FUTURES MARKET

Initial margin:
This is the initial amount of cash that must be deposited in
the account to start trading contracts. It acts as a down
payment for the delivery of the contract and ensures that
the parties honor their obligations.
Variation margin:
This is the amount of cash or collateral that brings the
account up to the initial margin amount once it drops below
the maintenance margin.
Maintenance margin:
This is the balance a trader must maintain in his or her
account as the balance changes due to price fluctuations.
It is some fraction - perhaps 75% - of initial margin for a
position. If the balance in the trader's account drops below
this margin, the trader is required to deposit enough funds or
securities to bring the account back up to the initial margin
requirement. Such a demand is referred to as a margin call.
The trader can close his position in this case but he is still
responsible for the loss incurred. However, if he closes his
position, he is no longer at risk of the position losing
additional funds.
Marking to the market:
Problems can arise when the market-based measurement
does not accurately reflect the underlying asset's true value.
This can occur when a company is forced to calculate the
selling price of these assets or liabilities during unfavorable
or volatile times, such as a financial crisis. For example, if
the liquidity is low or investors are fearful, the current selling
price of a bank's assets could be much lower than the actual
value. The result would be a lowered shareholders' equity.
This issue was seen during the financial crisis of 2008/09
where many securities held on banks' balance sheets could
not be valued efficiently as the markets had disappeared

from them. In April of 2009, however, the Financial

Accounting Standards Board (FASB) voted on and approved
new guidelines that would allow for the valuation to be
based on a price that would be received in an orderly market
rather than a forced liquidation, starting in the first quarter
of 2009.
This is done most often in futures accounts to make sure that
margin requirements are being met. If the current market
value causes the margin account to fall below its required
level, the trader will be faced with a margin call.
Basis: The basis reflects the relationship between cash price
and futures price. (In futures trading, the term "cash" refers
to the underlying product). The basis is obtained by
subtracting the futures price from the cash price.The basis
can be a positive or negative number. A positive basis is said
to be "over" as the cash price is higher than the futures
price. A negative basis is said to be "under" as the cash price
is lower than the futures price.

Strong or Weak Basis

The basis changes from time to time. If the basis gains in value
(say from -4 to -1), we say the basis has strengthened. On the
other hand, if basis drops in value (say from 8 to 2), we say the
basis has weakened.
Short term demand and supply situations are generally the main
factors responsible for the change in the basis. If demand is
strong and the available supply small, cash prices could rise
relative to futures price, causing the basis to strengthen. On the
other hand, if the demand is weak and a large supply is available,
cash prices could fall relative to the futures price, causing the
basis to weaken.
However, although the basis can and does fluctuate, it is still
generally less volatile than either the cash or futures price.
Basis Risk
Basis risk is the chance that the basis will have strengthened or
weakened from the time the hedge is implemented to the time
when the hedge is removed. Hedgers are exposed to basis risk
and are said
to
have
a
position
in
the
basis.

BACKWARDATION
HYPOTHESIS
AND
CONTANGO
HYPOTHESIS (all three hypothesis covered in ans in case
he asks..)

There have been 3 hypotheses to explain the price of futures

contracts over their term: expectations hypothesis, normal
backwardation,
and
contango.
The expectations
hypothesis is the simplest, since it assumes that the futures
price will be equal to the expected spot price on the delivery
date. In this case, the price of the futures contract does not
deviate from the future spot price, yielding a profit neither to
the long position nor the short position. However, the
expectations hypothesis does not represent reality, since the
expected future spot price is uncertain. Therefore, there must
be a risk premium available to induce traders to take a position
in the futures contract.

Normal backwardation exists when the price of futures

contracts is below the expected delivery date spot price.
Prices for contracts with nearer maturity dates are higher
than those with later maturities. Contango exists when the
price of futures contracts is higher than the expected spot

