A financial future contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified price and at a specified time and place.

Traded on an exchange which sets certain standardized norms for trading in the future contract.

Financial futures contract--Meaning

Financial futures contract--Meaning

A financial future contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified price and at a specified time and place.

Traded on an exchange which sets certain standardized norms for trading in the future contract.

Types of financial futures contracts Futures contracts are of two major categories:

Financial futures

Commodity futures

Financial futures are not different from commodity futures except of the underlying asset, for example, in commodity futures a particular commodity like foodgrains,metals, vegetables etc are traded whereas in financial futures, various particular financial instruments like equity shares,depentures,bond,treasury,securities,currencies,etc traded.

Types of financial futures contractsInterest rate futures:

It is one of the important financial futures in the, world.(1975).

Important interest bearing securities are like…

-Treasury bills

-Notes

-Bonds

-Debentures

-Euro-dollars deposits

-Municipal bonds

Contd This market is also further categorized into short-term and long-

term interest bearing instruments. A few important interest rate futures traded on various exchanges, are notional gild contracts short-term deposits futures:

Treasury bill futures Euro-dollar futures Treasury bond futures Treasury notes futures.

Contd:Foreign currency Futures: These financial as the name indicates trade in the foreign

currencies, thus also known as exchange rate futures. Important currencies in which these futures contracts are made such as:

US-dollar

Pond sterling

Yen

French Francs

Canadian dollar

Stock Index futures:

These contracts are based on stock market indices. Stock

index futures contracts are mainly used for hedging and speculation purposes. These are commonly traded by mutual funds, pension funds, investment trusts, insurance companies,speculators,arbitrageurs and hedgers.

Example:

Dow Jones Industrial Average

Standard and Poor’s 500

New York stock Exchange Index.

Singapore International Monetary Exchange(SIMEX)

S&P CNX Nifty

Bond Index Futures:

These futures contracts are based on particular bond, indices

i.e. indicates of bond prices. We know that prices of debt instruments are inversely related to interest rates, so that bond index is also related inversely to them.

Example:

Municipal Bond Index futures-(US Municipal Bonds) which is traded on Chicago Board of Trade (CBOT)

Cost of living Index Futures: This is also known as Inflation futures. These futures contracts are

based on a specified cost of living index.

Example:

Consumer Price Index

Wholesale Price Index

International Monetary Market (IMM) in Chicago.

Operators /Traders in the futures markets Hedgers: Hedge is a position taken in futures for the purpose of

reducing exposure to one or more types of risk. A person who undertakes such position is called ‘hedger’. Hedger use future market to reduce risk caused by movement

in prices of securities, commodities, exchange rates, interest rates, indices, etc.

A hedger will take a position in future market, is opposite a risk to which he exposed.

An opposite position to a perceived(understand) risk is called ‘hedging strategy in future markets’.

Hedging strategy adoption of a future position that, generates profits when market value commitment is higher than the expected value.

Example:

A treasurer of a company knows the foreign currency amount to be received at certain futures time may hedge(be cautious) the foreign exchange risk by taking short position.(selling foreign currency at a particular rate)in the future markets. He can take a long position(buying foreign currency at a particular rate) in case of future foreign exchange payment at a specific future date.

Speculators: An investor is willing to take risk by taking futures position with

expectation to earn profits. Example: A speculator forecasted the price of gold would be

Rs. 5500 per 10 grams after one month . Current price of gold is Rs.5400 per 10 grams, he take a long position in gold and expects to make a profit of Rs. 100 per 10 grams. Expected profit is associated with risk, gold price after one month decrease to Rs.5300 per 10 gram, may lose Rs.100 per 10 gram.

Speculators ,trade in the future market to earn profit on basis of difference in spot and future prices of the underlying asset.

Hedger use future market for avoiding exposure to adverse movement in price of an assets. Where as the speculators wish to take position based on such movement in the price of an asset.

In spot market a speculator has to make an initial cash payment equal to the total value of the asset purchased. No initial cash payment except the margin money to enter into forward market.

A speculator who use fundamental analysis of economic conditions of the market is known as fundamental analyst.

To predict future price on basis of past movement in the price of the asset is known as technical analyst.

A speculator who owns a seat on a particular exchange and trades in his own name is called a local speculator.

Local speculators classified into three- Scalper—try to make profits from holding positions for short

period of time. Pit speculators---like scalper take bigger positions and hold

them longer. Floor traders– consider inter commodity price relationship. Arbitrageurs: Arbitrageur is a trader who attempts to make profits by

locking in a riskless trading by entering into transactions in two or more markets.

Arbitrage keeps the future and future prices in line with one another.

Arbitrage trading helps to make market liquid, ensure accurate pricing and enhance price stability.

