Futures Contract

[Submitted by CA. Vibhuti Gupta,
New Delhi]

November 10, 2008

A futures contract is a contract, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality at a certain date in the future, at a price (futures price) determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.

Characterstics of Future Contract

1. Future contracts are organized / standardized contracts, which are traded on the exchanges.
2. These contracts, are standardized by the exchanges are very liquid in nature.
3. In futures market, clearing corporation/ house provides the settlement guarantee.
4. Counter party risk exists, but is assumed by the Clearing House reducing the risk to almost nil.
5. Very high Liquidity as contracts are standardized contracts.
6. Where a forward contract can only be reversed with the same counter party with whom it was entered into, a futures contract can be reversed with any member of the exchange.

Standardization

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

1. The underlying asset or instrument which could be anything from a barrel of crude oil to a short term interest rate.
2. The type of settlement, either cash settlement or physical settlement.
3. The amount and units of the underlying asset per contract, which can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
4. The currency in which the futures contract is quoted.
5. The delivery month.
6. The last trading date.

Margin of Future Contracts

Futures margin rates are set by the futures exchanges and some brokerages will add an extra premium to the exchange minimum rate in order to lower their risk exposure. Margin is set based on risk. The larger dollar value moves that a futures market makes, the higher margin rates can be expected

1. Initial margin Initial Futures Margin: It is a security deposit to ensure that traders have sufficient funds to meet any potential loss from a trade. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client’s account
2. Maintenance margin: A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.

3. Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls.

4. Performance bond margin: The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.

Settlement of the Future Contracts

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

1. Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. The Nymex crude futures contract uses this method of settlement upon expiration.
2. Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.

Expiry of the Contract

Expiry is the time and the day that a particular delivery month of a futures contract stops trading and the final settlement price for that contract month and year obtains.

Futures contracts and exchanges

There are many different kinds of futures contracts, reflecting the many different kinds of tradable assets of which they are derivatives. Following is the list of of tradable commodities futures contracts, see List of traded commodities.

1. Foreign exchange market
2. Money market
3. Bond market
4. Equity index market
5. Commodities Market

Index Futures: Index futures are the future contracts for which underlying is the cash market index. For example: BSE may launch a future contract on "BSE Sensitive Index" and NSE may launch a future contract on "S&P CNX NIFTY".

Frequently used terms in Index Futures market: -

1. Contract Size - is the value of the contract at a specific level of Index. It is Index level * Multiplier.
2. Multiplier - It is a pre-determined value, used to arrive at the contract size. It is the price per index point.
3. Tick Size - It is the minimum price difference between two quotes of similar nature.
4. Contract Month - is the month in which the contract will expire.
5. Expiry Day - is the last day on which the contract is available for trading.
6. Open interest - it's the total outstanding long or short positions in the market at any specific point in time. As total long positions for market would be equal to total short positions, for calculation of open Interest, only one side of the contracts is counted.
7. Volume - Number of contracts traded during a specific period of time - During a day, during a week or during a month.
8. Long position - Outstanding/unsettled purchase position at any point of time.
9. Short position - Outstanding/ unsettled sales position at any point of time.
10. Open position - is the outstanding/unsettled long or short position at any point of time.
11. Physical delivery - Open position at the expiry of the contract is settled through delivery of the underlying. In futures market, delivery is low.
12. Cash settlement - Open position at the expiry of the contract is settled in cash. These contracts are designated as cash settled contracts. Index Futures fall in this category.
13. Alternative Delivery Procedure (ADP) - Open position at the expiry of the contract is settled by two parties - one buyer and one seller, at the terms other than defined by the exchange. World wide a significant portion of the energy and energy related contracts (crude oil, heating and gasoline oil) are settled through Alternative Delivery Procedure.

Equity futures are futures on stock market indices. The biggest equity markets include the Dow Jones Industrial index, S&P 500 and the FTSE100 in the UK. Trading Index futures is an ideal way to speculate on price movements of the big indices without having to physically own the shares. One advantage that makes equity index future trading appealing is the fact that these contracts typically have a low margin requirement.

Dow Jones Index

Dow Jones Futures: Dow Jones Futures are futures contracts on the Dow Jones Industrial Index. The Dow is made up of the biggest companies across nine industries.

Dow Futures Contract: A standard Dow contract is 10 times the index value. For example if the index is priced at 13,000 points, the contract will be for $130,000. There are also mini sized Dow futures (also known as Dow emini). These contracts are half the size of the standard contracts. The Symbol for Dow contracts is ZD. The mini Dow contract symbol is YM.

FTSE Index

FTSE Futures : FTSE Futures are contracts on Britain’s top 100 companies.

FTSE Contracts: FTSE 100 Index futures are priced at 10x the FTSE price. For example if the FTSE is priced at 6,000, the contract will be £60,000.The FTSE 100 futures contract symbol is LFX.

NASDAQ Index

NASDAQ Futures: NASDAQ Futures are futures contracts on the NASDAQ 100 index. The NASDAQ contains companies both in and out of the United States. The index is tech heavy and does not include financial companies.

NASDAQ Futures Contract: One contract is 100 times the price of the index. For example if the NASDAQ was priced at 2,500 points, a standard contract would be worth $250,000. There are also mini NASDAQ contracts that are half of this value. The requirements for the mini contract are half of this. The symbol standard NASDAQ contract is ND and NQ for the mini contract.

S & P 500 Index

S&P 500 Futures : The S&P 500 consists of 500 large cap stocks. The vast majority of these are companies based in the United States.

S & P 500 Futures Contract: The SP 500 contract is 250 times the price of the index. For example if the S&P 500 is currently priced at 1,500 points, the contract will be $375,000. This is too high for many traders. There is also a mini contract. The mini contract is 5 times smaller than the standard contract. The symbol for the standard contract is SP

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