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Futures
A Future or a Futures Contract is a contract to buy or sell a stated commodity or financial claim at a specified price at some specified time in the future. They are agreements between two parties to undertake a transaction at an agreed price on a specified future date. However, they differ from forwards in some important respects. Futures contracts are exchange based instruments trades on a regulated exchange. The buyer and the seller of a contract do not transact with each other directly. The clearinghouse becomes the formal counter party to every transaction. This reduces the risk of non-compliance with the contract significantly for the buyer or seller of a future, as it is highly unlikely that the clearing house will be unable to fulfil its obligations. The exchange provides standardised legal agreements traded in highly liquid markets. The contracts cannot be tailor-made. The fact that the agreements are standardised allows a wide market appeal because buyers and sellers know what is being traded: the contracts are for a specific quality of the underlying, on specific amounts with specific delivery dates. Features of Futures Contracts (Brahmaiah p.29) The main features of futures contracts are as follows: 1. Futures contracts are traded on organised exchanges. 2. Futures contracts have standardised contract terms 3. Futures exchanges are associated with clearing houses to guarantee fulfilment of obligations. 4. Futures positions can be closed easily. 5. Futures trading requires margin payment 1. Organised Exchange Futures are traded only on organised exchanges. In the USA there are more than 10 organised exchanges, which deal in futures contracts, the Chicago Board of Trade being the oldest one. There are over 40 such exchanges all over the world. The importance of having an organised exchange is that they provide a central trading place in the absence of which there will not be enough potential to generate the depth of trading activity necessary to support a secondary market. In a circular way the existence of a secondary market encourages more traders to enter the market and in turn provides additional liquidity. An organised exchange also encourages confidence in the futures market by allowing for the effective regulation of trading. The various exchanges set and enforce rules and collect and disseminate information on trading activity and the commodities being traded. Thus, organised exchanges ensure liquidity generated by having a central trading place, effective regulation, and the flow of information which necessary for the development of any market. 2. Standardised Contracts Futures contracts are standardised contracts. The underlying asset, the contract size, the delivery arrangements, delivery months, price quotes, daily price movement limits etc are standardised.

6 a) The Asset: When the asset is a commodity, there may be quite a variation in its quality. So in a futures contract, the exchange stipulates the grade or grades of the commodity that are acceptable. For example:- The New York Cotton Exchange has specified the asset in its orange juice futures contract as US Grade A, with Brix value of not less than 57 degfrees, having a Brix value to acid ratio of not less than 13 to 1, with factors of colour and flavour each scoring 37 points or higher and 19 for defects, with a minimum score 94. In the case of some commodities, a range of grades can be delivered but the price received is adjusted depending on the grade chosen. However, the financial assets in futures contracts are generally well defined and unambiguous. There is no need to define A USD or GBP or Japanese Yen. b) The Contract Size The Contract size specifies the amount of the asset that has to be delivered under the contract. This is an important decision for the exchange. If the contract size is too large, many investors who wish to hedge relatively small exposures or who wish to take relatively small speculative positions will be unable to use the exchange. On the other hand, if the contract size is too small, trading may be expensive since there is a cost associated with each contract traded. Whereas the value of assets to be delivered under commodity futures, the value of assets to be delivered under financial futures will be rather high. c) Delivery Arrangements. It is mainly concerned with the place at which the delivery of the underlying asset is to be made. It is more important in the case of commodity futures since there may be significant transportation cost associated with the delivery of many commodities. The place of delivery is not a problem in the case of financial futures. So the place of delivery will be predetermined by the exchange. For example: - the Chicago Mercantile Exchange random length lumber contract, the delivery location is specified as On track and shall either be unitised in double-door boxcars or , at no additional cost to the buyer, each unit shall be individually paper wrapped and loaded on flatcars. Par delivery of hem-fir in California, Idaho, Montana, Nevada, Oregon, and Washington, and in the province of British Columbia. d) Delivery Months. The delivery months vary from contract to contract and are chosen by the exchange to meet the need of market participants. For example, currency futures on the International Monetary Exchange have delivery months of march, June, September, and December; corn futures traded on the Chicago Board of Trade have delivery months of march, may, July, September, and December; pepper futures traded on the IPSTA Cochin, have February, march, April, June, July, October and December, as delivery months. At any given time, contracts trade for the closest delivery month and a number of subsequent delivery months. The exchange also specifies when trading in a particular months contract will begin. The exchange also specifies the last day on which trading can take place for as given contract. This is generally a few days before the last day on which delivery can be made.

