern yourself with calculating pip values. What you need to focus on is picking the right trading size for your account value and managing your positions according to your well thought out trading plan. The software will show you in real time exactly what the value of each pip is worth once you are in a position.

Expiry

All futures contracts eventually expire and this is the point when you will have to do one of two things: you either take delivery or you settle for the cash value if there is any left in the trade at the time of expiry. Of course, you always have the option to sell your contract back to the market and close your trade before the actual expiry date. This is what the vast majority of traders do.

Futures contract expirations typically coincide with the quarter end dates which are March, June, September, and December. These are delivery dates that are set on a particular day in the month. Sometimes they can be rolled over a period of days in the month. All the rules around expiry are set by the individual exchanges so it’s important that you find out what the particulars are before you trade on any futures exchange.

It’s important to know the last trading day for a contract. This is set by the exchange on a particular day of the month and will typically be made obvious to you as the most naming conventions of each futures contract will have the expiry month in it.

Each market will have different dates but most will usually set the expiration date around the end of the month. However, this is not always the case and if you are trading a particular type of asset it would be wise to make sure you know exactly when the expiry is going to take place.

It would be overkill for me to give you a list of expiry dates and a list of contracts here because by the time you are watching this much of the information could be irrelevant. The key is that you need to understand that the exchange that the futures contract is listed on is the entity in charge of making an orderly market and would therefore have all the details you need in order to place trades in that market. Your broker should also have this information readily available for you as well.

Clearing

Unlike in FX, the clearing and settlement of exchange traded futures is highly centralized. Being centralized means that you can only deal with one particular entity that offers a certain future if you want to trade that particular futures contract.

Clearing houses fulfil two important roles:

1. The clearing house becomes the legal counter party to the original transaction.
2. The clearing house guarantees the performance of all the contracts. This means that if the seller of the contract cannot pay the purchaser then the clearing house will pay the purchaser. However, the clearing house will have put in place many measures to ensure that this doesn’t happen.

In other words, the clearing house is the seller to all buyers and buyer to all sellers. They guarantee that if you make a profit on your trade that you will be able to cash it in with no issues.

There are three distinct roles in the clearing process:

1. Clearing House: this is the administrative center that coordinates delivery and settlement of all the futures contracts within the exchange.
2. Clearing Member: these are members of the relevant exchange who are authorised to clear business. They need substantial capital resources and tend to be large brokers and investment banks.
3. Non-Clearing Member: these are much smaller entities such as traders who do not satisfy the capital requirements for clearing membership. They gain access to the clearing system but are using the services of a clearing member. In other words, this is a retail trader trading through a retail broker who is a clearing member. A non-clearing member is most likely what you and I would be categorized as.

Try not to get too hung up on the particulars of how clearing works. For now this is just something to make you aware of as we build your foundation of the futures market. There is an enormous amount of information available for free on the internet if this is something that you are interested in learning extensively about. Go to Google, it will have all the answers.

Margin

There are two types of margin in trading:

1. Initial Margin

The initial margin is a returnable good faith deposit paid in cash or collateral. This is required by all traders entering a contract on an exchange through a broker. The amount of initial margin may vary subject to the amount of market volatility but this will all depend on your broker’s rules. If the market suddenly becomes highly volatile your broker may require additional margin on short notice because there are extra added risks in the market. Your broker has a vested interest to ensure that you do not lose more on your trade than your total deposit. Obviously the broker doesn’t want to be on the hook for money a client lost that they might not be able to pay back.

The initial margin is due to the clearing house immediately upon a position being opened. The clearing member requires that the margin be in place before that position is open to ensure that the trader has enough money in his or her account to handle the trade. These days this is all done electronically via your trading platform. The technology is so good now that there are only rare human interventions in extreme situations. It may sound a little difficult but with the advances in technology you really don’t need to think about much other than placing your trades in line with your well thought out trading plan.

2. Variation Margin

Traditionally variation margin represents the profit or loss on an open position each day. At the close of trading each trading day a settlement value is assigned to each contract. The clearing house calculates the profit or loss for each position for that day based upon the net movement from the previous day’s statement. This was the way it was done in the old days but now the reality is that this is done on a tick by tick basis every second of the trading day.

