Financial derivative types: Futures

A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardised one. Hence, it is rightly said that a futures contract is nothing but a standardised forward contract. It is legally enforceable and it is always traded on an organized exchange.

Clark has defined future trading “as a special type of futures contract bought and sold under the rules of organized exchanges”. The term ‘future trading’ includes both speculative transactions where futures are bought and sold with the objective of making profits from the price changes and also the hedging or protective transaction where future are bought and sold with a view to avoiding unforeseen losses resulting from price fluctuation.

A future contract is one where there is an agreement between two parties to exchange any asset or currency or commodity for cash at a certain future date, at an agreed price. Both the parties to the contract must have mutual trust in each other. It takes place only in organized futures markets and according to well established standards.

As in a forward contract, the traders who promises to buy is said to be in ‘Long position’ and the one who promises to sell is said to be in ‘Short position’ in futures also.

Features of Futures

  • Highly Standardised: Futures are standardised and legally enforceable. Hence, they are traded only in organized future exchanges. It is also difficult to modify the agreement according to the needs of the contracting parties. However, many variants of Future are available. But, once the agreement is entered into, the changes of modifying it are very remote.
  • Down payment: The contracting parties need not pay any down payment at the time of agreement. However, they deposit a certain percentage of the contract price with the exchange and it is called initial margin. This gives a guarantee that the contract will be honoured.
  • Settlement: Thought future contracts can be held till maturity, they are not so in actual practice. Future instruments are ‘marked to the market’ and the exchange records profit and loss on them on daily basis. That is, once a future contract is entered into, profits or losses to both the parties are calculated on a daily basis. The difference between the future price and the spot price on that day constitutes either profit or loss depending upon the prevailing spot prices. The spot price is nothing but the market price prevailing then. For example, on Monday morning A enters into a futures agreement with B to buy 50 kgs of Basmati Rice at Rs. 100/- per kg on Friday afternoon. At the close of trading on Monday, the futures price goes up by Rs. 10/- per kg. Now, a will get a cash profit of Rs. 500/- for 50 kg at the rate of Rs. 10/- per kg. A can also cancel the existing futures contract with the price Rs. 100/- per kg or he can enter into a new futures contract at Rs. 110/- per kg. Generally, these profits or losses are accumulated in the margin accounts of the parties. But, if there are continuous losses and if the initial margin falls below a minimum level called ‘maintenance margin’, then the exchange authorities will interfere. In such a situation the contract automatically lapses. The default risk due to such a lapse is limited to the profit or loss booked during that day. Since the exchange guarantees the performance of the contract of the contract by both the counterparties, the default risk is borne by the exchange.
  • Hedging of Price Risks: The main feature of a futures contract is to hedge against price fluctuations. The buyers of a futures contract hope to protect themselves from future spot price decreases. Parties enter into futures agreements on the basis of their expectations of the future price in the spot market for the assets in question.
  • Linearity: As stated earlier, futures contract is nothing but a standardised forward contract. Therefore, it also possesses the property of linearity. Parties to the contract get symmetrical gains or losses due to price fluctuation of the underlying asset on either direction.
  • Secondary Market : Futures are dealt in organized exchanges, and as such, they have secondary market too.
  • Non-Delivery of the Assets : The delivery of the assets in question is not essential on the date of maturity of the contract in the case of future contracts. Generally, paties simply exchange the difference between the future and the spot prices on the date of maturity.

Types of futures

Like forwards, futures may also be broadly divided into two types namely.

(i) Commodity Futures

(ii)Financial Futures

Commodity Futures:

A Commodity Future is a futures contract in commodities like agricultural products, metal and minerals etc.In organized commodity future markets, contracts are standardized with standard quantities.Ofcourse, this standard varies from commodity to commodity. They also have fixed delivery dates in each month or a few months in year.In India commodity futures in agricultural products are popular.

Some of the well established commodity exchanges are as follows:

  • London Metal Exchange (LME) to deal in non-ferrous metals
  • Chicago Board of Trade (CBT) to deal in soyabean oil
  • New York Cotton Exchange (CTN) to deal in cotton
  • Commodity Exchange, New York (COMEX) to deal in agricultural products
  • International petroleum Exchange of London (IPE) to deal in crude oil.

Financial Futures:

Financial Futures refer to a futures contract in a foreign exchange or financial instruments like Treasury bill, commercial paper, stock market index or interest rate. it is an area where financial service companies can play a very dynamic role. Financial futures are very popular in Western Countries as hedging instrument to protect against exchange rates/interest rate fluctuation and for ensuring future interest rates on loans.

Just like forward rate currency contracts and forward rate contracts on interest rates, we have futures contracts on currency and interest rates. But, the primary objective of futures markets is to enable individuals and companies to hedge against price fluctuations. For example risks due to interest rate fluctuations and exchange rate fluctuations are common. These risks can not be eliminated but transferred to counterparty. This counterparty may have a hedging motive with opposite requirements.

The stock index futures contract is a futures contract on major stock market indices. This type of contract is very much useful for speclators, investors and especially portfolio managers. They can hedge against future decline or increase in prices of portfolios depending upon the situation.

Generally the asset will not be delivered on the maturity of the contract. The parties simply exchange the difference between the future and the spot prioces on the date of maturity.But, these kinds of financial futures are relatively new in India.

Some of the well established financial futures exchanges are the followings:

  • International Monetary Markets (IMM) to deal in U.S. treasury bills, Euro dollar deposits, Sterling etc.
  • London International Financial Futures Exchange ( LIFFE) to deal in Euro dollar deposits.
  • New York Futures Exchange (NYFE) to deal in sterling, Euro dollar deposits etc.