Unit ii

 A financial future contract is an agreement between two
parties to buy or sell a specified quantity of an asset at a specified
price and at a specified time and place.
 Traded on an exchange which sets certain standardized norms
for trading in the future contract.
Financial futures contract--Meaning

Financial futures contract--Meaning
 A financial future contract is an agreement between two
parties to buy or sell a specified quantity of an asset at a specified
price and at a specified time and place.
Traded on an exchange which sets certain standardized norms for
trading in the future contract.

Types of financial futures contracts
Futures contracts are of two major categories:
 Financial futures
 Commodity futures
 Financial futures are not different from commodity futures
except of the underlying asset, for example, in commodity
futures a particular commodity like foodgrains,metals,
vegetables etc are traded whereas in financial futures, various
particular financial instruments like equity
shares,depentures,bond,treasury,securities,currencies,etc traded.

Types of financial futures contracts
Interest rate futures:
It is one of the important financial futures in the, world.
(1975).
Important interest bearing securities are like…
-Treasury bills
-Notes
-Bonds
-Debentures
-Euro-dollars deposits
-Municipal bonds

Contd
 This market is also further categorized into short-term and long-
term interest bearing instruments. A few important interest rate
futures traded on various exchanges, are notional gild contracts
short-term deposits futures:
 Treasury bill futures
 Euro-dollar futures
 Treasury bond futures
 Treasury notes futures.

Contd:
Foreign currency Futures:
 These financial as the name indicates trade in the foreign
currencies, thus also known as exchange rate futures.
Important currencies in which these futures contracts are made
such as:
US-dollar
Pond sterling
Yen
French Francs
Canadian dollar

 Stock Index futures:
These contracts are based on stock market indices. Stock
index futures contracts are mainly used for hedging and
speculation purposes. These are commonly traded by mutual
funds, pension funds, investment trusts, insurance
companies,speculators,arbitrageurs and hedgers.
Example:
Dow Jones Industrial Average
Standard and Poor’s 500
New York stock Exchange Index.
Singapore International Monetary Exchange(SIMEX)
S&P CNX Nifty

Bond Index Futures:
These futures contracts are based on particular bond, indices
i.e. indicates of bond prices. We know that prices of debt
instruments are inversely related to interest rates, so that bond
index is also related inversely to them.
Example:
Municipal Bond Index futures-(US Municipal Bonds) which is
traded on Chicago Board of Trade (CBOT)

Cost of living Index Futures:
This is also known as Inflation futures. These futures contracts are
based on a specified cost of living index.
Example:
Consumer Price Index
Wholesale Price Index
International Monetary Market (IMM) in Chicago.

Operators /Traders in the futures markets
 Hedgers:
 Hedge is a position taken in futures for the purpose of
reducing exposure to one or more types of risk.
 A person who undertakes such position is called ‘hedger’.
 Hedger use future market to reduce risk caused by movement
in prices of securities, commodities, exchange rates, interest
rates, indices, etc.
 A hedger will take a position in future market, is opposite a
risk to which he exposed.
 An opposite position to a perceived(understand) risk is called
‘hedging strategy in future markets’.
 Hedging strategy adoption of a future position that, generates
profits when market value commitment is higher than the
expected value.

Example:
A treasurer of a company knows the foreign currency amount to
be received at certain futures time may hedge(be cautious) the
foreign exchange risk by taking short position.(selling foreign
currency at a particular rate)in the future markets. He can take a
long position(buying foreign currency at a particular rate) in case
of future foreign exchange payment at a specific future date.
 Speculators:
 An investor is willing to take risk by taking futures position with
expectation to earn profits.
 Example: A speculator forecasted the price of gold would be
Rs. 5500 per 10 grams after one month . Current price of gold is
Rs.5400 per 10 grams, he take a long position in gold and expects
to make a profit of Rs. 100 per 10 grams. Expected profit is
associated with risk, gold price after one month decrease to
Rs.5300 per 10 gram, may lose Rs.100 per 10 gram.