Could you imagine if there was a major market moving event that forced price way beyond what many client account valuations could handle at 10am Eastern Time and the broker didn’t look at settling the accounts until the close of the trading session at 4 pm? That would be 6 whole hours where the market could do whatever it wanted. This would be a nightmare situation that definitely happened in the old days but in this age of technology you would have had your position automatically liquidated by an algorithm long before your account was even close to being wiped out. This automatic real time liquidation of bad positions is for your protection. It’s also designed to protect the broker who doesn’t want their clients having negative account balances for obvious reasons. Most people would walk away from a negative account balance and stick the broker with the tab. Obviously the broker doesn't want a situation like this so they build in very strict risk management and account protection that you would have been made aware of at the time that you opened your trading account with them. If you have forgotten this information then you can always ask your broker for their current liquidation practices. Most platforms will have something built into it to make you aware when your position is getting close to liquidation.

Settlement and Delivery

The vast majority of futures contracts never go all the way to the point of delivery and are closed out with an offsetting position in the market before the expiry date. Those positions that are still open at the expiration of trading will be fulfilled by cash settlement or physical delivery.

With physical delivery, a feature of all futures markets is that delivery is the option of the seller. The seller of a futures contract is always in a short position. The short may determine anytime during the delivery period to send a notice of intention to deliver the physical goods. The amount of money paid by the buyer to the seller for delivery is fixed by the exchange on the delivery date. This is the exchange delivery settlement price or EDSP. The EDSP is a figure determined by the exchange and is often an average of prices set over a fixed period of time. Physical delivery exists in most bond and commodity futures.

With cash settlement, many contracts such as equity index products and short term interest rates are settled in cash. No physical delivery takes place because they are by definition electronic products. Contracts are closed out against the EDSP and cash changes hands electronically as a variation margin from the settlement of the previous day. Remember that variation margin is set to take care of the open profit and loss on a trade.

Cash settlement is how the vast majority of futures contracts are settled. Most brokers actually mark your account as cash settlement only unless you set up an arrangement with the broker to be able to actually take delivery. I mean, nothing would be worse for a retail trader to have traded an oil contract and have 500 barrels of oil showed up on your door step. For most retail traders they lack the huge amount of capital and storage space that would be required in order to be able to actually take delivery of a future.

Interest Rate Futures

Short term interest rates, such as the Eurodollar, are futures that are based on the rates at which banks trade instruments on their corresponding denominated currency, especially the rate at which banks will lend and borrow money from each other for upcoming one month and three month periods.

Whoa, that was a mouth full! I’m only going to point out interest rate futures to you and not get into depth on it because they are literally a course on their own. We are just going to define them and move on to more interesting things.

The chances are that you will never even consider or have enough money to trade in this market. However, interest rate futures are a term that is thrown around on the various news wires from time to time so it is worth noting what they are without over-complicating it.

Interest rate futures are something to be aware of and are a good spot to do some self-study for a more in depth understanding should you wish.

Cash Market

The cash market is also a basic concept to understand because you will constantly hear this referenced in your daily research and analysis.

Money markets instruments traded in the underlying cash markets are debt instruments. They typically, last for 12 or fewer months until their time to maturity. These include fixed deposits, certificate of deposit, bankers’ acceptances, commercial paper, repos and treasury bills, etc. The most common cash market instruments that you will hear referenced are treasuries and repos because these are performed by the central banks. Later on we will go deep into what central banks are because they are one of the most important things that we as Forex traders will need to understand.

It’s not vital to know how these markets actually function in depth. A basic understanding of what they are and the role they play is good enough. You will learn more about this as we go along.

Fixed Income

In the cash market we also have fixed income securities such as bonds. A bond is a loan document that bears interest to the purchaser of the bond. Think of it like a sophisticate IOU. Bonds are issued by companies, governments, and other supranational organizations and they do this in order to raise money for various capital projects. Bonds are categorised according to their lifetime, the issuer, the interest payment details, the credit rating and other various factors that the exchange deems important.

Fixed income bonds bear a fixed interest rate payment as you would guess from the term ‘Fixed’ in the name. This is called the coupon and is based on the nominal value of the bond. These interest payments are either annual or semi-annual depending on the interest schedule of the bond. The interest schedule of the bond is set by the originator or the entity that wrote the bond but it will either pay interest once or twice per year.

The bond futures that we will look at throughout the majority of this training are based on a basket of government issued fixed income bonds. For pricing purposes, government issued bonds are considered to be free from default risk (remember, the risk free rate?). Therefore, bonds have become the benchmark for the pricing of risk in all other financial assets.

Bond yields are dependent on the issuer’s credit worthiness and the remaining lifetime of the issue. Since the futures that we look at and will hear about in the news wires are all based on government debt of G8 nations this means that credit worthiness can be dropped from the equation.

Whether we believe so or not, the markets will look at the G8 nations as being free from default risk. This is because if the market was concerned about the default risk of G8 then this would likely be a historic and volatile time in the market where we would need to adapt to some very new and scary realities as Forex traders. For now, the correlation that we care the most about is between yield and remaining lifetime. This mathematical function is known as the yield curve.

