The CME Group Risk Management Handbook E-Book

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 894

Veröffentlichungsjahr: 2010

Beschreibung

Praise for The CME Group Risk Management Handbook "Wow! The CME Group Risk Management Handbook is a 'ten strike' and long overdue. A must-read and reference for the risk management industry!" --Jack Sandner, retired chairman of CME Group, member of the Executive Committee "This is a powerful book for its integration of futures and options markets with an understanding of the whole economy. It is an eye-opener to see how central these markets are to our economic lives." --Robert J. Shiller, Okun Professor of Economics, Yale University; Chief Economist, MacroMarkets LLC "Risk management is essential to successful investing, and The CME Group Risk Management Handbook provides the essentials for understanding risk management. In the wake of the financial turmoil of the last few years, managing risk should be part of any investment program. Among the key elements of risk management are stock index, bond, currency, and commodity futures as well as a growing number of futures, options, swaps, and other financial instruments built on indices tracking housing prices, weather conditions, and the economy. The CME Group Risk Management Handbook offers a comprehensive guide for using all of these to better manage financial risks." --David M. Blitzer, PhD, Managing Director and Chairman of the Index Committee, S&P Indices "Dare we ignore the advice of a financial institution, the largest of its kind in the world, that navigated the recent financial crisis without the aid of a single TARP dollar or access to the Fed's cheap loans? For CME Group, risk management has meant risk minimization as it enters its 151st year of life and its 85th year of central counterparty clearing without a single trading debt unpaid. It has been, and continues to be, a leader by example." --Philip McBride Johnson, former CFTC chairman "For the first time, a comprehensive handbook outlining the futures market in today's world is available. The CME Group Risk Management Handbook covers futures basics for the novice trader, while the veterans will benefit from an in-depth look at options and hedging. This handbook is a necessity for any professional, investor, or other market participant seeking to manage risk in the perpetually changing futures market." --H. Jack Bouroudjian, CEO, Index Futures Group

Leseprobe

Table of Contents

Title Page

Copyright Page

Foreword

Prologue

Acknowledgements

Introduction

CHAPTER 1 - Futures Market Fundamentals

WHAT IS A FUTURES CONTRACT?