7 e) Price Quotes. The futures price is quoted in a way that is convenient and easy to understand. For example, Crude Oil futures on the New York Mercantile Exchange are quoted in dollars per barrel to two decimal points. Treasury bond and Treasury note futures prices on the Chicago Board of Trade are quoted in dollars and thirty-seconds of a dollar. The minimum price movement that can occur in trading is consistent with the way in which the price is quoted. Thus, it is $0.01 ( or 1 cent per barrel) for the Oil futures. f) Daily Price Movement Limits. For most contracts, daily price movement limits are specified by the exchange. The price will not be allowed to go beyond this limit in either way. For example, the daily price movement limit for Oil futures may be $1. If the price moves down by an amount equal to the daily price limit, the contract is said to be limit down. If the price moves up by the limit, it is said to be limit up. A move equal to the daily price limit in either direction is called a limit move. Normally, trading ceases for the day once the contract is limit up or limit down. However, in some instances, the exchange has the authority to step in and change the limits. The purpose of fixing Daily Price Movement limits is to prevent excessive volatility arising from speculative excesses. g) Position Limits. Position limits are the maximum number of contracts that a speculator may hold. In the Chicago Mercantile Exchange, random-length lumber contract, the position limit is 1000 contracts with no more than 300 in any one delivery month. The position limits generally will not affects bonafide hedgers. The purpose of the position limits is to prevent speculators from exercising undue influence on the market. 3. Futures Clearing House The futures contracts are generally settled through the exchange clearinghouse. The exchange clearinghouse is an adjunct of the exchange and acts as an intermediary or middleman in futures transactions. It guarantees the performance of the parties to each transaction. The main purpose of the futures clearinghouse is to guarantee that all trades will be honoured. This is done by having a the clearing house interpose itself as the buyer to every seller and the seller to every buyer. Because of this substitution of parties, it is not necessary for the original seller (or buyer) to find the original buyer (or seller) when he decides to clear his position. Here the exchange clearinghouse acts as the counterparty for the trades made in the futures exchange. As a result, all an individual is to do is make an equal and opposite transaction that will provide a net zero position with the clearing house and cancel out his obligation. Because no trades occur directly between individuals, but between individuals and the clearinghouse, buyers and sellers realising gains in the market are assured that they will be paid. Such a guarantee is necessary for smooth flow of the transactions as the futures contracts are trades with minimal good-faith money. There are other important benefits of a clearinghouse, including providing a mechanism for the delivery of commodities and the settlement of disputed trades.

8 4. Daily Settlement of Contracts The futures clearinghouse operates a system of daily settlement called marking to market. At the end of every trading day the exchange calculates the profit or loss of the counter party created as a result of that days price changes. This profit or loss adjusted through his margin. The counter party that made a profit has his members margin account credited. This may be withdrawn the next day. Whereas the counter party that made the loss has his members margin account debited. The following morning the losing counter party must inject more cash to cover the loss. An inability to pay a daily loss causes default and the contract is closed, thus protecting the clearinghouse from the possibility that the counter party might accumulate further daily losses without providing cash to cover them. 5. Margin Payments Margin requirement is a safeguard of the futures market. The term futures margin refers to good faith money the purchaser puts down to ensure that the contract will be carried out. For dealing in futures, the broker will require the investor to deposit funds in what is termed as a margin account. There three types of margin associated with futures contracts namely, the initial margin, the maintenance margin and the variation margin. The amount that must be deposited at the time of the contract is first entered is known as the initial margin. At the close of the day each contract is marked to the market. The profit or loss made on each day is credited or debited to the members margin account as the case may be. The investor is entitled to withdraw any balance in the margin account in excess of the initial margin. However, the balance in the margin account shall never become negative. To ensure this a maintenance margin, which is somewhat lower than the initial margin is set. If the investor suffers loss while making the contract marked to market, he has to bring in additional margin. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial level the next day. The extra funds deposited are known as the variation margin. Difference between Futures and Forward contracts Futures contracts are similar to forward contracts. The contractual provisions and obligations of purchasers and sellers of forward contracts closely resemble to those found in futures contracts. However, there are some basic differences between the two. 1. Futures contracts can be traded only on organised exchanges whereas forward contracts are traded off-exchange 2. In the case of delivery is not usually intended nor occurred, whereas in the case of forward contracts delivery is intended and occurred 3. Futures are standardised whereas separate terms and conditions are specified for each forward contract. 4. A forward contract is a contract between the buyer and seller only. But in the case of futures contract exchange is the counter-party to the buyer and the seller. 5. Futures markets are regulated by identifiable regulatory authorities, whereas forward markets are self regulatory.