Future contracts allow the price risk to be separated from the reliability risk by removing the former from the set of factors giving rise to opportunism. The governance structure supplied by the exchange authority effectively eliminates reliability risk from future trading. The seller of futures contracts incurs a liability not to the buyer, but to the clearing house, and likewise the buyer acquires an asset from the clearing house. The clearing house in effect guarantees all transactions. In addition, the exchange rules, especially regarding its members’ contract, severely limit their ability to behave opportunistically. Organized exchanges greatly reduce default and reliability risk from future contracts. This is achieved by transferring transactions over price risks from a personal to an impersonal market through standard form futures contracts traded in self-regulated market price.
Future contracts are standard form contracts with only one negotiable term: price. The standardization of future contracts has significant implications for transaction costs. This is so for several reasons. First, contracts standardization eliminates the costs of bargaining over non-price terms and of enforcing contract provisions. Second, it reduces monitoring costs that are generally incurred in principal-agent relationships. The principal only needs to give his broker instructions as to price and quantity which are easily observed. The monitoring costs in the future market are, therefore, significantly lower than those in the spot market, where numerous other matters require attention and provide the broker with opportunities to take advantage of the principal. Third, contract standardization makes all futures contracts of a particular maturity month perfect substitution. The fungibility of futures contracts is not a property shared by forward contracts. The liquidity and competitive nature of future trading also reduce the waiting costs of brokers and speculators for acceptable bids and offers. The ask-bid, one of the component of the transaction costs of futures trading is directly correlated with the search costs of finding acceptable bids and offers. We know in a market with incomplete information, buyers and sellers will have to search each other out. The costs of such search activity will differ and will be greater the more geographically dispersed and heterogeneous are buyers and sellers. The fact is that, the transaction costs arise because the parties to transactions are different individuals with different information, divergent motives and mutual suspicions and because expenditure of resources can reduce the gap in information and protect the parties against each other. Search costs not only raise the cost of activities but may preclude otherwise value maximizing transactions from taking place. The market information is important not only because it reduces waiting costs but also because it ensures that competitive pressures exist to keep waiting costs to a minimum for any volume of trade. Since there is competition among the futures traders and hence there is weeding out effect with excessive search costs and poor forecasting ability. The large traders make a regular profit whereas small traders make losses since the performance difficulties occasioned by opportunism raise the cost of transacting. Each party is confronted with a reliability risk. Reliability risk is an important source of transaction costs because it will pay individuals to guard against opportunism and contract breach. Acquiring information on the reliability of those with whom one transacts yields benefits in the form of reduced losses due to default and incomplete or inferior performance.
Future Market Operations
So far as future market operation is concerned, evolution is its feature and thus a collateral margin that has evolved is to reduce the default risk. As opposed to margins or stock accounts, a futures margin payment is not a form of down payment on the balance due since a futures transaction is not an investment of initial capital in return for a later payoff, but rather in its purest form, is means of gradually settling the losses and gain on the contract and also as collateral against default. Margin payments are paid frequently in small amounts relative to the size of the contract, rather than in one large initial lump sum,. So as to preserve the basic character of a futures contract as a forward agreement deferred payments for deferred delivery. In fact, daily cash settlement procedure is an important aspect of the futures markets, integral in maintaining the trading system. Each of the transaction requires a good faith deposit known as initial margin, to be posted with a broker. The minimum amount of initial margin required is set by the exchange based on the price volatility of the underlying products. The value of a contract position is assessed, marked to market daily and these changes are settled in cash on a daily basis. For example, if a contract prices increase, the longs who have purchased the contract would receive cash equal to the value of gains, while the shorts-who have sold contracts –would have to pay in funds equal to the value of losses. This process is known as variation margin, keeps the value of each market participants’ position current and constitutes to the credit of the futures market. Initial margin ensures that the participants will pay variation-margin deficit. When the system is tied with the variation margin vehicle through which daily marks to market occur, an individual gains the ability of offset a position at any time without regard to who was initially of the other side of the transaction. This is a key to ease of trading and confidence in the futures markets. This makes the possibility of taking a large market position without committing a large amount of capital. For this reason, futures contracts are considered an extremely highly leveraged instrument relative to most financial securities. Although high leverage is often associated with high financial instability and high default risk, futures markets have a history of financial integrity and low default risk is largely a property of the intricate, multi-tiered, continually adjusting marginalizing system.
In order to understand the operation of the futures market, let us take an imaginary example. Suppose there is an investor who contracts his broker on June 6, 2011 to buy two Nov. 2011 gold futures contracts on the exchange ABC Commodity Exchange. Let us again suppose that the current futures price is $500 per ounce. Since the contract size is 100 ounces, the investor has contracted to buy total of 200 ounces at this price. The broker will require the investor to deposit funds in what is termed a margin account the amount must be sited at the time the contract is first entered into is known as the initial margin. We assume this is $2500 per contract of $5,000 in total. At the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss. This is known as marking to market the account. Suppose by the end of June 6, 2011, the futures price has dropped from $500 to $497. The investor has a loss of 200x$3 or $600. This is because the 200 ounces of Nov. 2011 gold, which he contracted at $500, cannot be sold for $600 to $4400. Similarly, if the price of December 2011 gold rose to $503 by the end of the first day, the balance in the margin account would be increased by $600 to 5600. A trade is first marked to market at the close of the day on which it takes place. It is then marked to market at the close of trading on each subsequent day. Marking to market is not merely an arrangement between broker and client, however, when there is a $600 decrease in the future prices so that the margin account of an investor with a long position is reduced by $600, the investor’s broker has to pay the exchanges $600 the exchange passes the money on the broker of an investor with a short position. Similarly when there is an increase in the futures price, brokers for parties with short positions pay money to the exchange and brokers for parties wit long positions receive money from the exchange. The investor is entitled to withdraw any balance in the margin account in excess of the initial margin. In order to ensure that the balance in the margin account never becomes negative a maintenance margin, which is somewhat lower than the initial margin, is set. 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 margin level the next day. In case the extra funds deposited, known as variation margin, are not provided by the investor, the broker closes out the position by selling the contract. In the case of the investor considered earlier, closing out the position would involve underlying the existing contract by selling 200 ounces of gold for delivery in November 2011.
Credit: International Finance Notes-MGU