Unit – 5 Mechanics of Future Markets

Meaning of Forward Contract

A forward contract is a derivative security. It can be defined as the agreement today between
two parties to buy or sell an asset at a certain future time for an agreed price. One of the two
contracting parties in forward contract is called the buyer of the forward and the other party is known
as the seller of the forward contract. Buyer of forward contract agrees to buy an asset at a specified
price at the end of designed period of time. Seller of forward contract agrees to sell the assets at the
specified price and date. The buyer of the forward contract has right and obligation to buy and the
seller of the forward contract has also the right and obligation to sell as per the contract. However, it
is noteworthy that the contracting parties exchange neither cash nor the specific assets at the time of
contract. The assets agreed to be exchange in the future date is known as underlying asset. Buyer of
the forward contract will realize a profit if market price of underlying asset increases and seller of
forward contract will realize profit if the market price of underlying assets decrease at settlement
date.

Meaning of Future Contract

Future contract is similar to forward contract but the future contract are traded in future exchange
which gives guarantee to the counter party. A future contract can be defined as a commitment to buy
or sell a specified commodity of designed quality and quantity at a specific price and date in future.
Future exchange specifies the contract terms and condition to be included in future contract
so as to make it standardize future contract. Moreover, future market provides mechanism which
facilitates any party to complete his or her obligation at any time. Future contract is settled daily
which helps to reduce default risk. Daily settlement process is also called marked to market.

Forward Vs Future
i. Trading Forward contract always traded on Futures are always traded on organized
over the counter market. exchange market
ii. Nature of Forward contracts are negotiated Futures contracts are highly standardized
Document between two parties. So each contracts. It specifies the underlying asset,
forward contract is unique. quantity, delivery date and types of
settlement.
iii. Settlement Forward contracts are settled at the Future contracts are settled at the
Price forward price agreed on traded date. settlement price fixed on the last delivery
date of the contract.
iv. Credit The profit or loss on a forward The profit or loss on a futures contract is
Risk contract is only realized at the exchanged in cash every day so there is
settlement date so there is high less credit risk.

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 credit risk.
v. Delivery Goods are actually taken delivery at The physical delivery of assets are
a specified future date. virtually never taken only settle up with
cash.

Specification of Futures:
When developing a new contract, the exchange must specify the nature of the agreement between
two parties. It must specify the asset, the contract size, delivery date, price limits etc.
i. The Assets: Future exchange lists the assets or factor on which futures contract can be made.
The asset may be commodity, and financial assets. When the asset is a commodity there may be
quite variation in the quality of that is available in the market place. But the financial asset in
futures contract are generally well defined and un ambiguous.
ii. The Contract Size: The contract size specifies the amount of asset or the number units of
underlying asset that has to be delivered under one contract. This is an important decision for an
exchange.
iii. Delivery Arrangements: The place where delivery will be made must be specified by the
exchange like warehouse or store. This is particularly important for commodities that involve
significant transportation costs. The delivery locations are specified.
iv. Delivery months: A future contract is referred to by its delivery month such as march potato
futures, July silver futures etc. the exchange must specify the precise period during the month
when delivery can be made. For many futures contracts, the delivery period is the whole month.
The delivery month vary from contract to contract and are choosen by the exchange to meet the
needs of market participants.
v. Price Quotes: The exchange specifies the quotation unit. The quotation unit is simply the unit in
which the price is specified.
vi. Price Limits: For most contracts, daily price limits are specified by exchange. If in a day the
price moves dawn from the previous day's close by an amount equal to the daily price limit, the
contract is said to be limit down. If it moves up by the limit, it is said to be limit up.
vii. Position Limits: Position limits are the maximum number of contracts that a speculator may
hold. The purpose of these limits is to prevent speculators from exercising undue influence on the
market.

