CHAPTER 5

Futures Contracts
OBJECTIVES
What is a futures contract?
What are the differences between a futures contract
and a forward contract?
What is the role of a clearing corporation in futures
exchanges?
What is meant by margin and marking-to-market in
futures markets?
How to understand futures quotes?
How can one arbitrage between futures markets and
spot markets?
How are futures contracts traded?
WHAT IS A FUTURES CONTRACT?

A futures contract is an agreement to either

buy or sell a specified quantity of a specified
asset at a certain time in the future for a
price that is agreed upon at the time of
entering into the contract
 TERMINOLOGY OF A FUTURES
CONTRACT
Underlying asset: the asset on which the
futures contract is written, or the asset that
will either be bought or sold at a future
time
Maturity date: The future date at which the
underlying asset will either be bought or
sold
Futures price: the price that is determined
at the current time for an exchange in the
future
Contract Size: Quantity of asset that will
be bought or sold
FUTURES CONTRACTS VERSUS
FORWARD CONTRACTS
Though both determine the price for a future transaction
at the current time, the differences are:
Negotiability: Forwards are non-negotiable, whereas
futures can be traded on exchanges i.e. party entering
into a future contract to buy an asset can at a later time,
enter into future contract to sell the same asset before
the maturity of the contract. Futures provide more
liquidity as compared to forward contracts
Standardization: Futures are standardized, whereas
forwards are custom-made. Standardization reduces the
flexibility as compared to forward contracts with respect
to size, date of maturity and date of delivery
Liquidity: Futures are standardized and negotiable they
can be traded on futures exchanges and hence easier
and cheaper to trade than forward contracts . Hence ,
futures are more liquid as compared to forwards
FUTURES CONTRACTS VERSUS
FORWARD CONTRACTS
Performance: Parties to forwards face
counterparty risk i.e. the possibility of non
compliance with the contractual obligations.
Since futures are traded through
exchange, parties do not face the non
performance risk
Cash needs: Forwards do not require
immediate cash outlay, whereas futures
may require margin payments
Ability to reduce losses: In forwards, the
party cannot reduce losses if the price
moves in favor, whereas in futures, the
party can get out of the contract by taking a
counter-position in the market
Parameter Forward Contract Futures Contract
Negotiability Non negotiable Negotiable
Trading place Over-the-counter Exchange
Liquidity Non-liquid Highly liquid
Type of contract Custom made Standardized
Counterparty risk Present Absent
Cash needs None at the Margin amounts
beginning

Ability to rduce Cannot reduce Can reduce losses

losses losses
PARTICIPANTS IN FUTURES
MARKETS
Hedgers who hold a position in the asset
and want to reduce the price risk while
taking a position in futures
Speculators who do not hold a position in
the asset, but take a position in futures
based on their expectation in the price
movement of the asset
Arbitrageurs who take opposite positions
in the asset and futures simultaneously,
whenever there is mispricing in the two
markets
SPECIFICATIONS OF A FUTURES CONTRACT
Futures contracts specifications include:
The underlying asset(Quality, grade)
Contract size
Delivery arrangement, i.e. location and
alternative location
Delivery arrangement, i.e. alternative grade
Delivery month
Delivery notification(should notify the intention of
enforcing the contract or closing out with
offsetting position )
Daily price movement limits(limit up, limit down)
Position limits-deciding the number of contracts
that can be held by a trader in futures so as to
prevent a speculator from exercising an undue
influence on the market
CLOSING OUT POSITION

Whenever a trader enters the futures

market, he is said to take an open
position

Closing out a position means that the

trader takes an offsetting position in
futures, so that the net position is zero and
he has no further obligations
ARBITRAGE BETWEEN FUTURES AND SPOT
MARKETS
Theoretically during the delivery period futures
price should be the same as the price of the
underlying asset in the spot market
If the future price is not the same as the spot
market price, arbitrage opportunity will arise.
When the assets prices are mispriced, arbitrage
occurs
Mispricing means one of the asset is relatively
overpriced and the other is relatively underpriced
Actions of the arbitragers will bring the prices of
the two assets in line and mispricing will
disappear
 Arbitrageur will buy relatively underpriced
asset and sell relatively over priced asset
If the future price is more sell the asset at
a future price and buy the asset at spot
price which will result in profit of F-S
If spot is higher as compared to futures,
the transactions will be reversed and profit
will be S-F
PERFORMANCE OF CONTRACTS
Counterparty risk is eliminated by futures
exchanges through:

Creation of the clearinghouse

Instituting margins

Marking-to-market all futures positions

CLEARINGHOUSE
Part of the futures exchange
Acts as the intermediary for all
transactions
Guarantees performance of all contracts
by clearing all the contracts through
clearing members
Clearing members need to post clearing
margins
They have to clear the margin account that
is marked-to-market every day
MARGIN FOR TRADERS
Since the clearing member is not obliged to
take any position in a contract, but simply
clears them, he or she will collect margins from
brokers and traders

Each broker will collect the margin from the

trader and maintain their margin account

This margin account will be marked-to-market

daily
 MARKING TO MARKET
Marking-to-market means that the margin
account of the traders is adjusted every day
using the daily settlement price
If marking-to-market results in gain for the trader,
the margin balance will increase by the amount
of gain
If it results in a loss for the trader, the margin
balance will decrease by the amount of loss
By marking-to-market, the contract can be
considered closed out every day; at the
beginning of the next day, a new contract is
effectively entered into
 MARGIN CALL
When traders make a loss by marking-to-market, the
margin account balance will decrease