OVERVIEW OF POPULAR FINANCIAL FUTURES CONTRACTS

ANATOMY OF A FUTURES TRANSACTION

CONCLUSION

NOTES

CHAPTER 2 - Order Entry and Execution Methodologies

OPEN OUTCRY/PIT TRADING

INTRODUCTION OF THE CME GLOBEX PLATFORM

TRADE MATCHING ALGORITHMS

ABOUT OPTIONS MARKETS

EX-PIT TRADING

CONCLUSION

NOTES

CHAPTER 3 - Role of the Clearinghouse

FINANCIAL SAFEGUARDS

FINANCIAL SURVEILLANCE

DEFAULT BY A CLEARING MEMBER

RESOURCES BACKING CME GROUP CLEARING SYSTEM

CUSTOMER PROTECTION

DISASTER RECOVERY AND BUSINESS CONTINUITY

RULE ENFORCEMENT

FINANCIAL AND REGULATORY INFORMATION SHARING

CONCLUSION

CHAPTER 4 - Currency Futures: The First Financial Futures

EVOLUTION OF FOREIGN EXCHANGE MARKETPLACE

OVER-THE-COUNTER CURRENCY TRADING VEHICLES

EXCHANGE-TRADED CURRENCY FUTURES AND OPTIONS

FOREIGN EXCHANGE MARKET GROWTH AND TRENDS

CONCLUSION

NOTES

CHAPTER 5 - Stock Index Futures Fundamentals

MECHANICS OF STOCK INDEX FUTURES

E-MINIS VERSUS EXCHANGE-TRADED FUNDS

PRICING STOCK INDEX FUTURES

SPREADING STOCK INDEX FUTURES

HEDGING WITH STOCK INDEX FUTURES

PORTABLE ALPHA STRATEGIES

CONCLUSION

NOTES

CHAPTER 6 - Eurodollar Futures

EURODOLLAR FUTURES MARKET

SPECULATING ON SHAPE OF YIELD CURVE

TERM TREASURY/EURODOLLAR (TED) SPREADS WITH FUTURES AND OPTIONS

INTEREST RATE SWAP MARKET

GROWING UP TOGETHER

PRICING RELATIONSHIP

HEDGING TECHNIQUES

CONCLUSION

TECHNICAL APPENDIX: COMPLICATIONS AND SHORTCUTS FOR PRICING AND HEDGING SWAPS

NOTES

CHAPTER 7 - Understanding U.S. Treasury Futures

COUPON-BEARING TREASURY SECURITIES

TREASURY FUTURES DELIVERY PRACTICES

MEASURING RISK OF COUPON-BEARING SECURITIES

RISK MANAGEMENT WITH TREASURY FUTURES

MACRO HEDGING WITH TREASURY FUTURES

HEDGING CORPORATES WITH TREASURY FUTURES

TRADING THE YIELD CURVE WITH TREASURY FUTURES

CONCLUSION

NOTES

CHAPTER 8 - Commodities: Backbone of the Futures Industry

WHAT ARE COMMODITIES?

GRAIN MARKETS

LIVESTOCK MARKETS

ENERGY PRODUCTS

PRECIOUS METALS

THE FORWARD CURVE

INTERMARKET COMMODITY SPREADING

CLEARPORT OVER-THE-COUNTER CLEARING FACILITY

CONCLUSION

APPENDIX: MAJOR COMMODITY MARKET SPECIFICATIONS

CHAPTER 9 - Alternative Investment Market Fundamentals

WEATHER

RESIDENTIAL HOUSING FUTURES

ECONOMIC INDICATORS

CONCLUSION

NOTES

CHAPTER 10 - Fundamental Market Indicators

WHY THESE INDICATORS?

TRADING VOLUMES

VOLATILITY : DAILY NET CHANGE

VOLATILITY : DAILY HIGH-LOW RANGE

CONCLUSIONS

APPENDIX: ECONOMIC INDICATOR DESCRIPTIONS

NOTES

CHAPTER 11 - Technical Analysis Primer

WHY TECHNICAL ANALYSIS?

INTERPRETING CHARTS

ELLIOTT WAVE THEORY

INTRADAY TRADING TECHNIQUES

TREND-FOLLOWING SYSTEMS

CONCLUSION

CHAPTER 12 - Fundamentals of Option Markets

WHAT IS AN OPTION?

MATHEMATICAL OPTION PRICING MODELS

HISTORIC AND IMPLIED VOLATILITIES

MEASURING OPTION PERFORMANCE

CONCLUSION

CHAPTER 13 - Option Trading Strategies

OPTION SPREADS

HORIZONTAL SPREADS

DIAGONAL SPREAD

COMPARING VERTICALS, HORIZONTALS, AND DIAGONALS

WEIGHTED SPREADS

VOLATILITY-DRIVEN STRATEGIES

SPECIALTY OPTION STRATEGIES

MATCHING STRATEGY AND FORECAST

CONCLUSION

CHAPTER 14 - Hedging with Options

BASELINE FUTURES HEDGE

BUYING PROTECTION WITH PUTS

YIELD ENHANCEMENT WITH CALLS

IN-AND OUT-OF-THE-MONEY OPTIONS

MATCHING STRATEGY WITH FORECAST

COLLAR STRATEGY

DELTA-NEUTRAL HEDGE

CONCLUSION

About the Authors and Contributors

Index

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Copyright © 2010 by Chicago Mercantile Exchange, Inc.

All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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The information herein is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by CME Group Inc. or any of its subsidiaries as to accuracy, completeness, nor any trading result and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

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Library of Congress Cataloging-in-Publication Data:

The CME group risk management handbook: products and applications/John W. Labuszewski . . . [et al.].

p. cm. - (Wiley finance series)

Includes bibliographical references and index.

ISBN 978-0-470-13771-0 (cloth)

1. Futures. 2. Risk management. I. Labuszewski, John.

HG6024.A3C587 2010

332.64’52-dc22

2009054060

Foreword

However we view it, the twentieth century must be assessed as remarkable. Although it recorded a new low in the history of violence—with two world wars and the Holocaust—it was also a century that bespoke of unprecedented advances in human endeavor: At its outset, Joseph J. Thompson’s detection of the electron proved that atoms were at the foundation of matter just as the Greeks believed; Emmeline Pankhurst lit the torch on behalf of women’s right to vote; Gregor Mendel discovered how inherited traits are passed on; Wilbur and Orville Wright transformed human transportation at Kitty Hawk; Sigmund Freud unlocked the mysteries of our subconscious; and Albert Einstein, the foremost scientist of the century, recorded his earth-shaking three papers. The combination of these breakthroughs fulfilled their promise and directed the destiny of humankind. Metaphorically speaking, the twentieth century propelled civilization from the horse and buggy to the moon and beyond.

