Futures and Forwards are contracts by which one party agrees to buy the

underlying asset at a future, predetermined date at a predetermined price. The

other party agrees to deliver the underlying at the predetermined date for the
agreed price. Hence, a Forward Contract and a Futures Contract represent a
binding commitment between a buyer and a seller to execute a transaction in
some underlying asset on a future date under the terms that are fully specified
in the present. Both type of contracts specify (1) precise description of the
asset to be traded (2) Quantity (3) price (4) Range of delivery dates (5) location
and manner of delivery.

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commodity-futures-market-in-india.pdf?sfvrsn=f5056e91_2

 Example: A wheat farmer who contracts on March 2024, to sell 5000

bushels of wheat to a cereal producer on July 15, at a price of $5.00. The

contract should also specify the brand of wheat (say, number 2 red

winter wheat) and the manner of delivery (e.g, by truck to the buyer’s

loading dock.). What the farmer does, in effect, is to lock-in the price

that he will receive and the cereal producer essentially fixes the cost of
 its input at an early date. Both parties avoid the risk associated with the

fluctuations of price in the spot market in July.

The farmer is said to have taken a short position and the cereal producer is

said to have taken a long position in the market.

Forward Market: Let us denote by F (t) forward price agreed upon at the
present time t for delivery at maturity time T . By S(t ) we denote the spot price
at t . At maturity time T , the investor with the short position will have to deliver
the good currently priced in the market at the value S(T ) and will receive in
exchange the forward price F (t) The payoff for the short side of the forward
contract ( the farmer selling the wheat) can therefore be expressed as
: F (t)−S (T )

The payoff for the long side (The cereal owner) will be the opposite: S(T )−F (t)
, he pays F (t) to the wheat producer at date T and receives the delivery of the
wheat and sells at price S ( T ) .Thus a forward contract is a zero-sum game
II Types of players in the futures market and their objectives:

There are three types of players:

(1) Hedgers who seek to reduce risk via lock-in effects.

(2) Speculators, who either buy or sell in spot as well as futures market,

depending on their hunch about the movements of prices in these markets.

(3) Arbitrageurs: They simultaneously undertake buying (long) in one market

and selling in another market (short) in order to reap risk-less profits.

III Differences between futures and forward markets and mechanics of the

futures markets.

There are important differences between Forward and Futures.

Fragmented Markets: Forwards are privately negotiated bilateral agreements

between two parties but the futures contracts are exchange traded financial

instruments. Hence, except for a few instances where the dealers in the

forward market form a network, the forwards, in general, are fragmented

markets. Lack of information in the forwards markets implies that there is no

guarantee that parties will end up with best deals both in terms of price and

quality. The futures are mediated by a clearing house that assumes full

responsibility in order to execute contracts.

1. Secondary Markets: In futures there is a secondary Market while there is

no such things at in the forward market. Suppose that bad weather

destroys crop of the farmer when July arrives. What happens to the binding

commitment on his/her part to deliver 5000 bushels of wheat to cereal

producer? In futures, there is a secondary market so that the wheat farmer

can transfer his/her obligations to a third party while in the forward market,

all parties have to renegotiate the deals. Thus, presence of a secondary

market in futures attracts information traders (speculators and

 arbitrageurs) who provide liquidity in the market which offsets temporary

imbalances.

2. Credit Risk: In forwards, parties enter agreements at an initial date to

deliver goods at a later date. No financial transaction takes place at a initial

date. However, as the time marches on, forward price for the delivery day

in question moves away from the contracted price. Such a movement in

price leads to gains and losses to both parties. In fact, gains of a party are

exactly equal to the loss of the other party. For example, if there is an

increase in forward price at a later date, the seller loses because he is

committed to deliver at a contracted price and the buyer gains because

he/she has locked in the price via the original futures contract. Hence,

profitable counter party faces the risk of default vis-à-vis the other party.

Clearing house ensures integrity of financial transactions and eliminates the

credit risk by introducing a variety of safeguards.

 Differences between Futures and Forward Markets:

The futures contracts are marked to market, meaning that that both sides
of the contract must keep a cash account whose balance will be updated
on a daily basis, depending on the changes of the futures price in the
market. At any point in time there will be in the market a futures price for a
given underlying with a given maturity.

A farmer can lock the future price of wheat by promising to deliver

specified bushel of wheat and receives F (t)at the time when contract
matures at date T , when the price at the spot market is S ( T ) . His pay-off at
date T (profit/loss) payoff will be F (t)−S ¿). .
 However, unlike the forward contract, this payoff will be spread over the
life of the futures contract in the following way: every day there will be a
new futures price for that contract, and the difference with the previous
price will be credited or charged to the investor’s cash account, opened for
this purpose.

Marking to market is a way to guarantee that both sides of a futures

contract will be able to cover their obligations. Below is an example how
the future market works via different kinds of margin requirements.

Mechanics of the Futures Trading and the role of Secondary Market:

 Step 1: Suppose that two counter parties A and B enter matching orders.

The party A promises to sell one July contract at a price of $ 4.00.

