FUTURES IN INVESTMENT PORTFOLIO

Future derivatives were developed to address the problems that were present in forward
derivatives. A future’s agreement is a contract between two parties that agree to sell or buy a
commodity or an asset at a specified time and price in the future.As compared to forward
contracts, future contracts are traded at proper exchanges and legally standardized. To
maintain the liquidity of futures, the regularized exchanges have certain specific standards in a
contract. A standard futures contract contains standardized underlying instrument, standard
quality and quantity that can be delivered at a specified time under standard settlement. A
futures agreement can finalized before maturity by offsetting. As per statisics more than 99%
futures are called off this way.

The standardized items in a futures contract are: -

 Quantity of the asset

 Quality of the asset

 Time and location of delivery

 The units of price quotation and minimum price change

 Location of payment

Difference between futures and forwards agreements

Future’s contracts are often considered the same to be forwards. This is not the case.This is due
to the fact that both derivatives are used for the same purpose of hedging the risk in the
scenario of uncertain future prices. Futures were designed specifically keeping in mind the
liquidity and party risk problems prevalent in the forward contracts.

Comparison between futures and forwards

Futures Forwards
Trade on an organized exchange Over the counter in nature

Terms are standardized Terms can be customized

Highly liquid Less liquid

Includes margin payments No concept of margin payment

Terminologies in Future’s

 Spot price:

Spot price is the price at which a commodity trades in the spot market.

 Futures price:

The futures price is the price at which the futures contract trade in the futures market.

 Contract cycle:

The period over which a contract trades. The index futures contracts on the NSE have one-
month, two-months and three-months 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 mentioned 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.

 Size of contract:

The amount of asset that has to be delivered under one contract. For in-stance, the contract
size on NSE’s futures market is 200 Nifties.

 Basis:

The difference between the futures price and the spot price is termed as the basis.Each
contract has a specific and different basis every month.In a standard and normal market
scenario, a basis will always be positive.Thus futures price will mostly appreciate as compared
to the spot price.

 Carrying cost

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
 Initial margin is the amount which must be deposited in the margin account when a futures
contract is formed.

 Marking-to-market:

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

 Maintenance margin:

Maintenance margin is somehow lower than the initial margin. It is designed in such a way so
the balance in the margin account never gets in the negative zone. If by any chance the margin
account balance falls less than the maintenance margin, the entity receives a margin call and
expects to top up the margin account to the initial margin.This is carried out just before the
commencement of trading next day.

Who trades futures contracts?

A lot of corporations and individuals are interested in futures contracts. These entities need to
hedge their respective risks. Thus they are termed as hedgers. Also individuals that are
interested to make profit gains just by correctly estimating the price movements trade futures
derivatives. Entities of this sort are termed as speculators. Speculation is quite different but
gets a lot of attraction by investors who want to invest money.

Pit or Trading Floor ?

All entities of the world are present on a single platform

E-bay analogy

E-bay provides modern solutions in this technological global world. Investors from all around
the world are present at one platform and thus a market price is determined accordingly.

Example of Futures

– Southwest Airlines

Airlines have to offer a lot reservations in advance.The most important cost driver in determining ticket
prices is that of jet fuel.Southwest airlines thus buy oil futures in advance so as to mitigate the risk by
hedging it.A long position in oil futures will enable southwest to handle any losses in real price related to
increase in fuel prices.

FUTURES MARKET IN COVID-19 PANDEMIC

OIL MARKETS

Due to COVID-19, oil and other energy supplies have seen drastic changes.Oil futures have hit
the lowest at negatives prices because the demand of oil is really low and oil is stuck in
pipelines and tanks.

BASIC COMMODITIES

COVID-19 has destroyed the supply chain mechanism of basic commodities that decreased
futures prices.Most of the dairy farmers had to see low demands from processors because of
lockdowns thus forcing them to waste fresh milk supplies on the ground.