To put it another way, the technology of the last century moved humankind from the vast to the infinitesimal. In physics, Einstein’s theory of general relativity dealt with the universe—the big. As the century progressed we journeyed to quantum physics—the little. Similarly, we moved from macro to the micro in biology—from individual cells to gene engineering. And just as technology brought us to subatomic particles in physical science, just as technology brought us to molecules in biological science, so in financial markets when computer technology was applied to established investment strategies, the evolution from the big to the little was strikingly similar. With computer science, the most complicated risk-management structure could be broken down into its separate components. Financial engineers disaggregated, repackaged, and redistributed risks and their corresponding rewards, exchanging one set of risks and rewards for another that responded better to investors’ preferences. We moved from macro to micro applications. In other words, the over-the-counter (OTC) derivatives market with its attendant risks was born. Indeed, derivatives were the financial equivalents to particle physics and molecular biology. Charles Sanford, the former chairman of Bankers Trust, dubbed it “particle finance.”

Derivatives in OTC venues and those on regulated futures exchanges are used by the largest and most sophisticated financial institutions in the world—domestic and international banks, public and private pension funds, investment companies, mutual funds, hedge funds, energy providers, asset and liability managers, mortgage companies, swap dealers, and insurance companies. Financial entities that face foreign exchange, energy, agricultural, or environmental exposure use our markets to hedge or manage their price risk. Financial intermediaries that have exposure in equities use our markets to hedge or to benchmark their investment performance. Financial institutions that have interest rate exposure from lending and borrowing activities, or their dealing in OTC interest rate instruments, swaps, and structured derivatives products, or their proprietary trading activities use our markets to hedge or arbitrage their exposure in money market swaps or to convert their interest rate exposure from a fixed rate to a floating rate or vice versa.

Few would argue that the modern era of futures markets was born with the launch of financial futures at the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME). This first-mover advantage provided the momentum that ultimately brought the CME Group to today’s pinnacle of futures markets. The metamorphosis ensued directly after August 15, 1971, the date when President Nixon dropped the U.S. dollar convertibility to gold. By closing the gold window, Nixon’s action led to an irreversible breakdown of the system of fixed exchange rates, initiated the modern era of globalization, and provided the rationale for the CME and other futures exchanges to prove that the traditional idea about use of futures markets in physical commodities was applicable to instruments of finance and beyond.

Our birthright in futures markets was to mediate risk during a narrow window for a few big agricultural products. Upon adulthood we extended this heritage into finance. With the advent of the digital age we launched CME Globex, becoming electronic and international. Now we provide risk-management capabilities on a nearly round-the-clock basis on a vast array of products that cover the gamut from finance to energy, from securities to the environment, from banking to agriculture. We provide alternative investments coverage, maintain strategic alliances with other exchanges, serve as a global benchmark for valuing and pricing risk, provide most transparent markets, offer an array of mini products for individual investors, and maintain educational facilities along with a complement of banking services. Most importantly, we manage an efficient, financially sophisticated central-party clearinghouse that guarantees, clears, and settles every trade within a no-debt structure.

Although OTC derivatives experienced problems during the 2007- 2008 financial breakdown, the financial safeguards in regulated futures markets proved solid and demonstrated our market’s undeniable value in the management of complex business risks.

Our introduction of Globex near the end of the twentieth century transported the trading pit to every corner of the globe. Whereas as little as six years ago American futures exchanges were still limited to floor-based execution, now the trading screen enables customers around the globe to execute trades without the need for physical representation on the floor of an exchange. The impact on growth is evidenced in the quantum leap in our annual transaction volume since the launch of CME Globex. Not so long ago if a financial official, say, in China, made a statement that affected the value of the dollar, it could take hours if not days before that knowledge was translated into market action. Today, nobody of consequence can say anything anywhere without the potential of it being instantly reduced into a buy or sell on a screen. You can execute a complex spread or do an entire panoply of connected transactions that includes markets across multiasset classes as fast as your fingers press the keys. The digital age reduced the Globex execution speed from 2,500 milliseconds a decade ago to less than 10 milliseconds today.

