Futures Contracts

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract.

Future Contracts
Futures
The owner of a future contract has the OBLIGATION to sell or buy something in the

future at a predetermined price.

Scenario:
You are a farmer and you know that you will harvest corn in three months from today on. How can you protect yourself from loosing if corn price happens to drop until March by using corn forward contracts?

t 1/1 3/1 Harvest

Future Contracts
You lock into a price by holding a short position in a corn future contract with a maturity date a little bit longer than the harvest date. Suppose the price drops...
You close out the corn contract and the gain in the futures market will offset the loss in the spot market

You either take delivery and lock in a price.

A futures contract makes unfavourable price movements less

unfavourable and a favourable price movements less favourable!

Features
Standardized contract for deferred delivery Traded on organized future exchange Clearing house acts as middle man b/w the contracting parties Contract seller is called short Contract buyer is called long Both parties post a performance bond called margins; initial margins, maintenance margin & variation margin Margins are held by the clearing house

Types of Future contract

Commodity
Agricultural Metal Precious metal

Financial
Stocks Indices Currencies Treasury Bills Interest rates

Contract Specification
Assets
Commodity futures, specifications on quality, make, size etc. are needed Financial assets are clear-cut

Contract size
Amount of asset to be delivered in one contract

Delivery Agreement
Imp. For commodity futures, specifies where delivery is to be made

 Delivery month
Specifies the delivery month the precise period during the month when the delivery is to be made

Price quotes
Quotes to be convenient & easy to understand. The minimum price movement to be consistent with the way the price is quoted

Price Limit
It is an established amount in which a price may increase or decrease in any single trading day from the previous day's settlement price

Tick size
It is the smallest increment (tick) by which the price of stocks, futures contracts or other exchangetraded instrument can move.

Clearing House & its Role

It acts as an intermediary for each future contract CH of the exchange becomes the opposite party to each investor based on their positions CH is always neutral: maintaining both long & short, an identical number of contracts Elimination of uncertainty of default risk is essentially the job of a clearing house

 CH is associated with a futures exchange & is concerned with matching, processing, registering, confirming, settling & guaranteeing the trades on the futures exchange

Operations of margin
Margin account
The A/c in which the investor/trader is required to deposit the margin or amount for transactions

Initial margin
It is required to be deposited for futures transaction based on contract value. It could vary b/t 5% or 10% of the contract value

 Marking-to-market [M-2-M]
After initial margin is deposited, a change in the price of the futures contract would change the percentage relationship b/w the margin & contract value. At the end of each day the margin A/c is adjusted to reflect the investors gain or loss The gain or losses are netted against the margin

 Maintenance margin
This is generally 75% of initial margin amount If on account of losses on M-2-M, if the margin falls below maintenance margin, the trader is required to bring the margin to the level of initial margin level

Margin call
In the process of M-2-M, the investor receives a margin call & is required to deposit additional funds to bring the balance to the level of initial margin in a very short period of time

 Variation margin
When the margin fall below the maintenance margin, the amount that is called upon to be deposited is called variation margin

Clearing Margin
Margin deposited by the members of clearing house The margin are calculated on the number of contracts the member has taken a long position & short position either on gross or net basis

Settlement of Futures Positions

Physical delivery Cash delivery Offsetting futures transactions Exchange for physical