Example: At the expiration of the gold future contract, the future price is Rs. 5500 per 10 gram, but spot price is Rs. 5480 per 10 gram. An arbitrageur purchase the gold for Rs.5480 per 10 gram and go short position that expires immediately. And make a profit of Rs. 20 per 10 grams by delivering the gold for Rs.5500.

Spreaders: Spreading is a specific trading activity offset(equalize) future

position by creating almost net position. Spreaders believe in lower expected return but at the less risk. Spreaders must forecast the factors which affect the changes in

the spread Interest rate behavior is an important factor causes changes in

the spreads. A spread reduces the risk even if forecast is incorrect.

Function of futures market Hedging: Hedging function which is also known as price insurance, risk

shifting or risk transference function. Traders or participants can hedge their risks or protect from

the adverse price movement in the underlying assets in which they deal.

Example: A farmer is expecting to produce 1000 tons of wheat in next six month, he establish a price for the quantity by selling 10 wheat future contracts, each being of 100 tons. By selling these future contract, farmer intends to establish a price today that will be harvested in the future.

Future market also serve as a substitute for a cash market sale, a cash market sale was impossible since wheat was not in existence.

Contd: Like interest rate future contract which protect the financial

institutions such as commercial banks, insurance companies, mutual funds, pension funds etc, the adverse change in the value of asset and liabilities due to interest rate movements.

Hedging activities are much useful for society to control, shift, avoid, reduce, eliminate and manage efficiently various types of risks.

Price discovery: Revealing of information about future cash market prices

through the future market. A trader agrees to receive or deliver a commodity or asset at a

certain future time for a price which is determined now. Creates a relationship between the future price and the price

that people expect to prevail at the delivery date.

Contd: Provide an expression consensus(compromise) of the today

expectation about a specified future time. Traders can compare the spot and future prices and able to

decide the optimum allocation of their quantity of underlying asset between immediate sale and future sales.

Useful for producers, farmers, etc. Financing function: Future contracts are standardized contract, it is easier for the

lenders about assurance of quality, quantity and liquidity of the underlying asset.

It is much familiar in the spot market, but it is also unique to future markets.

Lender are more interested to finance hedged asset stock rather than un-hedged stock. The hedged asset stock are protected against the risk of loss of value.

Liquidity function: Future market deals with transaction which are matured in the

future period. Operated on the basis of margins which determined on the rides

involved in the contract. Buyer and seller have to deposit only a fraction of the contract

value , known as a margins. Trader in future market do business much larger volume than spot

market and make market more liquid. Example: A speculator estimates a price increase in the silver

future market from the current future price of Rs. 7500 per kg. The market lot being 10 kg, he buys one lot of future silver for Rs.75000(7500x10).Assuming the 10 percent margin, the speculator is to deposit only Rs. 7500. Supposing that a 10 percent increase occurs in the price of silver to Rs. 8250 per kg. The value of transaction also increase Rs. 82500, incurring profit of Rs.7500.

Price stabilization : Future market reduces both the heights of the peaks and the

depth of the low. Causative(contributing) factor responsible for such price

stabilizing influence are , speculation, price discovery, tendency to panic,(alarm, fear) etc.

Disseminating information: Disseminate information quickly, effectively, and inexpensively,

and reducing the monopolistic tendency in the market. Information disseminating service enables the society to

discover or form suitable true /correct/equilibrium prices. Serve as barometers of future in price, determination of correct

prices on spot market now and in future. Creating a significant number of jobs and attracts a considerable

volume of transactions from Non-residents. Generating foreign

Specification of the future contract Future contract are initiated through a particular exchange. An exchange must specify in detail the exact nature of contract

of the agreement between two parties. Before registered at exchange, the trader or investor willing to

buy or sell have to contract a ‘broker’ who is authorized to trade on the floor of an exchange on behalf of clients or customers.

Exchange perform three function:

(1) provide and maintain a physical market place know as ‘The Floor’ where future transactions are sold and purchased by the members of the exchange.

(2) Maintain and enforce ethical and financial norms applicable to the future trading under taken on the exchange.

(3) To promote business interest of the members because the exchange’s main objective is to extend the facilities for such trading to its members.

Objective to buy a seat on the exchange: to engage in floor trading activities, and to get the right, as per exchange norms, to execute future trade without paying commission to the broker.

Two type of trader or broker on the floor of the exchange:

(1) Commission brokers---charge a fee for executing contract or trade on behalf of their customer.

(2) Local traders----trade for their own account. Different types of orders which can be placed by a customer to

the broker: Market order—the investor is prepared to trade at the current

market price. Place a market order with their broker and are passed to commission broker representing two sides.

Limit order—customer specifies a certain price and request the transaction be executed only at a specified price or a better one is obtained, otherwise not.

Stop order---investor informs the members or broker to trade at any price once the market price has reached at a certain level. Used to protect losses, preserve profits and take new position.

