We looked at an example of a Forwards Contract, in which two parties agreed to trade cash for goods at a future date. We examined the structure of the transaction to understand how price variations affect the parties. We had identified 4 major risks or issues concerning forward-looking contracts towards the end of this chapter. Our conclusion was that futures contracts are structured to mitigate the most serious risks associated with forward agreements, namely:
The same example will be used in the next chapter. You may find it helpful to review the example from the previous chapter.
One thing is clear from the preceding chapter: A forward agreement can help you to see the value of assets and make a significant profit. It is easy to find a counterpart willing to take the other side. A forward agreement has its limitations, which are all overcome by futures agreements.
The Futures contract, also known as Futures Agreement, is an improvisation of a Forwards Agreement. The Futures Contract retains the core transactional structure that is found in a Forwards Market. It eliminates all risks associated with a forward's contract. As long as you have an accurate directional picture of the asset's price, a Forward Agreement will provide you with a financial advantage. This is what I mean by 'core transactional structures'.
Although it may sound absurd, this is the core 'transaction architecture' of an older generation car. It was designed to move you from point A to point B. The new car has many safety features, including airbags and seat belts, ABS, power steering, etc. However, it retains the core "transaction structure", i.e. This guide will help you get to the next point. This is the same difference between the futures and forwards agreements.
We now know that the transactional core of futures and forwards are the same. Therefore, it makes sense to examine the features that differentiate the Futures from forwards. This chapter will give us a glimpse into the features, but we'll get into more detail later.
Remember the example in the previous chapter. In that case, ABC jeweller agreed with XYZ for a specific amount of gold to be purchased at a particular point in the future. Imagine this: What if ABC couldn't find XYZ to be a counterpart to the agreement? In such circumstances, even though ABC may have a particular view about gold and be willing to enter into a financial arrangement, they would be helpless since there is no counterpart to the agreement.
Imagine this. Imagine ABC deciding to go to a financial store instead of spending time looking for a counterparty. ABC would need to declare its intent to create a financial supermarket, and all the willing counterparties would be ready to support it. A true financial supermarket would not only have people who view gold but also people who view silver, copper, crude oil and just about any other asset class.
This is how Futures Contracts are made accessible. They are accessible to everyone and not just corporate entities like ABC Jewelers. Futures contracts can be purchased in the financial super market, also known as the "Exchange". You can choose to exchange stock or commodity.
A futures contract is structured differently to a forwards one, as we all know. This is to mitigate the risk involved in the forwards markets. Let's take a look at these points which distinguish the futures from the forward-s agreement.
You may not know much about futures. That's okay. Keep the following points in mind. In the next section, we will look at a futures example. Once you have that, it is time to understand how Futures agreements work.
Futures contract mirrors the underlying – In the case ABC jewellers and XYZ Gold Dealers, the forwards' arrangement was based upon the asset of gold. The Futures Contract however, is based upon the asset's future value. The futures price is a simulation of the asset. This is also known as the underlying. A contract called the 'Gold Futures' can be used to trade gold. Consider the futures contract and the underlying asset as twins. The futures contract is subject to the same conditions as the underlying asset. The futures contract would be priced higher if the underlying asset's price goes up. The futures contract's value will also drop if the underlying price goes down.
Standardized contracts - This agreement was to cover 15 kilograms of gold with certain purity. The agreement could have been for 14.5Kgs or 15.25Kgs if both parties agreed. The parameters of a futures contract are set. They cannot be changed.
Futures contracts are easily tradable Contrary to a forward contract, a futures contract is not binding until its expiry date. If my opinion changes, I can transfer the contract and end the agreement.
Futures Market highly regulated. A regulatory authority heavily regulates Futures markets and, in turn, the entire financial derivatives industry. The Indian Securities and Exchange Board (SEBI), is the regulator. This means that there is always someone watching over the market activities and making sure everything runs smoothly. This means that default on futures agreements is unlikely.
Futures contracts are time-bound - This point will be explained in more detail later. But for now, keep in mind that each futures contract you have has different time frames. The previous chapter showed that ABC jewellers held a particular view on gold. This was kept in perspective by keeping the 3 month time frame. Contracts would be available for ABC in the following time frames: 1 month, 2 and 3 months. "The contract expires is the end of its term.
Cash settled The majority of futures contracts can be cash-settled. The cash differential is the only amount that is paid. You don't have to worry about moving the physical asset. The regulatory authority oversees the cash settlement, ensuring transparency.
Let's summarize it all. This table summarizes the differences in the "Forwards Contract" and "Futures Contract".
|Forwards Contract||Futures Contract|
|Contracts can be traded over-the-counter (OTC).||The exchange allows you to trade futures contracts.|
|Contracts can be modified.||Future contracts are standard.|
|High counterparty risk||There is no counterparty risk|
|Non regulated||SEBI (in India), regulates|
|Contracts cannot be transferred.||Transferable, therefore easily tradeable|
|Time-bound to a 1-time period||Multiple time frame contracts available|
|Settlements can be made in cash or physical currency.||Cash settlement|
At this point, I believe it is important to emphasize the difference between the spot and futures prices. The spot price refers to the price at which an asset trades in the "regular" market, also known as the "spot market". If we're talking about gold as an underpinning, there are two prices to be aware of: gold in the Spot market, also known as the Spot market, and gold in Futures, which is the Gold Futures. Spot market and futures market prices are linked, so if one moves up, the other will also move up.
These are just a few of the perspectives we have. Let's now look at some other futures contract nuances.
Before we can understand the workings of futures contracts, it is important to first understand some other aspects of futures trading. These points will be discussed in more detail at a later stage. For now, a good working knowledge of the following points is necessary.
Lot Size -Future - This is a pre-determined contract that covers all aspects of the agreement. One such parameter is the lot size. The lot size is the minimum amount you can transact in a futures agreement. The lot size of an asset varies.
Contract Value XYZ Gold Dealers and ABC Jewellers agreed to purchase 15 kgs Gold at a rate of Rs.2450/gram or Rs.245,000/kg. The whole deal was worth Rs.2450,000/- per gram or Rs.24,50,000/- per kilogram. The contract value is Rs.3.675 crore in this instance. The contract value simply means the amount of the asset's price. The minimum lot size (or quantity) that is required to enter a futures agreement is pre-determined. The contract value for a futures arrangement can be described as "Lot Size x Price".
Margin –We refer to the ABC jewellers and XYZ Gold Dealers at the time of this agreement. Both parties would have accepted to honor the agreement as of the 9th December 2014. Both parties would have agreed to honor the contract at the expiry date of the agreement, i.e. 9 th February 2015. Notice that there is no money exchange on 9 December 2014.
In a futures agreement however, each party will need to deposit money at the time a transaction takes place. This is the token advance that is required to agree. The broker must deposit the money. The amount of money that must be deposited is usually calculated at a percentage of the contract value. This is the margin amount. Futures trading is dominated by margins. We will discuss this more later. Remember that a margin amount, which is a percentage of the contract's value, is required in order to enter into a futures arrangement.
Expiry All futures contracts are bound by time. The date the contract expires or expires is the last date that the agreement can be valid. The contract ends when the expiry date is reached. Be aware, however, that once a contract expires the exchanges create new contracts.
These few points should help you understand the basics of futures trading.