Financial Matters - Futures

HISTORY OF FUTURES

Merton Miller, the 1990 Nobel Laureate had said that “financial futures represent the most significant financial innovation of the last twenty years.” The first exchange that traded financial derivatives was launched in Chicago In the year 1972. A division of the Chicago Mercantile Exchange, it was called the international monetary market (IMM) and traded currency futures. The brain behind this was a man called Leo Melamed, acknowledged as the “father of financial futures” who was then the Chairman of the Chicago Mercantile Exchange. Before IMM opened in 1972, the Chicago Mercantile Exchange sold contracts whose value was counted in millions. By 1990, the underlying value of all contracts traded at the Chicago Mercantile Exchange totaled 50 trillion dollars.

These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Mercantile Exchange, the Chicago Board of Trade and the Chicago Board Options Exchange. By the 1990s, these exchanges were trading futures and options on everything from Asian and American stock indexes to interest-rate swaps, and their success transformed Chicago almost overnight into the risk-transfer capital of the world.

INTRODUCTION OF FUTURES

Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contract, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contract, the exchange specifies certain standard features of the contract. It is standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (Or which can be used for reference purpose in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 90% of futures transactions are offset this way. The standardized items in a futures contract are:

· Quantity of the underlying

· Quality of the underlying

· The date and the month of delivery

· The units of price quotation and minimum price change

· Location of settlement

DEFINITION

A Futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of futures price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. Comparison between two as follows:

FUTURES

1.Trade on an Organized Exchange

2.Standardized contract terms

3. hence more liquid

4. Requires margin

payment

5. Follows daily Settlement

FORWARDS

1. OTC in nature

2.Customized contract terms

3. hence less liquid

4. No margin payment

5. Settlement happens at end of period

FEATURES OF FUTURES:

· Futures are highly standardized.

· The contracting parties need not pay any down payment.

· Hedging of price risks.

· They have secondary markets to.

TYPES OF FUTURES

On the basis of the underlying asset they derive, the futures are divided into two types:

· Stock Futures

· Index Futures

PARTIES IN THE FUTURES CONTRACT

There are two parties in a futures contract, the buyers and the seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is who is SHORT on the futures contract.

MARGINS:

Margins are the deposits which reduce counter party risk, arise in a futures contract. These margins are collect in order to eliminate the counter party risk. There are three types of margins:

Initial Margins:

Whenever a future contract is signed, both buyer and seller are required to post initial margins. Both buyers and seller are required to make security deposits that are intended to guarantee that they will infect be able to fulfill their obligation. These deposits are initial margins and they are often referred as purchase price of futures contract.

Mark to market margins:

The process of adjusting the equity in an investor’s account in order to reflect the change in the settlement price of futures contract is known as MTM margin.

Maintenance margin:

The investor must keep the futures account equity equal to or grater than certain percentage of the amount deposited as initial margin. If the equity goes less than that percentage of initial margin, then the investor receives a call for an additional deposit of cash known as maintenance margin to bring the equity up to the initial margin.

ROLE OF MARGINS:

The role of margins in the futures contract is explained in the following example: Siva Rama Krishna sold an ONGC July futures contract to Nagesh at Rs.600; the following table shows the effect of margins on the Contract. The contract size of ONGC is 1800. The initial margin amount is say Rs. 30,000 the maintenance margin is 65% of initial margin.

PRICING FUTURES:

Pricing of futures contract is very simple. Using the cost-of-carry logic, we calculate the fair value of a future contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to captures the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below.

F = Se^rT

Where:

F = Futures price

S = Spot Price of the Underlying

r = Cost of financing (using continuously compounded

Interest rate)

T = Time till expiration in years

e = 2.71828

(OR)

F = S (1+r- q) t

Where:

F = Futures price

S = Spot price of the underlying

r = Cost of financing (or) interest Rate

q = Expected dividend yield

t = Holding Period

FUTURES TERMINOLOGY

Spot price:

The price at which an asset trades in the spot market.

Futures Price:

The price at which the futures contract trades in the futures market.

Contract cycle:

The period over which a contract trades. The index futures contracts on the NSE have one-month and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading.

Expiry date:

It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.

Contract size:

The amount of asset that has to be delivered Under one contract. For instance, the contract size on NSE’s futures markets is 200 Nifties.

Basis:

In the context of financial futures, basis can be defined as the futures price minus the spot price. These will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.

Cost of carry:

The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.

Initial margin:

The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.

Marking-to-market:

In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking-to-market.

Maintenance margin:

This is some what lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. 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 before trading commences on the next day.