 Speculators ,trade in the future market to earn profit on basis
of difference in spot and future prices of the underlying asset.
 Hedger use future market for avoiding exposure to adverse
movement in price of an assets. Where as the speculators wish
to take position based on such movement in the price of an
asset.
 In spot market a speculator has to make an initial cash
payment equal to the total value of the asset purchased. No
initial cash payment except the margin money to enter into
forward market.
 A speculator who use fundamental analysis of economic
conditions of the market is known as fundamental analyst.
 To predict future price on basis of past movement in the price
of the asset is known as technical analyst.
 A speculator who owns a seat on a particular exchange and
trades in his own name is called a local speculator.

 Local speculators classified into three-
 Scalper—try to make profits from holding positions for short
period of time.
 Pit speculators---like scalper take bigger positions and hold
them longer.
 Floor traders– consider inter commodity price relationship.
 Arbitrageurs:
 Arbitrageur is a trader who attempts to make profits by
locking in a riskless trading by entering into transactions in
two or more markets.
 Arbitrage keeps the future and future prices in line with one
another.
 Arbitrage trading helps to make market liquid, ensure accurate
pricing and enhance price stability.

 Example: At the expiration of the gold future contract, the
future price is Rs. 5500 per 10 gram, but spot price is Rs. 5480
per 10 gram. An arbitrageur purchase the gold for Rs.5480 per
10 gram and go short position that expires immediately. And
make a profit of Rs. 20 per 10 grams by delivering the gold for
Rs.5500.
 Spreaders:
 Spreading is a specific trading activity offset(equalize) future
position by creating almost net position.
 Spreaders believe in lower expected return but at the less risk.
 Spreaders must forecast the factors which affect the changes in
the spread
 Interest rate behavior is an important factor causes changes in
the spreads.
 A spread reduces the risk even if forecast is incorrect.

Function of futures market
 Hedging:
 Hedging function which is also known as price insurance, risk
shifting or risk transference function.
 Traders or participants can hedge their risks or protect from
the adverse price movement in the underlying assets in which
they deal.
 Example: A farmer is expecting to produce 1000 tons of
wheat in next six month, he establish a price for the quantity
by selling 10 wheat future contracts, each being of 100 tons.
By selling these future contract, farmer intends to establish a
price today that will be harvested in the future.
 Future market also serve as a substitute for a cash market sale,
a cash market sale was impossible since wheat was not in
existence.

Contd:
 Like interest rate future contract which protect the financial
institutions such as commercial banks, insurance companies,
mutual funds, pension funds etc, the adverse change in the
value of asset and liabilities due to interest rate movements.
 Hedging activities are much useful for society to control,
shift, avoid, reduce, eliminate and manage efficiently various
types of risks.
 Price discovery:
 Revealing of information about future cash market prices
through the future market.
 A trader agrees to receive or deliver a commodity or asset at a
certain future time for a price which is determined now.
 Creates a relationship between the future price and the price
that people expect to prevail at the delivery date.

Contd:
 Provide an expression consensus(compromise) of the today
expectation about a specified future time.
 Traders can compare the spot and future prices and able to
decide the optimum allocation of their quantity of underlying
asset between immediate sale and future sales.
 Useful for producers, farmers, etc.
 Financing function:
 Future contracts are standardized contract, it is easier for the
lenders about assurance of quality, quantity and liquidity of
the underlying asset.
 It is much familiar in the spot market, but it is also unique to
future markets.
 Lender are more interested to finance hedged asset stock
rather than un-hedged stock. The hedged asset stock are
protected against the risk of loss of value.

 Liquidity function:
 Future market deals with transaction which are matured in the
future period.
 Operated on the basis of margins which determined on the rides
involved in the contract.
 Buyer and seller have to deposit only a fraction of the contract
value , known as a margins.
 Trader in future market do business much larger volume than spot
market and make market more liquid.
 Example: A speculator estimates a price increase in the silver
future market from the current future price of Rs. 7500 per kg. The
market lot being 10 kg, he buys one lot of future silver for
Rs.75000(7500x10).Assuming the 10 percent margin, the
speculator is to deposit only Rs. 7500. Supposing that a 10 percent
increase occurs in the price of silver to Rs. 8250 per kg. The value
of transaction also increase Rs. 82500, incurring profit of Rs.7500.