price on the delivery date, and the price of futures contracts

with later delivery dates are higher than those with sooner
delivery dates.
John Maynard Keynes and John Hicks explained this state of
affairs as a result of farmers wishing to shed risk so that they
can get guaranteed prices for their product, so they entered
into the short side of the futures contract by offering the
contracts at lower prices than the expected delivery date spot
price. This enticed others to enter into the long position of the
contract since they can be expected to profit by the delivery
date. Thus, the longs' profit is equal to the farmers' loss, but
the farmers accept this in exchange for a guaranteed price for
their product.
Contango takes the opposite view of futures prices.
The contango hypothesis contends that the buyers of the
products are the natural hedgers since they also want a
guaranteed price, so they are willing to pay a higher price than
the expected spot price to achieve that result. This results in
higher
future
prices
for
longer-term
contracts.
So contango exists in a futures market when future prices
increase progressively with longer maturities. This is the most
common situation, since many commodities, which are traded
with futures contracts, have carrying costs, including storage,
insurance, and financing plus there must be some
compensation for the risk of holding the underlying asset. If the
short position does not hold the underlying, then a risk
premium must be paid to compensate for the risk. A contango
market encourages investors to buy the near contracts and
take delivery to sell in the later months, and for companies to
increase stockpiles of the commodity.
Obviously, whether backwardation or contango prevails
depends on the preponderance of the short or long positions.
The net hedging hypothesis stipulates that an excess of
shorts will cause a normal backwardation, whereas an excess of
longs will result in contango.

 Market order: An order that an investor makes through a

broker or brokerage service to buy or sell an investment
immediately at the best available current price. A market order
is the default option and is likely to be executed because it does
not contain restrictions on the buy/sell price or the timeframe in
which the order can be executed.
A market order is also sometimes referred to as an "unrestricted
order."
A market order guarantees execution, and it often has low
commissions due to the minimal work brokers need to do. Be
wary of using market orders on stocks with a low average daily
volume: in such market conditions the ask price can be a lot
higher than the current market price (resulting in a large
spread). In other words, you may end up paying a whole lot
more than you originally anticipated! It is much safer to use a
market order on high-volume stocks.
Limit order: An order placed with a brokerage to buy or sell a
set number of shares at a specified price or better. Because the
limit order is not a market order, it may not be executed if the
price set by the investor cannot be met during the period of time
in which the order is left open. Limit orders also allow an investor
to limit the length of time an order can be outstanding before
being canceled.
While the execution of a limit order is not guaranteed, it does
ensure that the investor does not pay more than he or she is
willing to. Depending on the direction of the position, limit orders
are sometimes referred to more specifically as a buy limit order
or a sell limit order. For example, a buy limit order that stipulates
the buyer is not willing to pay more than $30 per share, while a
sell limit order may require the share price to be at least $30 in
order for the sale to take place.
Limit orders can have specific conditions added to them. An
investor may indicate that the order must be executed

immediately or canceled, which is called a fill or kill (FOK) order.

They may also require that all desired shares be bought or sold at
the same time if the trade is to be executed, which is called an all
or none order.
Limit orders typically cost more than market orders because they
can be more difficult to fill. Despite this, limit orders let investors
get their specified purchase or sell price. Limit orders are
especially useful on a low-volume or highly volatile stock.
Scalper
A person trading in the equities or options and futures market
who holds a position for a very short period of time in an
attempt
to
profit
from
the
bid-ask
spread.
A person who buys large quantities of in-demand items, such as
new electronics or event tickets, at regular price, hoping that the
items will sell out. The scalper will then resell the items at a
higher price. Such transactions often occur on the black market.
This type of scalping is illegal under certain conditions.
What are the features of a future contract?
In a futures contract there are two parties:
1. The long position, or buyer, agrees to purchase the
underlying at a later date or at the expiration date at a price
that is agreed to at the beginning of the transaction. Buyers
benefit from price increases.
2. The short position, or seller, agrees to sell the underlying at
a later date or at the expiration date at a price that is agreed
to at the beginning of the transaction. Sellers benefit from
price decreases.
Prices change daily in the marketplace and are marked to market
on a daily basis.

At expiration, the buyer takes delivery of the underlying from the

seller or the parties can agree to make a cash settlement.
(OR)
FUTURES CONTRACTS:
A Futures Contract is an exchange traded contract to buy or sell
at a predetermined quantity of an asset on a predetermined
future date at a predetermined price.
FEATURES:
Contract between two parties through an exchange
Price decided today
Quantity decided today
Margins are payable by both the parties
Circuit Filters are decided by the exchange
No counter party risk as Clearing Corporation becomes
counter party to each trade.

DIFFERENCE BETWEEN FORWARDS AND FUTURES:

FORWARDS:
Standardized contract terms.
Requires margin payment.

 Follows daily settlement.

Traded on exchanges.
FUTURES:
Customized contract term.
No margin payment.
Settlement at the end of the period.
OTC in nature.