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Futures Contracts

To hedge against the adverse price movements

1. A legal agreement between a buyer and a seller.

2. the buyer agrees to take delivery of an asset at a specified price at the end of a designated period of time.

3. the seller agrees to make delivery of an asset at a specified price at the end of a designated period of time.

4. The price is determined today

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Futures Contracts

• Key Elements– Futures Price– Settlement Date or Delivery Date– Underlying Asset

• Futures Positions– Long futures (The buyer)– Short futures (The seller)

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Example

Asset= XYZ (the underlying)

Price = $100

Bob: the buyer

Sally: the seller

Settlement: 3 months from today

Delivery and Payment at settlement date

Price determined today

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Margin Requirements

Initial Margin– minimum dollar amount per futures contract– provides investor with substantial leverage

Maintenance Margin– minimum level to which an equity position may

fall due to adverse price movements

Variation Margin– amount necessary to bring equity account back to

initial margin level

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Example

Value of the Future contract = $50,000 If P = 10 and Number of Bonds= 5000

= (5000 × 10) = $50, 0001. Initial margin = 4%

= (0.04 × 50000) = 2000

2. Maintenance Margin2% = 1000

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Example

1. If price increases and values goes up to $60,000, no problem.

2. If price decreases and he gets a loss of I. $ 500, no action will be taken as equity

(1500) is still above the MM.

II. $ 1000, no action will be taken as equity (1000) is at the MM.

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Example

3. If price decreases and he gets a loss of – $ 1500, action will be taken as equity (500) is

below the MM.– He needs to deposit $ 1500 as a variation

margin.

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Example

• If price increases and he gets a profit of $ 1500, he can take it out.

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Example-1

Futures contracts on sweet crude oil closed the day at $65.

The exchange sets the additional margin requirement at $2, which the holder of a long position pays as collateral in her margin account.

A day later, the futures close at $66. The exchange now pays the profit of $1 in the mark-to-market to the holder.

The margin account still holds only the $2.

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Difference between Forward and Futures

Futures contracts• Futures contracts are perforce

standardized by time to maturity and amount.

• Credit risk is minimal for futures contracts because the clearinghouse associated with the exchange guarantees the other side of the transaction

• Futures contracts are marked to market at the end of each trading day.

Forward contracts

• The forward market is not. It is an OTC market with no clearinghouse.

• There is greater credit risk and illiquidity in the forward market. Contracts are thus more expensive.

• Forward contracts are not.

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