 Price stabilization :
 Future market reduces both the heights of the peaks and the
depth of the low.
 Causative(contributing) factor responsible for such price
stabilizing influence are , speculation, price discovery, tendency
to panic,(alarm, fear) etc.
 Disseminating information:
 Disseminate information quickly, effectively, and inexpensively,
and reducing the monopolistic tendency in the market.
 Information disseminating service enables the society to
discover or form suitable true /correct/equilibrium prices.
 Serve as barometers of future in price, determination of correct
prices on spot market now and in future.
 Creating a significant number of jobs and attracts a considerable
volume of transactions from Non-residents.
 Generating foreign

Specification of the future contract
 Future contract are initiated through a particular exchange.
 An exchange must specify in detail the exact nature of contract
of the agreement between two parties.
 Before registered at exchange, the trader or investor willing to
buy or sell have to contract a ‘broker’ who is authorized to
trade on the floor of an exchange on behalf of clients or
customers.
 Exchange perform three function:
(1) provide and maintain a physical market place know as
‘The Floor’ where future transactions are sold and purchased
by the members of the exchange.
(2) Maintain and enforce ethical and financial norms
applicable to the future trading under taken on the exchange.

(3) To promote business interest of the members because the
exchange’s main objective is to extend the facilities for such
trading to its members.
 Objective to buy a seat on the exchange: to engage in floor
trading activities, and to get the right, as per exchange norms, to
execute future trade without paying commission to the broker.
 Two type of trader or broker on the floor of the exchange:
(1) Commission brokers---charge a fee for executing contract
or trade on behalf of their customer.
(2) Local traders----trade for their own account.
 Different types of orders which can be placed by a customer to
the broker:
 Market order—the investor is prepared to trade at the current
market price. Place a market order with their broker and are
passed to commission broker representing two sides.

 Limit order—customer specifies a certain price and request
the transaction be executed only at a specified price or a better
one is obtained, otherwise not.
 Stop order---investor informs the members or broker to trade
at any price once the market price has reached at a certain
level. Used to protect losses, preserve profits and take new
position.
 Stop limit order--- just like stop order, the investor instructs
the broker to enter into a position after the market price has
reached at a certain level.
---- Limit price may or may not be equal to spot price.
example---an investor who took the long position of SBI
share at Rs.350may instructs his broker to sell if the future
price falls to Rs.340 but to accept no less than 330.

 Market-if-touched---investor instructs the broker to trade at
whatever price can be obtained once the market has reached at
certain level.
----Technical analyst who believe that the market will reach on
extreme before turning and wish to trade as soon as the price is
reached.
 Alternative order--- investor put two order but wants only one to
be filled up, which limits the potential profit order.
---example customer who entered a long position for SBI share at
Rs. 350 may instruct the broker to sell if the price either increase to
Rs.360 or falls to Rs. 340.
 Contingent order– broker is asked to take a certain position if the
price of another contract reaches a given level.
 Spread order—spread order require a certain difference between
the prices of the opposing contract rather than specific prices.

 Standardization:
 Standardized terms set by exchange on which future contract
are to be traded.
 Example: only gold future contract are traded at the
commodity exchange, inc (COMEX) in New York.
 Benefit of standardized specification, is concentrated in few
contract resulting in more liquidity of contract.
 Future contract specifies every aspects of the deal regarding
the asset, size, price limits future period, trading hours,
delivery, settlement, etc.
The asset:
 On commodity future market , the asset are commodity like
food grains, metals, oil, gas, etc.
 On financial future market, financial asset like equities, debt,
currencies, etc.

Contd:
 Specifying the asset, exchange must stipulate (specify) the
grade or grades of commodity which are acceptable.
 Example: Specification of the deliver-able grade of gold is
given as “Refined gold in the form of one 100- ounce bar on
the three 1-kilo gold bars array not less than 995 fineness.(fine
quality)
 Financial assets, problem of quality do not arise. No need to
specify grade of US dollar, UK pound sterling.
 Contract size:
 Specify the amount of the asset to be delivered under one
contract.
 Example: contract size or trading unit of the Chicago Board of
Trade(CBOT) 100 –ounce gold future is 100 troy ounces.