Stop limit order--- just like stop order, the investor instructs the broker to enter into a position after the market price has reached at a certain level.

---- Limit price may or may not be equal to spot price.

example---an investor who took the long position of SBI share at Rs.350may instructs his broker to sell if the future price falls to Rs.340 but to accept no less than 330.

Market-if-touched---investor instructs the broker to trade at whatever price can be obtained once the market has reached at certain level.

----Technical analyst who believe that the market will reach on extreme before turning and wish to trade as soon as the price is reached.

Alternative order--- investor put two order but wants only one to be filled up, which limits the potential profit order.

---example customer who entered a long position for SBI share at Rs. 350 may instruct the broker to sell if the price either increase to Rs.360 or falls to Rs. 340.

Contingent order– broker is asked to take a certain position if the price of another contract reaches a given level.

Spread order—spread order require a certain difference between the prices of the opposing contract rather than specific prices.

Standardization: Standardized terms set by exchange on which future contract

are to be traded. Example: only gold future contract are traded at the

commodity exchange, inc (COMEX) in New York. Benefit of standardized specification, is concentrated in few

contract resulting in more liquidity of contract. Future contract specifies every aspects of the deal regarding

the asset, size, price limits future period, trading hours, delivery, settlement, etc.

The asset: On commodity future market , the asset are commodity like

food grains, metals, oil, gas, etc. On financial future market, financial asset like equities, debt,

currencies, etc.

Contd: Specifying the asset, exchange must stipulate (specify) the

grade or grades of commodity which are acceptable. Example: Specification of the deliver-able grade of gold is

given as “Refined gold in the form of one 100- ounce bar on the three 1-kilo gold bars array not less than 995 fineness.(fine quality)

Financial assets, problem of quality do not arise. No need to specify grade of US dollar, UK pound sterling.

Contract size: Specify the amount of the asset to be delivered under one

contract. Example: contract size or trading unit of the Chicago Board of

Trade(CBOT) 100 –ounce gold future is 100 troy ounces.

• Contd:• If contract size is too large then the trader will be hesitating

and will have speculation positions.• If contract size is very small then trading may be expensive.• Correct size of the contract is very important decision and

depends on likely users. Delivery month: Contract month identify the expiry cycle of delivery dates. Delivery month vary from contract to contract and chosen by

the exchange to meet the requirement of market. Exchange specifies when trading in a particular month’s

contract will begin and last day on which trading can take place for a given contract.

• Delivery arrangement:• Place where delivery will be made must be specified by the

exchange.• Most important for commodities than the financial instrument due

to transportation cost incurred on delivery of the goods.• Obligation of the seller and buyer of a future contract to deliver

the underlying asset, during contract expiration period.• Future contract specifies a First notice day (position or

presentation day), Last notice day (notice day), and Last trading day (delivery day).

• Daily price movement limits:• Exchange puts on the maximum price change permitted per day.• If price moves down by an amount to daily price limit, the

contract is called limit down. If it moves up by the daily price limit ,it is said to be limit up.

• Position limit:• Position limit means the maximum number of contract a

speculator may hold. Example Chicago Mercantile Exchange has put the position limit of 1000 for the speculator with not more than 300 in any one delivery month.

• Objective of this limit is to protect market from excessive trading from the speculator.

Clearing house Clearing house is a financial institution associated with the future

exchange that guarantees the financial integrity and performance on future contract.

Considered as thirty party between the buyer and seller of future contract, taking no active position in market but assuring for every short position there is a long position.

Functions of clearing house: Clearing house keeps track records of all the transaction taken place

during a day, it calculate the net position of each of its members. Clearing house guarantees all the trader in future market will

honour their obligations. It plays as a middle man in the future contract.

All buying and selling futures contract require daily collection and payment of funds to parties of future transaction.

Contd: It collects amount of net losses and pays the net gain for the

day to respective member. Observed, that the clearing house is well established, large,

financially sound institutions and risk of future default by the clearing house is very small.

Operation of margin• Addition to clearing house, to safeguards the future contract,

important requirement for margin and daily settlement.• Margin requirement applicable to investor and a trader of the

clearing house.• Two parties are directly trading in future market for a certain

prices, risk for backing out of parties to the contract. May not have financial resources to honour the contract.

• This is why margin come into picture. Concept of margin: An investor who enters into a future contract is required to

deposit funds with the broker called a margin. Objective is provide financial safeguard for ensuring the

investor to perform their contract obligations.

• Amount of margin may vary from contract to contract and even broker to broker.

• Margin deposit in different forms like cash, bank’s letter of credit and treasury securities.

• Margin account may or may not earn interest. This loss of interest is the cost of margin requirement.