Indeed, advanced technology has dramatically altered the nature and definition of the trader, morphing the computer into an instrument that uses artificial intelligence and algorithms that direct the execution of the trade itself. These apply advanced proprietary mathematical models to execute countless sophisticated trading strategies to capture even minute profits based on price correlations, price distortions, and value associations between markets. Housed within proprietary trading enterprises throughout the globe—sometimes referred to as high-frequency trading operations—they are an extension of the digital revolution and supply enormous liquidity and breadth to market structures both in equities and futures and options markets.

The preceding brief historical sketch of financial markets provides a clear understanding that OTC derivatives and exchange-traded futures are a product of the dramatic changes in the science and technology of the twentieth century. The same can be said for the modern Chicago Mercantile Exchange—now CME Group. Clearly, during the last century the “House That Pork Bellies Built” in the 1960s evolved into today’s “House That Innovation Built.” Far less known, however, is the fact that during the same time span it was also the “House That Education Built.” Among its achievements was the CME’s commitment to advance market education. Beginning in the early 1970s, and continuing throughout its ensuing four-decade march to the top of the futures world, the CME was and remains a leading force in advancing academic education, courses, textbooks, studies, learning centers, workshops, and symposia in the field of futures and options.

It was the first exchange to promote a center for futures education in partnership with the Commodity Exchange, Inc. at Columbia University in the early 1970s, to establish in 1978 a prize in financial writing at the University of Chicago, and to endow chairs for the study of futures at both the University of Chicago and Northwestern University in the 1990s. In 2003, it founded the CME Center of Innovation. Among its accomplishments is the establishment of the Fred Arditti Innovation Award to individuals who have made significant conceptual or practical contributions to commerce or markets. The Innovation Center also teamed up with the Mathematical Sciences Research Institute (MSRI) to create a prize for the innovation of mathematical, statistical, or computational methods in the study and behavior of markets. In 2007, the original Chicago Mercantile Exchange Trust Trust (created in 1969) was converted into the CME Charitable Trust with a primary goal of promoting, teaching, and learning about financial markets, futures, and derivatives. Indeed, it would be impossible to attempt to enumerate the number of books, textbooks, magazines, journals, and periodicals about financial markets that have been published as a result of these initiatives.

As the expansion of futures markets continues into the twenty-first century, so will the need for education. The present publication, The CME Group Risk Management Handbook by principal authors John W. Labuszewski, John E. Nyhoff, Richard Co, and Paul E. Peterson, is a continuation of CME’s grand educational tradition. Labuszewski, Nyhoff, Co, and Peterson are extremely well qualified for this undertaking, having spent their professional lives in our industry at this exchange and with brokers and asset managers that utilize exchange products. The handbook, with contributions by Dale Michaels, Jim Moran, Brett Vietmeier, Fredrick Stum, and Charles Piszczor, contains information, data, details, facts, and background of a vital nature concerning the use and application of the most notable products traded at CME and beyond. The material includes consummate intelligence with respect to both the underlying fundamentals that affect the instruments described as well as technical analysis and interpretations of price movements. This handbook, a long sought-after work, will in my opinion become an indispensable reference textbook for futures and option markets.

Leo Melamed Chairman Emeritus CME Group

Prologue

The financial marketplace continuously grows more complex and exciting as new technologies and products emerge. Since the recent economic crisis, transparency, liquidity and security have become increasingly important.

CME Group has always evolved to match the technological needs of our markets and to offer reliable risk management tools to our customers. For example, the launch of CME Globex, our high-speed electronic trading platform, created a 24-hour marketplace. This launched CME Group into the global markets, where we continue to flourish with extensive product listings and strategic partnerships.

The reliability of our markets was also further demonstrated with the 2002 introduction of CME ClearPort, a central counterparty clearinghouse that settles and guarantees every trade. Risk is distributed among clearing members, allowing the clearinghouse to guarantee the performance of every transaction - and the security of every clearing member’s customer.

This evolution has spanned 160 years. The CME Group Risk Management Handbook: Products and Applications collects our product history and illustrates the development of our innovative risk management applications. The CME Group Research and Product Development team worked with Clearing, Market Regulation and Products and Services senior staff members to create a comprehensive reflection of our history, products and business model.

CME Group has always been a proponent of market education and active in developing academic courses, textbooks, learning centers and workshops to advance the futures and options field. This book is another excellent resource for market participants, which will be especially useful during these rapidly changing times.

Terry Duffy Executive Chairman CME Group Inc.