• Contd:
• If contract size is too large then the trader will be hesitating
and will have speculation positions.
• If contract size is very small then trading may be expensive.
• Correct size of the contract is very important decision and
depends on likely users.
 Delivery month:
 Contract month identify the expiry cycle of delivery dates.
 Delivery month vary from contract to contract and chosen by
the exchange to meet the requirement of market.
 Exchange specifies when trading in a particular month’s
contract will begin and last day on which trading can take place
for a given contract.

• Delivery arrangement:
• Place where delivery will be made must be specified by the
exchange.
• Most important for commodities than the financial instrument due
to transportation cost incurred on delivery of the goods.
• Obligation of the seller and buyer of a future contract to deliver
the underlying asset, during contract expiration period.
• Future contract specifies a First notice day (position or
presentation day), Last notice day (notice day), and Last trading
day (delivery day).
• Daily price movement limits:
• Exchange puts on the maximum price change permitted per day.
• If price moves down by an amount to daily price limit, the
contract is called limit down. If it moves up by the daily price
limit ,it is said to be limit up.

• Position limit:
• Position limit means the maximum number of contract a
speculator may hold. Example Chicago Mercantile Exchange
has put the position limit of 1000 for the speculator with not
more than 300 in any one delivery month.
• Objective of this limit is to protect market from excessive
trading from the speculator.

Clearing house
 Clearing house is a financial institution associated with the future
exchange that guarantees the financial integrity and performance
on future contract.
 Considered as thirty party between the buyer and seller of future
contract, taking no active position in market but assuring for every
short position there is a long position.
 Functions of clearing house:
 Clearing house keeps track records of all the transaction taken place
during a day, it calculate the net position of each of its members.
 Clearing house guarantees all the trader in future market will
honour their obligations. It plays as a middle man in the future
contract.
 All buying and selling futures contract require daily collection and
payment of funds to parties of future transaction.

Contd:
 It collects amount of net losses and pays the net gain for the
day to respective member.
 Observed, that the clearing house is well established, large,
financially sound institutions and risk of future default by the
clearing house is very small.

Operation of margin
• Addition to clearing house, to safeguards the future contract,
important requirement for margin and daily settlement.
• Margin requirement applicable to investor and a trader of the
clearing house.
• Two parties are directly trading in future market for a certain
prices, risk for backing out of parties to the contract. May not
have financial resources to honour the contract.
• This is why margin come into picture.
 Concept of margin:
 An investor who enters into a future contract is required to
deposit funds with the broker called a margin.
 Objective is provide financial safeguard for ensuring the
investor to perform their contract obligations.

• Amount of margin may vary from contract to contract and
even broker to broker.
• Margin deposit in different forms like cash, bank’s letter of
credit and treasury securities.
• Margin account may or may not earn interest. This loss of
interest is the cost of margin requirement.
 Types of margin:
 Three type of margin such as initial margin, maintenance
margin and variation margin.
 Initial margin:--original amount must deposit into account to
establish future contract.
 To determine initial margin, exchange consider the degree of
volatility (unpredictability) of price movement in past of the
underlying asset.

• Exchange has right to increase or decrease quantum of initial
marginal depending upon change in future price.
• Most of the future contract, initial margin may be 5 per cent or
less of underlying asset’s value.
• Completion of all obligation with investor future position, initial
margin is returned to trader.
 Maintenance margin:
• Maintenance margin is the minimum amount which must be
remained(kept) in a margin account.
• Normally about 75 per cent of the initial margin.
• Future price move against (beside) the investor resulting in
falling margin account below the maintenance margin, broker
will make a call. Demand for additional fund is called margin
call.
• Example initial margin on future contract is Rs.5000 and
maintenance margin Rs. 3750(75% initial margin).