If the balance falls below a specified amount set by the

exchange (the variation margin), the broker will issue a
margin call to the trader

Upon receiving the margin call, the trader must post

additional margin to ensure that the balance in the
margin account reaches the original margin based on
the contract that was entered into

If no additional money is paid, the broker will close out

the position, and pay the balance in the margin
account to the trader
POSTING MARGIN
The margin amount, as well as the amount to be
paid if a margin call is received, will be decided by
the broker and conveyed to the trader

The margin amount is to be paid by the next day

after the notification is received

The margin amount can be paid in the form of cash,

or in terms of any exchange-approved security

If securities are provided for a margin, the margin

balance will be calculated based on the market
values of the securities every day in addition to the
marking-to-market of the futures
 MARGIN ACCOUNT -- EXAMPLE
On day 0, one enters into a long futures contract at INR
320. The contract size is 1000. The initial margin is
5% of the value, and the variation margin is 5000. The
settlement prices for the next 7 days are given as:

Day Settlement Price

1 322
2 313
3 316
4 313
5 309
6 311
7 314
Day Settlement Gain/Loss Margin Amount
Price
0 320 n/a 16000
1 322 +2000 18000
2 318 - 4000 14000
3 316 -2000 12000
4 313 -3000 9000
5 309 -4000 16000
6 311 +2000 18000
7 314 +3000 21000

On day 5, the margin call is given as the balance

drops to 5000. One must pay an additional INR
11,000 on Day 5.
MARGIN REQUIREMENTS
Margin requirements for a bonafide hedger such
as a rice merchant who needs rice in future and
buys futures contracts will be lower because risk
of non performance is smaller
Margin requirements for an investor with a day
trade will also be lower since he will close his
position very next day
For an investor who enters a spread contract
will have a lower margin since spread involves
both long and short positions, variations in the
margin account will be small as gain in short will
be compensated by loss in long and vice versa
PRICE QUOTE
The price quote shows:
Underlying asset
Contract size
Price unit(i.e. in kg, MT, ounces ,etc)
Expiry date(Maturity )
Opening Price
Highest price during the day
Lowest price during the day
Settlement price
Change in settlement price
Open interest
Volume of trading
SETTLEMENT PRICE
Settlement price is the price at which margin
accounts are marked-to-market every day

Usually calculated as the average price at

which the contract was traded during the
last half-hour of trade

If there is no trade during that time, the

theoretical price is calculated using the spot
market price and cost of carry
 OPEN INTEREST
This is the total number of outstanding
futures contracts available for delivery at a
certain time
The sum of all long or all short positions
Provides an indication of trading in that
contract, as well as contract liquidity
If open interest is high, liquidity is also high,
and a trader will be able to easily close out
the position
Generally, open interest is small at the start
of a contract, increasing over time; near
maturity, it falls, as many traders close out
their positions
 CALCULATING OPEN INTEREST
On any given day, some traders may enter
into futures contracts with either long or
short positions; some may close out their
initial positions
If the number of new trades is greater than
the number of contracts closed out, the
open interest will increase
If the number of new trades is the same as
the number of contracts closed out, the
open interest will not change
If the number of new trades is less than the
number of contracts closed out, the open
interest will decrease
CONVERGENCE OF FUTURES TO SPOT

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)
CONVERGENCE OF FUTURES TO
SPOT
Suppose that future price is more than the
spot price
Traders will take the arbitrage opportunity
Will short a futures contract, buy the asset
and make delivery
This will lead to reduction in futures prices.
Hence companies will find attractive and will
enter into long contract Therefore price will
again rise.
Hence, price will remain very close to spot
price during the delivery period.
PATTERN OF PRICES
If the futures price decreases along with
decrease in maturity, the futures market is
said to be a normal market

If the futures price increases with the

decrease in maturity, the futures market is
said to be an inverted market
CONTANGO AND NORMAL
BACKWARDATION
Whilenormal and inverted markets refer to the
shape of the futures price curve, contango and
normal backwardation refer to the pattern of
futures prices over time

Contango occurs when the futures price is

above the expected spot price, implying that the
futures price will fall over time

Normal backwardation occurs when the futures

price is below the expected spot price, implying
that the futures price will increase over time
FINAL SETTLEMENT
This is the settlement on the maturity date
Could be through delivery or cash
settlement

Settlement procedure will be provided by

the exchange
In the NSE, single stock futures are settled
through cash, while interest rate futures
are settled through delivery
SETTLEMENT THROUGH
DELIVERY
The period during which delivery can be made is
decided by the exchange
The exact time during the delivery period when
delivery will be made is decided by the party that has
a short position in futures
Intention to deliver will be communicated to the
exchange through the broker with information on the
number of contracts, location, and grade to be
delivered
Exchange will choose randomly a party that has a
long position to take delivery
Exchange will adjust the settlement price for place of
delivery and asset quality
 CASH SETTLEMENT
Many contracts are cash-settled

Final settlement price will be calculated by the

exchange using the closing spot price of the
underlying asset

Margin balance of all traders will be calculated

using this final settlement price

If the margin balance is positive, the trader will be

paid the balance
If the margin balance is negative, the trader will
need to pay this amount to the exchange
TYPES OF ORDERS
Market Orders
Limit Orders
Stop Orders
Stop-Limit Orders
Market-if-touched Orders
Time-of-day Orders
Open order or good-till-cancelled order
A fill-or-kill order
PRICING OF FUTURES
Similar to pricing of forwards

Theoretical price is calculated using the

cost-of-carry model

The actual market price is based on the

demand and supply for the contract

The actual market price need not equal the

theoretical price at all times