(deliver 5000 bushels of wheat on July 1) and B is bidding to buy one

contract (i.e contracting to take delivery of the wheat in July) These

orders are transmitted to the floor of the futures exchange where they

are executed by floor brokers in the trading pit. Once they agree upon

the terms of contracts, brokers of the respective parties contact the

clearing house. Now, the party A has the obligation to deliver wheat to

the clearinghouse in July which, in turn, pays $4.00 per bushel at that

time. In a similar manner, the party B has an obligation to buy in July

from the clearing house.

Hence, the clearing house plays the role of a buyer to a seller and vice versa. In

order to eliminate the “Credit Risk” the clearing house introduces “margin
requirement” and make “contracts marked to the market. These two elements

ensure that no default takes place.

 There are three types of margin requirements.

 Initial Margin: To open a futures position, every trader must deposit a

specified “initial margin” amount with his broker as collateral. This is

typically in the range of 3 to 10 percent of the contract value.

 In the example: The total value of the contract is $4.00 x 5000 = $20,000.

Hence, both parties have to deposit and initial margin of $1,000 (= 5% of $4.00

x 5000)= 5% of $20,000

(a) “Variation Margin”: All open contracts are marked to the market at the

close of the trading every day and the day’s profits and losses are

transferred in cash from the account of losers to those of winners. These

daily cash flows generated by the fluctuations in future prices are known as

“variation Margin”.

(b) “Maintenance Margin”. Since contracts are marked to the market, there

cash inflows to the winner and cash outflows to the losers. Excess cash can

be withdrawn. However, if the cash position of a party dips below a

specified level, the party has to deposit the difference in order to maintain

the margin. Such a specified level of margin below which a party gets a

“margin call” is known as Maintenance Margin.

  Example: At March 2, a farmer sells one July Futures contracts at

$4.00 / bushel. Meaning that on July 1st, the farmer will sell 1 unit of

wheat at a price of $4.00 to the buyer in the futures market, 5000 units

of wheat. The total value of the contract is $4.00 x 5000 = $20,000

(a) Initial Margin: $1,000 (= 5% of $4.00 x 5000)= 5% of $20,000

(b) Variation Margin : On the first day the settlement price is $4.05. The farmer

loses 5 cents per bushel. He has committed to sell the July futures at $4.00 but

at the end of the day buyers are paying $4.05 /bushel for the same July future

contract. Hence, He loses [4.05- 4.00] x 5000 =$250. Or he makes this extra

profit if he cancels the original contract ( $4.00). To prevent such action, the

exchange mandates a transfer of $250 to buyer’s account. That is, this amount

is deducted from his margin. So his balance in the margin account is $(1000 –

250) = $750.

The day after (March 3) price rises to $4.08 leading to a further decline of

reserves in the margin account by another $150. (=.03 x 5,000). Now at the end

of the day, the reserve is $600. If the maintenance margin is $650, he would

get a margin call to deposit $400 immediately; otherwise the contract will get

cancelled. On March 4, the futures price (suppose) falls to $4.02. This

produces a gain $300 ( = (=.06 x 5,000) to the farmer compared to previous

day’s position. Hence, it needs to be added to the Margin account which is now

$900.

This process continues till the day before maturity 30 th June and price of the

futures on the date of expiry is the spot price on that day.

 How are these adjustments are connected to final pay-offs in the Futures Market?

To answer the question, look at the changes in the pay-off each day as the furtures prices

of the same expiration date adjusts the balance:

Adjustment of Margins: [ ($4.00- $4.05) + ($4.05 - $4.08) + ($4.08 - $4.02)] + ------------ +

( Price at the day before expiry – Spot price at the expiry) + Deposits returned back.

Adjustment of prices: ($4.00- $4.05) + ($4.05 - $4.08) + ($4.08 - $4.02) +-------

---------- ------------ + ( Price at the day before expiry – Spot price at the expiry)

¿ F ( t )−{ ( F ( t )−F ( t +1 ) } + { F ( t +1 )−F ( t+2 ) } + { F ( t+2 )−F ( t +3 ) } ±−−−−∓ { F ( T −2 )−F (T −1 ) }+ { F ( T −1 )−S (

Is the same as in forward price. But gains and losses are distributed over time

from the day of entering the contract to the expiration date and in between> .

Closing out of a position:

As the time progresses and A’s position is marked to the market daily, he/she has two

options. (a) The farmer can deliver the promised amount of bushels of wheat at a price of

$4.00 per bushel or (b) can close out his/her position by resorting to futures market and

reversing the initial transaction in the futures market. That is, by buying a July contract will

offset his initial obligation to the clearing house. Suppose that the farmer buys July futures

contract on June 20th at the prevailing price of $3.75. A’s margin account will be now $1000

+ .25 x 5000 =$2250.

Open Interest: Suppose that the farmer buys July future contracts (on June 25) from a third

party, say, Z. If Z is also closing out an existing futures position (from buy to sell), then both

counter parties contracts would be extinguished and the open interest would fall by one

contract.

 Relationship between Some the Futures and spot price:

Let F = forwards price and S0 =spot price at date 0, r = rate of interest, D =dividends.

C = coupon payments.

If the Securities providing no income in between so that , D=C=0.

t
F=S0 (1+r )

If interests are compounded (m) times per anum, then.

F=S0 ¿ ¿On the other hand, with continuous compounding, the equation becomes

F=S0 ( exp , ) rT