• Next day party has sustained a loss of Rs.1000, reducing
balance in margin to Rs.4000. further decreased and sustained
loss is Rs.500. Balance in margin account to Rs,3500,below
maintenance margin, broker will make a call to fill the margin
account to Rs.5000, level of initial margin.
 Variation margin:
 Additional amount which has to be deposited by trader with
the broker to bring balance of margin account to initial margin
level.
 Above example the variation margin be Rs.1500 (5000-3500)
difference of initial margin and balance in margin account.
 Investor not pay initial margin immediate, broker may proceed
to unilaterally close out account by entering into offsetting
future contract.

 Margins and marking-to-market(daily settlement):
 Observed, initial margin sometime is even less than 5 per cent
which is very small considering total value of future contract.
 This smallness is reasonable, because another safeguard built
in system known as daily settlement marking-to-market.
 All transaction are settled on daily basis. the system of daily
settlement in future market is called marking-to-market.
 Trader realize their gains or losses on daily basis to understand
this process of daily settlement.
 Future contract is closed out and rewritten at a new price
everyday.

Closing a future position(Settlement)
 Physical delivery:
 Liquidating future position is by making or taking physical
delivery of goods or asset, exchange provided alternatives as
to when, where, and what will be delivered.
 Choice of the party with a short position, the party is ready to
deliver, it will send a notice of intention to deliver to
exchange.
 Price is settled with a possible adjustment for quality of the
asset and chosen delivery location.
 Exchange selects a party with an outstanding long position to
accept delivery.

 Cash settlement/ delivery:
 Procedure is a substitute of physical delivery and do not
require physical delivery.
 Exchange notifies about cash delivery as the settlement
procedure.
 Certain financial future like stock indices, treasury securities,
euro-dollar, time deposit, municipal bonds, etc.
 Cash settlement contract expires, exchange sets its final
settlement price equal to spot price of the underlying asset on
that day.
 Prices of cash settlement contract is just like the prices of
delivery contract at their expiration period.

 Offsetting:
 Liquidating the future position is to effect an offset (make-up
for) future transaction or via a reversing trade which reverses
the existing open position.
 Example, initial buyer (long) liquidates his position by selling
(going short) an identical futures contract (which means same
delivery month and same underlying).Similarly, initial seller
(short) goes for buying (long) an identical future contract.
 Clearing house plays a significant role in facilitating
settlement by offset.
 This method is relatively simple, require good liquidity in the
market and entail usual brokerage cost.
 There are two parties X and Y. X has an obligation to clearing
house to accept 10000 bushels of cotton in september and to
pay Rs. 180 per bushels.

Y has a obligation to the clearing house to deliver 10000
bushels of cotton in September and to receive Rs.180 per
bushels. Both party can reverse or offset their position in that
way where by buyer become seller and seller becomes the
buyer.
 Exchange of futures for physical (EFP):
 Liquidating future contract in a form of physical delivery,
called exchange of future for exchange .
 A party holds a future contract like to liquidate his position
that is different from those the exchange offers.
 Example, a party may like to deliver the asset before the
specified future period, or may deliver the asset at different
place, or deliver outside the normal trading hours, etc.
 EFP, system permits to exchange a future position for a cash
position that meets both the parties preference, party must find
willing to make the trade.

Difference between Futures and Forward Contract
Forwards contract Futures contract
1)Private contract between the
twp parties bilateral contracts
Traded on organized exchanges
2) Not standardized(customized) Standardized contract
3) Normally one specified
delivery date
Range of delivery dates
4)Settle at the end of maturity.
No cash exchange prior to
delivery date.
Daily settled. Profit/loss are paid
in cash.
5) More than 90 per cent of
forward contract are settled by
actual delivery of assets.
Not more than 5 per cent of
future contract are settled by
delivery.
6) Delivery or final cash
settlement usually takes place
Contract normally closed out
prior to the delivery.

Contd:
7) No margin money required Margins are required of all the
participants
8) Cost of forward contract based
on bid-ask spread.
Entail brokerage fee for buy and
sell order
9) There is credit risk for each
party. Hence, credit limit must be
set for each party.
Exchange clearing house
becomes the opposite side to
each future contract. Thereby
reducing credit risk substantially.

Unit ii

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Unit ii