Acknowledgments

In 1979, I was fortunate enough to be hired on to the staff of the Chicago Board of Trade (CBOT) as a junior economist. I consider myself fortunate because, at the time, I don’t believe I could accurately have articulated the differences between the CBOT and the Chamber of Commerce. At the time, the futures industry largely was regarded as a provincial Chicago-based curiosity dominated by agricultural contracts and locally based brokerage firms specializing exclusively in commodities. Financial futures had only recently been introduced, options were banned in the industry, and electronic trading was inconceivable.

A great deal has changed in the 30 intervening years. To begin, I’d like to think that I’ve learned to distinguish the functions of a derivatives exchange and the Chamber of Commerce during that period! But more importantly, these markets have grown far beyond a provincial curiosity. Today, the most significant institutions in the world routinely use futures and options on futures as a component of their risk-management and trading programs. Countless innovative products and structures have been introduced by the industry. Electronic trading technologies have promoted internationalization of the marketplace, facilitating active participation by traders from every corner of the globe. Trading activity has grown tremendously as a result of these developments.

The story is not only one of growth but of consolidation. It wasn’t too long ago that the Chicago Mercantile Exchange (CME) was regarded as second fiddle to the venerable CBOT. But exchanges began to demutualize in the early 2000s, setting the stage for consolidation as the CME, CBOT, and New York Mercantile Exchange (NYMEX) were reorganized under the CME Group holding company umbrella. Thus, a single derivatives exchange began to offer the most diverse array of products running the gamut from interest rates, equities, currencies, agricultural commodities, and energy to metals, all offered on the same trading platform and processed through the same clearing mechanism.

This book was developed as the Research & Product Development Department of CME Group began to document the many functions and products provided by the newly consolidated exchange. It is intended to serve as a primer and reference regarding the most significant of CME Group products and the applications to which they may be deployed. (Please note that the specific terms and conditions of particular futures or option contracts are subject to amendment. Please consult the current version of the CME, CBOT, or NYMEX Rulebooks for the most up-to-date specifications.)

This book was very much a group effort. Principal authors include John E. Nyhoff, Richard Co, Paul E. Peterson, and myself. Contributing authors include Dale Michaels, James Moran, Charles Piszczor, Fred Sturm, and Brett Vietmeier. (Principal authors are those who have developed material appearing in more than one chapter, whereas contributing authors have provided material appearing in a single chapter.)

We would further like to express our gratitude to a variety of supporters who have provided encouragement or insights that have found their way into the text. These include (alphabetically) Lori Aldinger, Peter Barker, David Boberski, Jim Boudreault, Jack Bourodijian, Scott Brusso, Jack Cook, Kate Darcy, Phupinder Gill, Larry Grannan, Dan Grombacher, Matt Kelly, Matt Kluchenek, Dave Lehman, Tina Lemieux, Craig LeVeille, Bob Levin, Gene Mueller, Bill Parke, Rick Redding, Jerry Roberts, Derek Sam-man, Jack Sandner, Fred Seamon, Sayee Srinivasan, Sabrina Su, Kim Taylor, Bob Turner, Lucy Wang, Scot Warren, Julie Winkler, David Wong, and Steve Youngren. (We extend apologies to those whose names may inadvertently have been omitted.)

Finally, a special acknowledgment goes to CME Group Chairman Emeritus Leo Melamed, who shaped and molded the industry as we know it today, and to CME Group’s Executive Chairman Terry Duffy and Chief Executive Officer Craig Donohue, who are guiding CME Group into the future.

John W. Labuszewski November 2009

Introduction

As Chief Executive Officer of CME Group, I am proud to present The CME Group Risk Management Handbook: Products and Applications. This book is a reflection of our collective wisdom on CME Group products and their risk management applications gleaned over the past 160 years.

Since the mid-nineteenth century, CME Group’s exchanges have been where the world comes to manage risk. During this time, the risks that businesses and investors face have evolved. Financial, agricultural commodity, energy and metals markets, as well as alternative markets such as real estate and weather, have become increasingly complex and global. CME Group has kept pace with this evolution, providing an ever-growing range of sophisticated products and services for both the listed and over-the-counter markets. Our futures and options products enjoy global distribution across more than 85 countries and territories and trade electronically virtually 24 hours a day.

Equally important is our business model. The liquidity and transparency that are hallmarks of the CME Group marketplace stem from our central counterparty clearing model. CME Clearing stands at the center of this model, serving as the buyer to every seller and the seller to every buyer, thereby guaranteeing the performance of every transaction. No customer has ever lost any money as the result of a clearing member default at CME Group, including during the Great Depression and up through the most recent global economic crisis. Even under the most turbulent conditions, our markets have proven to be safe, sound, secure, and reliable.

