A future contract is an agreement between two parties to buy or sell an underling asset at a certain price after a certain time frame. The time frame generally ranges from 1 month and beyond. Futures market is a remedy to the problems countered by the market players while participating in the forwards market. Future contracts are more standardized in nature and are traded on an exchange, compared to the forwards contract. The standardized contracts consist of an underlying asset with a standard specification like quality, quantity, location of settlement, and a definite time frame.
The noble laureate , 1990, Mr. Merton Miller says that financial futures represent the most significant financial innovation of the last twenty years.
To overcome the pertinent problem of ‘Credit risk’ in the forward contracts, a group of businessmen in Chicago formed the Chicago Board of Trade (CBOT) in 1848 with an intention to provide a centralized location to know the buyers and sellers. In the year 1865, CBOT went one step further and listed the first exchange traded financial derivatives called Futures Contracts. In the year 1919, a spin-off of the CBOT- Chicago Butter and Egg Board was recognized to trade in futures. Its name was later changed to Chicago Mercantile Exchange (CME). Both the CBOT and CME are recognized as the two largest Financial Exchanges of the modern era.
The ‘ Father of Financial Futures’, Mr LEO Melamed, then chairman of CME, was instrumental in launching the first financial derivatives in the year 1972, in the form of currency futures through the International Monetary Market (a division of CME). During the mid 80’s financial futures became most actively traded derivative instruments. In the recent years, market for financial derivatives has grown by leaps and bounds. In the class of equity derivatives, futures and options on stock indices have gained more popularity then individual stocks.
Futures Terminology:
To understand Futures one needs to be familiar with the terms given below:
a) Spot Prices: The price of the underlying asset in the market currently.
b) Futures Price: The anticipated price at which participants buy/sell the futures contract.
c) Contract Cycle: The term of the contract. Currently, India the exchange traded futures have a cycle like 1 month, 2 month and 3 month and terms generally used for the contract are Current Month, Near Month and Far Month, respectively. The contracts at NSE expire on the last Thursday of every month and a new contract bearing a 3 month expiry is introduced.
d) Expiry Date: This is the last date on which the contract is traded. Post this date the contract ceases to exist.
e) Contract Size: This is also called as the LOT SIZE of the contract. It signifies the standard quantity of the assets to be delivered under one contract.
f) Basis: It is defined as the Future price minus the spot price. In a normal market, if the future price exceeds the spot price it is assumed that the basis is positive and the underlying can reap better profits on the expiry and vice versa.
g) Cost of Carry: The relationship between the spot and the future price can be summarized in the terms of 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.
h) Initial Margin: It is the amount that must be deposited in the account at the time of entering (creating position) the future contract.
i) Marking-to-market: It is the difference of price between the closing prices of two trading days. This is settled everyday by the exchange. At the end of the trading day the margin account is adjusted to reflect the investor’s gain / loss depending in the future’s closing price.
j) Maintenance Margin: This is somewhat lower than the initial margin. This is set to ensure that the balance is the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and he is required to top up it with the shortfall. Before the commencement of the next trading day.
IMPORTANCE OF THE DERIVATIVE MARKET IN AN ECONOMY
Derivatives market help in increase savings and investment in the long run for the economy. The derivatives market has to bear a lot of criticism and fear in the economy but it performs a no of economic functions. These can be read as below:
1. Prices in an organized derivative market reflect the perception of the market participants about the future and lead to price discovery of the underlying asset. The prices of the derivatives converge the price of the underlying at the expiration of the contract term. This helps in discovery of not only the future price but also the current price of the asset
2. The derivatives market helps to transfer risk.
3. The derivatives help the spot market in witnessing higher trading volumes as there are more number of participants.
4. This market helps in shifting the speculation to a more controlled environment. In the absence of an organized derivative market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in this kind of mixed market.
5. Existence of an organized derivative market helps the economy by acting as a catalyst for new entrepreneurial activities. It often energizes others to create new businesses, new products and new employment opportunities in an economy.
