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The Margin Account and Marking to Market
The total profit or loss realized by the long trader who buys a contract at time 0 and closes,
or reverses, it at time t is just the change in the futures price over the period, F
t
2 F
0
.
Symmetrically, the short trader earns F
0
2 F
t
.
The process by which profits or losses accrue to traders is called marking to market. At
initial execution of a trade, each trader establishes a margin account. The margin is a secu-
rity account consisting of cash or near-cash securities, such as Treasury bills, that ensures
the trader is able to satisfy the obligations of the futures contract. Because both parties to
a futures contract are exposed to losses, both must post margin. To illustrate, return to the
first corn contract listed in Figure 22.1 . If the initial required margin on corn, for example,
is 10%, then the trader must post $3,620 per contract of the margin account. This is 10% of
the value of the contract, $7.24 per bushel 3 5,000 bushels per contract.
Because the initial margin may be satisfied by posting interest-earning securities, the
requirement does not impose a significant opportunity cost of funds on the trader. The ini-
tial margin is usually set between 5% and 15% of the total value of the contract. Contracts
written on assets with more volatile prices require higher margins.
On any day that futures contracts trade, futures prices may rise or may fall. Instead of wait-
ing until the maturity date for traders to realize all gains and losses, the clearinghouse requires
all positions to recognize profits as they accrue daily. If the futures price of corn rises from
724 to 726 cents per bushel, the clearinghouse credits the margin account of the long position
for 5,000 bushels times 2 cents per bushel, or $100 per contract. Conversely, for the short
position, the clearinghouse takes this amount from the margin account for each contract held.
This daily settling is called marking to market. It means the maturity date of the con-
tract does not govern realization of profit or loss. Instead, as futures prices change, the pro-
ceeds accrue to the trader’s margin account immediately. We will provide a more detailed
example of this process shortly.
Marking to market is the major way in which futures
and forward contracts differ, besides contract standard-
ization. Futures follow this pay-(or receive-)as-you-go
method. Forward contracts are simply held until maturity,
and no funds are transferred until that date, although the
contracts may be traded.
If a trader accrues sustained losses from daily marking
to market, the margin account may fall below a critical
value called the maintenance margin. If the value of the account falls below this value,
the trader receives a margin call, requiring that the margin account be replenished or the
position be reduced to a size commensurate with the remaining funds. Margins and
What must be the net inflow or outlay from
marking to market for the clearinghouse?
CONCEPT CHECK
22.2
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C H A P T E R
2 2
Futures
Markets
779
On the contract maturity date, the futures price will equal the spot price of the com-
modity. As a maturing contract calls for immediate delivery, the futures price on that
day must equal the spot price—the cost of the commodity from the two competing
sources is equalized in a competitive market.
2
You may obtain delivery of the commod-
ity either by purchasing it directly in the spot market or by entering the long side of a
futures contract.
A commodity available from two sources (spot or futures market) must be priced identi-
cally, or else investors will rush to purchase it from the cheap source in order to sell it in
the high-priced market. Such arbitrage activity could not persist without prices adjusting
to eliminate the arbitrage opportunity. Therefore, the futures price and the spot price must
converge at maturity. This is called the convergence property.
For an investor who establishes a long position in a contract now (time 0) and holds that
position until maturity (time T ), the sum of all daily settlements will equal F
T
2 F
0
, where
F
T
stands for the futures price at contract maturity. Because of convergence, however, the
futures price at maturity, F
T
, equals the spot price, P
T
, so total futures profits also may be
expressed as P
T
2 F
0
. Thus we see that profits on a futures contract held to maturity per-
fectly track changes in the value of the underlying asset.
Suppose the maintenance margin is 5% while the initial margin was 10% of the value
of the corn, or $3,620. Then a margin call will go out when the original margin account
has fallen in half, by about $1,810. Each 1-cent decline in the corn price results in a $50
loss to the long position. Therefore, the futures price need only fall by 37 cents (or 5%
of its current value) to trigger a margin call.
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