This book draws on the considerable knowledge and talent of the CME Group Research and Product Development department, supplemented by the expertise of senior staff members from our Clearing, Market Regulation, and Products and Services departments. On behalf of our senior management team, I applaud their efforts.

The world is increasingly realizing the importance of risk management. For both new and experienced market participants, this book can serve as a road map for developing a sound understanding of risk and a successful strategy for managing it across any asset class.

Craig S. Donohue Chief Executive Officer CME Group Inc.

CHAPTER 1

Futures Market Fundamentals

John W. Labuszewski

The precise origins of the futures markets are obscure but arguably might be traced back to ancient Greece or medieval Europe or perhaps Japan. Modern futures markets as we know them today emerged from the North American grain trade as it evolved during the nineteenth century, driven in large part by the development of grain transportation patterns in the central and eastern United States. In more recent times since the early to mid-1970s, a variety of financial futures have been introduced in addition to the more traditional agricultural or physical commodity futures markets. These instruments now cover products as diverse as interest rate, equity, and foreign exchange markets but have been extended to include somewhat more esoteric items including real estate values, economic indicators, and even weather conditions.

Whereas futures were once regarded as arcane trading vehicles largely used by speculators in search of outsized profits, they are now widely regarded and accepted by institutional and retail traders alike as a legitimate and even essential component of many investment and risk-management programs. The popularity of these instruments has in fact grown to achieve immense scale. The notional value of futures transacted frequently exceeds the values traded in the underlying markets to which these futures are tied. In the process, these instruments have focused attention and interest on Chicago as the epicenter of futures market developments and innovation.

CME Group stands out as the leader in this regard, representing the amalgam of futures exchanges including Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), New York Mercantile Exchange (NYMEX), and Commodity Exchange (COMEX).

It is beyond the scope of this chapter to discuss the many direct and less subtle uses of these versatile risk management and investment tools. Rather, it is our intent to introduce and discuss the fundamental terminology and concepts associated with the futures markets in general and the specific instruments traded on CME Group as the leading derivatives trading organization whose products are distributed worldwide and attract active participation from all parts of the globe.

WHAT IS A FUTURES CONTRACT?

Perhaps the first and most fundamental question to consider is simply, “What is a futures contract?” A simple answer is that a futures contract represents a standardized commitment to make or take delivery of a specific quantity and quality commodity or security during a specified future delivery month. For example, one may transact CME Group futures contracts based on $1 million face value of Eurodollars; or $100,000 face value of 10-year Treasury notes; or based on a value equal to $50 times the venerable Standard & Poor’s 500 (S&P 500) stock price index; or, 12.5 million Japanese yen; or 40,000 pounds of live cattle; or 1,000 barrels of crude oil. Actually, the question becomes a bit more complicated to the extent that not all futures contracts actually call for the physical delivery of the underlying product or security. As discussed later, many futures contracts are settled in cash and never actually entail a physical delivery.

Because futures contracts trading on a particular exchange are standardized or generic, they are fungible and readily offset. A fungible item is one that is precisely alike another. Futures are fungible in the sense that one (for example) March 2008 CME Eurodollar futures contract is exactly like every other March 2008 CME Eurodollar futures contract and can be used to offset a previous transaction. That is, a market participant may buy, or “go long,” a March 2008 CME Eurodollar futures contract and subsequently sell a March 2008 CME Eurodollar contract at the prevailing market price before entering the delivery or cash settlement process. As a result, the original commitment to buy is canceled. Or a market participant may sell, or “go short,” futures and subsequently buy at the prevailing market price before entering the settlement or delivery process. This series of transactions means that the original commitment to sell is canceled.

Although we often speak of the futures markets in the generic, it is noteworthy that futures exchanges also typically offer options on futures contracts. Options generally come in the form of call options and put options. A call option conveys the right to buy, or go long (for example), one Eurodollar futures contract at a specific strike or exercise price on or before a specific expiration date. A put option conveys the right to sell, or go short (for example), one Japanese yen futures contract at a specific strike or exercise price on or before a specific expiration date. One may either buy or sell (or write) puts or calls and, as such, there are four fundamental transactions one may engage in with respect to options. The buyer of an option pays a negotiated premium or price to the seller or writer of an option in consideration for rights received by the buyer and obligations assumed by the seller.