The Yield Curve

All bonds have various maturity dates. For example, the United States may have issued 3 month, 9 month, 2 year, 5 year, and 10 year bonds. Bonds with a longer remaining lifetime tend to yield more than those with a shorter lifetime under normal market conditions. This is what we refer to as a normal yield curve. A flat yield curve is where all the remaining lifetimes have the same rate of interest. An inverted yield curve is where longer dated bonds yield a lesser rate of interest compared to shorter term bonds.

The yield curve is a picture of where interest rates are today. It’s also a picture of where the market expectations are for where interest rates will be in the future. The yield curve shows the rate of return that can be locked in now for various terms into the future.

The investments that are constructed in a yield curve should all have the same risk, the same features, and the same coupon rate. This means that you if you are looking at a yield curve for US treasuries then it will only contain information about US Treasuries and not some other instrument.

As another example, to construct a yield curve of German government bonds of varying coupon rates the variants in those coupon prices and rates can be factored out so that price is comparable. The idea is that you want to compare apples to apples and not apples to oranges when constructing a yield curve.

There are four basic shapes of yield curves that you should be aware of:

1. The Normal Yield Curve
2. The Inverted Yield Curve
3. The Flat Yield Curve
4. The Hooked Yield Curve

The Normal Yield Curve

The normal yield curve is characterized by the nearby yields being lower than further dated yields. This progresses from the shortest dated and lowest yield to the longest dated and highest yield in a relatively smooth curve just like this chart.

An image of the normal yield curve.

Inverted Yield Curve

The inverted yield curve is where the shorter dated investments are yielding more than longer dated yields. This situation tends to happen very rarely. But times that this situation does happen are when the markets are extremely uncertain which causes a flight to safety. When the market gets scared it will dump its money into risk free assets causing prices to inflate on shorter lifetime to maturity investments.

This typically occurs for a short period of time before reverting back to a more normal yield curve.

An image of an inverted yield curve.

Flat Yield Curve

A flat yield curve indicates that yields for short, medium and long term investments are all roughly the same. This tends to happen when the market is really uncertain of what the future holds. The future direction of the economy could be better or worse than it is right now but the market is in a wait and see mode for some more information to help understand what the next move will be.

An image of the flat yield curve.

Hooked Yield Curve

The hooked yield curve is also sometimes called a humped yield curve. It resembles a bell curve with a long tail. What this situation indicates is that medium-term rates exceed both the short term and the long term rates.

When we are talking about government debt this is typically interpreted as a slowing of the economy as a whole.

An image of the humped yield curve.

The 3 Explanations for Yield Curves

1. The Liquidity Preferences Hypothesis

Investors dislike having their money tied up for too long and will demand extra return for having to put their money at risk for longer holding periods. The longer the investor has to defer their current consumption the more marginal compensation they will demand in order to pay for not being able to use their hard earned money today.

Investors will almost always prefer a high liquidity investment and will accept a lower return to get the safety of knowing they can get out of their investment at any time should they need to. This ensures that when the investor wants to sell their holdings they can do so very efficiently without any headaches.

2. The Expectations Hypothesis

The yield curve is a picture of what people expect interest rates to be from now and into the future. For example, a humped yield curve with a peak at two years out means that people generally expect interest rates to rise for two years, after which they will then trend down again.

In the FX market traders spend their lives trying to predict and move price in line with what their expectations are for central bank interest rate changes. When we are talking about futures, if a central bank changes their benchmark interest rate it will have massive implications on the government debt market.

As you will learn throughout this training, trading Forex is massively influenced by interest rates and the market expectations for where interest rates are going.

3. Market Segment Hypothesis

This is based on the idea that there is not one continuous debt market. Rather, there are several distinct segments with different players within each segment.

For example, the short term market is dominated by banks and money market dealers who through very competitive supply and demand arrive at a series of short term interest rates. The second market segment which includes mutual funds, corporations and casualty insurers typically only borrow and invest in the medium-term because this is what their businesses rely on. The long term debt markets are mostly influenced by businesses with long term projects and liabilities such as pension funds, life insurers and property companies that buy and sell from each other which in doing so sets the rates in the long end of the market.

Basically, what the market segment hypothesis is saying is that certain segments of the market have different needs and will borrow debt or seek interest for various reasons, not just to make a profit.

In the real world, the answer to how interest rates and yield curves are derived is likely a combination of all these hypothesises. There are definitely real reasons for all of these hypotheses to have some real world effects on prices.