I know the collateral yield could be stated as the return on the collateral in a future contract. But I still don’t understand which side posts collateral in a future contract. Besides how can the collateral could be used to earn profit? As in house loan, which the house will be see as the collateral, the house is not the property of the lender so the lender cannot use it to make profit. I though collateral is just a promise for the lender and cannot manipulate it until borrower defaults.
Both the long and the short post collateral, often in the form of T-bills. The T-bills earn interest; that’s the collateral yield.
You post house as the collateral for loan, but you don’t give interest of house to the bank because the house doesn’t gererate profit. Why in the future case you have to give the interest of collateral to the counterpart? I thought a collateral is just a promise of the contract and you cannot touch it until the borrower defaults.
I don’t quite understand your question. Nobody’s giving the interest to anyone else.
If I enter into a futures contract I have to post a margin: collateral. I choose to post that in the form of T-bills, which earn interest, which I keep. That interest is my collateral yield.
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Expanding a little on S2K’s post, as I understand it. Collateral yield here refers to the opportunity return you make with the remaining capital that is not locked up for margin requirments. Which we assume to be the risk free rate. When you enter a long (or short) position on future contracts, the price you lock in to be payed in the future is still available to the long investor except for a small margin. That free cash can be used to earn a risk free return until the contract settles. The short hedger can earn collateral yield from the underlying asset during that period as well. Let’s say rent for a property.
You mean both partys post collateral like T-bills and the earn the interest of their own posted T-bills, dont you? What if the future contract worth 10000, which collateral do I have to post? T-bills paying 10000 at maturity or 10000+interest at maturity?
If I lock in one future contract for wheat at a price of $105 per unit to be delivered in 3 months, then I have to put up front a small margin requirement, let’s say $5. The remaining of the $100 available during the next three months can be used to earn interest on a risk free T-bill, so it’s part of my total return.
I think you’re starting to follow the logic, but you’re making it too complicated. In a futures contract, each side is required to post the initial margin. The initial margin for futures is standardized based on the underlying. It’s not like the initial margin posted in a stock trading account.
The benfit (or flaw) with futures is that the initial margin is a fraction of the contract value, giving you an opportunity to access the futures market with high levels of leverage. So, in your example, a futures contract worth $10,000 would most likely require only a small amount of margin to be posted. To keep the concept easy, we’ll say that the short and the long both deposit cash.
This cash is a good faith deposit that is required by the exchange to engage in the contract. While I’m having difficulty linking your original example of a mortgage, I suppose you could consider this initial margin an escrow account. Much like escrow, this initial margin can earn interest, leading to money earned on the initial margin, or collateral, hence collateral yield.
An example: Crude oil expiring in December is trading at ~$76. A crude oil contract is 1,000 barrels. $76 multiplied by 1,000 barrels is… $76,000 worth of oil. The initial margin is around $3,700. So, for $3,700 collateral or initial margin, you control $76,000. You can earn interest in the $37,000. Assuming the contract is held to expiration (which would be silly unless you want to take delivery of the oil), the long pays the remaining value, and the short delivers 1,000 barrels.
Who pays the interest of the margin? The clearinghouse?
As I wrote above, usually the parties deposit T-bills as collateral. The interest is paid by the US government.
I’ve never heard of collateral yield being applied to anything other than the actual collateral posted as the margin. Is it common to apply that term to assets you don’t deposit as collateral? That seems weird.
I don’t have hands-on experience with trading futures, but from what I understand, the price you have settle in the future can earn a RFR until then, so it builds up as part of your total return.
But I’m probably wrong, since I’m assuming that all investors do exactly that, while the free cash can be used for higher/more risky yields. You’re most likely right, the collateral yield should only apply on the margin deposit.
At 14:55 Minutes in