Mechanics of Future Trading

In this section, we will discuss the general mechanism in which the exchanges organize the
trading of futures.
i) Account at Brokerage Firm: Before placing an order to trade futures contracts, an individual
must open an account with a broker. Because of risk of futures trading can be quite high, the

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 individual must make a minimum deposit usually at least 5000 and sign a disclosure statement
acknowledging the possible risks.
ii) Placing an Order: One can place several types of order. There are essentially the same as the
option orders. Stop orders and limit orders are used as well as good till canceled and day orders.
iii) Role of the Clearing House: Futures clearinghouse is an independent corporation that
guarantees the every trade in futures exchange. The clearing house acts as an intermediary in
futures transactions. The clearing house has a number of clearing member firms, who must
deposit funds with the exchange.
It guarantees the buyer that seller will perform and guarantees the seller that the buyer
will perform.
iv) Margin Operation and Daily Settlement: Before entering into a future contract the perspective
trader must maintained initial margin and maintenance margin. The objective to margin is to
provide a financial safeguard and survival of clearing house ensuring that investors will perform
their contract obligations.
At the end of each day, a committee composed of clearing house officials establishes a
settlement price. This usually is an average of the prices of the last few trades of the day. Using
the settlement price, each account is marked to market. If the difference is positive because the
settlement price increased, the dollar amount is credited to the margin accounts of those holding
long positions. It is charged to the accounts of those holding short positions. If the difference is
negative because the settlement price decreased, the dollar amount is credited to the holders of
short positions and charged to those holding long positions. This process sometimes called daily
settlement. Futures markets credit and charge the price changes on a daily basis.
A. Margin Operation
In case of long position
ℑ−MM
Minimum price change to receive a margin call = F 0−
Contract ¿ ¿ ¿
Profit in long position = (ST – F0) × Contract size

Minimum gain for withdrawals from margin account per contract

¿
= Amount ¿ be withdrawn
Contract ¿ ¿ ¿
Price at which gain makes = Fo + minimum gain

In case of short position

ℑ−MM
Minimum price change to receive a margin call = F 0+
Contract ¿ ¿ ¿
Profit in short position = (F0 – ST) × Contract size

Minimum gain for withdrawn from margin account per contract.

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 ¿
= Amount ¿ be withdrawn
Contract ¿ ¿ ¿
Price at which gain makes = Fo-Minimum Gain

Where: F0 = Current Future Price

ST = Expected spot price/price at the close of position

B. Daily Settlement
Daily a clearing house official establishes a settlement price and compare with previous
day’s price. If the difference is the positive then margin account is credited and if negative then
margin account is debited. If margin account balance falls below than maintenance margin then
investors will received margin calls.
Daily gain or loss = (settlement price – previous day price) ×contract size

Margin account balance = IM + daily gain or loss

Margin call amount = IM – margin account balance. (If fall below than mm)

Daily Settlement Table

Date Settlem Daily Cumulat Margin Mar
ent price gain or loss ive gain or a/c balance gin call
loss
Ope Fo - - IM
ning

Way of closing Futures:

The majority of futures contracts that are initiated do not lead to delivery. The reason is that most
investors choose to close out their positions prior to delivery period specified in the contract. Making
and taking delivery under the terms of a futures contract is often inconvenient and in some instance,
it is quite expensive. This is true even for a hedger to close out the futures position and then buy or
sell the assets in the usual way.
Closing out futures position involves entering into an opposite trade to the original one. The
following are the different alternatives to end a contract.
i. Making Delivery: When seller wants to make physical delivery or buyer wants to take delivery,
they have to go through certain procedures. Delivery usually is a three day sequence beginning
two business days prior. The clearing member firms report to the clearing house if their customer
who hold long position, two business days before intended delivery date. The holder of a short
position who intends to make delivery notifies the clearing house of its desire to deliver and
settled the contract.

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ii. Cash Settlement: On cash settled contracts such as stock index futures, the settlement price on
the last trading day is fixed at the closing spot price of the underlying asset such as the stock
index. All contracts are market to market on that day and the positions are deemed to be closed.
iii. Offsetting: Most trades close out their positions prior to expiration by taking reverse trade, like
taking long position to offset existing short position and taking short position to offset existing
long position, such a process is called offsetting.

Types of Futures Contracts

1. Agricultural commodities – wheat, corn, soybean, rice, oak, sugar.
2. Natural resources – metal and every products
3. Foreign currencies – dollar, pound , euro, yean
4. Treasury Bills and Eurodollars
5. Treasury notes and bonds.
6. Equities
7. Managed funds
8. Hedged fund
9. Options on futures

Calculation of Gain or Loss

 In case of long position
Profit or loss = ( ST-FO) × Contract size
 In case of short position
Profit or loss = = ( FO - ST) × Contract size
Where Fo = Price specified on contract price at beginning
ST = is the spot price on future price at end
Calculation of fair future price
Fair future price (FO) = SO ert
SO = Current price of stock
R = Risk free rate
T = maturity

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