Types of margin: Three type of margin such as initial margin, maintenance

margin and variation margin. Initial margin:--original amount must deposit into account to

establish future contract. To determine initial margin, exchange consider the degree of

volatility (unpredictability) of price movement in past of the underlying asset.

• Exchange has right to increase or decrease quantum of initial marginal depending upon change in future price.

• Most of the future contract, initial margin may be 5 per cent or less of underlying asset’s value.

• Completion of all obligation with investor future position, initial margin is returned to trader.

Maintenance margin:• Maintenance margin is the minimum amount which must be

remained(kept) in a margin account.• Normally about 75 per cent of the initial margin.• Future price move against (beside) the investor resulting in

falling margin account below the maintenance margin, broker will make a call. Demand for additional fund is called margin call.

• Example initial margin on future contract is Rs.5000 and maintenance margin Rs. 3750(75% initial margin).

• Next day party has sustained a loss of Rs.1000, reducing balance in margin to Rs.4000. further decreased and sustained loss is Rs.500. Balance in margin account to Rs,3500,below maintenance margin, broker will make a call to fill the margin account to Rs.5000, level of initial margin.

Variation margin: Additional amount which has to be deposited by trader with

the broker to bring balance of margin account to initial margin level.

Above example the variation margin be Rs.1500 (5000-3500) difference of initial margin and balance in margin account.

Investor not pay initial margin immediate, broker may proceed to unilaterally close out account by entering into offsetting future contract.

Margins and marking-to-market(daily settlement): Observed, initial margin sometime is even less than 5 per cent

which is very small considering total value of future contract. This smallness is reasonable, because another safeguard built

in system known as daily settlement marking-to-market. All transaction are settled on daily basis. the system of daily

settlement in future market is called marking-to-market. Trader realize their gains or losses on daily basis to understand

this process of daily settlement. Future contract is closed out and rewritten at a new price

everyday.

Closing a future position(Settlement) Physical delivery: Liquidating future position is by making or taking physical

delivery of goods or asset, exchange provided alternatives as to when, where, and what will be delivered.

Choice of the party with a short position, the party is ready to deliver, it will send a notice of intention to deliver to exchange.

Price is settled with a possible adjustment for quality of the asset and chosen delivery location.

Exchange selects a party with an outstanding long position to accept delivery.

Cash settlement/ delivery: Procedure is a substitute of physical delivery and do not

require physical delivery. Exchange notifies about cash delivery as the settlement

procedure. Certain financial future like stock indices, treasury securities,

euro-dollar, time deposit, municipal bonds, etc. Cash settlement contract expires, exchange sets its final

settlement price equal to spot price of the underlying asset on that day.

Prices of cash settlement contract is just like the prices of delivery contract at their expiration period.

Offsetting: Liquidating the future position is to effect an offset (make-up

for) future transaction or via a reversing trade which reverses the existing open position.

Example, initial buyer (long) liquidates his position by selling (going short) an identical futures contract (which means same delivery month and same underlying).Similarly, initial seller (short) goes for buying (long) an identical future contract.

Clearing house plays a significant role in facilitating settlement by offset.

This method is relatively simple, require good liquidity in the market and entail usual brokerage cost.

There are two parties X and Y. X has an obligation to clearing house to accept 10000 bushels of cotton in september and to pay Rs. 180 per bushels.

Y has a obligation to the clearing house to deliver 10000 bushels of cotton in September and to receive Rs.180 per bushels. Both party can reverse or offset their position in that way where by buyer become seller and seller becomes the buyer.

Exchange of futures for physical (EFP): Liquidating future contract in a form of physical delivery,

called exchange of future for exchange . A party holds a future contract like to liquidate his position

that is different from those the exchange offers. Example, a party may like to deliver the asset before the

specified future period, or may deliver the asset at different place, or deliver outside the normal trading hours, etc.

EFP, system permits to exchange a future position for a cash position that meets both the parties preference, party must find willing to make the trade.

Difference between Futures and Forward ContractForwards contract Futures contract

1)Private contract between the twp parties bilateral contracts

Traded on organized exchanges

2) Not standardized(customized) Standardized contract

3) Normally one specified delivery date

Range of delivery dates

4)Settle at the end of maturity. No cash exchange prior to delivery date.

Daily settled. Profit/loss are paid in cash.

5) More than 90 per cent of forward contract are settled by actual delivery of assets.

Not more than 5 per cent of future contract are settled by delivery.

6) Delivery or final cash settlement usually takes place

Contract normally closed out prior to the delivery.

Contd:

7) No margin money required Margins are required of all the participants

8) Cost of forward contract based on bid-ask spread.

Entail brokerage fee for buy and sell order

9) There is credit risk for each party. Hence, credit limit must be set for each party.

Exchange clearing house becomes the opposite side to each future contract. Thereby reducing credit risk substantially.