This article throws light upon the six major features of futures contracts. The features are:
- Organized Exchanges
- Clearing House
- Marking to Market
- Actual Delivery is Rare.
1. Organized Exchanges
Unlike forward contracts which are traded in an over-the-counter market, futures are traded on organized exchanges with a designated physical location where trading takes place. This provides a ready, liquid market in which futures can be bought and sold at any time like in a stock market.
In the case of forward currency contracts, the amount of commodity to be delivered and the maturity date are negotiated between the buyer and seller and can be tailor-made to buyer‘s requirements. In a futures contract, both these are standardized by the exchange on which the contract is traded. thus, for instance, one futures contract in pound sterling on the International Monetary Market (IMM), a financial futures exchange in the US, (part of the Chicago Board of Trade or CBT), calls for delivery of 62,500 British Pounds and contracts are always traded in whole numbers, i.e., you cannot buy or sell fractional contracts. A three-month sterling deposit on the London International Financial Futures Exchange (LIFFE) has March, June, September, December delivery cycle.
The exchange also specifies the minimum size of price movement (called the ―tick‖) and, in some cases, may also impose a ceiling on the maximum price change within a day. In the case of commodity futures, the commodity in question is also standardized for quality in addition to quantity in a single contract.
3. Clearing House
The exchange acts as a clearing house to all contracts struck on the trading floor. For instance, a contract is struck between A and B. Upon entering into the records of the exchange, this is immediately replaced by two contracts, one between A and the clearing house and another between B and the clearing house.
In other words, the exchange interposes itself in every contract and deal, where it is a buyer to every seller and a seller to every buyer. The advantage of this is that A and B do not have to undertake any exercise to investigate each other‘s creditworthiness. It also guarantees the financial integrity of the market. The exchange enforces delivery for contracts held until maturity and protects itself from default risk by imposing margin requirements on traders and enforcing this through a system called ―marking to market‖.
Like all exchanges, only members are allowed to trade in futures contracts on the exchange. Others can use the services of the members as brokers to use this instrument. Thus, an exchange member can trade on his own account as well as on behalf of a client. A subset of the members is the ―clearing members‖ or members of the clearing house and non- clearing members must clear all their transactions through a clearing member.
The exchange requires that a margin must be deposited with the clearing house by a member who enters into a futures contract. The amount of the margin is generally between 2.5% to 10% of the value of the contract but can vary. A member acting on behalf of a client, in turn, requires a margin from the client. The margin can be in the form of cash or securities like treasury bills or bank letters of credit.
5. Marking to Market
The exchange uses a system called marking to market where, at the end of each trading session, all outstanding contracts are reprised at the settlement price of that trading session. This would mean that some participants would make a loss while others would stand to gain. The exchange adjusts this by debiting the margin accounts of those members who made a loss and crediting the accounts of those members who have gained. This feature of futures trading creates an important difference between forward contracts and futures. In a forward contract, gains or losses arise only on maturity. There are no intermediate cash flows.
Whereas, in a futures contract, even though the gains and losses are the same, the time profile of the accruals is different. In other words, the total gains or loss over the entire period is broken up into a daily series of gains and losses, which clearly has a different present value.
6. Actual Delivery is Rare
In most forward contracts, the commodity is actually delivered by the seller and is accepted by the buyer. Forward contracts are entered into for acquiring or disposing off a commodity in the future for a gain at a price known today.
In contrast to this, in most futures markets, actual delivery takes place in less than one per cent of the contracts traded. Futures are used as a device to hedge against price risk and as a way of betting against price movements rather than a means of physical acquisition of the underlying asset. To achieve this, most of the contracts entered into are nullified by a matching contract in the opposite direction before maturity of the first.