Introduction to Futures Contract

The previous chapter saw the example of several straight forward contracts, where two parties enter into an agreement with each other that in the future one party will give some goods and the other party will pay some money for that goods. We have seen how such an agreement is made and the impact of price changes on these parties. At the end of the chapter, we also looked at four risks or drawbacks of forward contracts and also talked about how futures contracts were designed to overcome these:

• Liquidity Risk
• Default Risk
• Regulatory Risk
• Rigidity of the transitional structure

One thing is clear that you can make money in a forward agreement if you have an opinion about the future price of a commodity. All you have to do is find a party whose opinion is contrary to your opinion. However, it is also clear that there are some shortcomings in the forward agreement and to avoid those shortcomings, the futures agreement has been brought in.

A futures contract can be said to be an improved form of a forward contract, it is designed in such a way that the merits of the forward contract remain but its shortcomings are removed. Meaning in futures contract also you can make profit if you have a solid opinion about the future price of any commodity.

Understand this with an example. In the olden days, the function of the car was to transport people from one place to another. The new age car not only takes people from one place to another, but at the same time it also has many other facilities like seat belts, air bags, power steering etc. There is a similar difference between a forward contract and a futures contract.

A Look at the Futures Agreement

As we now know that the basis of a futures contract and a forward contract is the same. So one way to better understand futures contracts can be to understand the difference between the two.

We took an example in the previous chapter where ABC Jewelers entered into an agreement with XYZ Gold Seller to buy some gold after a certain period of time. Now just imagine that if ABC did not find any party with whom it would have been able to make this agreement, what would have happened? ABC has an opinion about the future of gold and wants to make a deal but they can’t find anyone they can negotiate with.

Now suppose that ABC, instead of spending time looking for a new party, decides to go to a supermarket where a lot of people are looking for another party to settle. Now in this super market ABC just has to announce that I have this opinion on gold and the one who has to come and settle against this opinion should come. Also let’s assume that there are a lot of people in this supermarket who have an opinion not only on gold but every item like silver, oil, copper, and even stocks and they are looking for a party to make a settlement.

Futures contracts are done in a similar manner. These are not available to a single company like ABC Jewellers but to every individual who wants to enter into such an agreement. In common language, we call this supermarket as an exchange. It can be a stock exchange as well as a commodity exchange.

As we know, the futures contract was brought in because there were some shortcomings in the forward contract and they needed to be rectified. Let us now see what are the things in a futures contract that is different from a forward contract.

You may not understand some of these things yet. But later when we give you examples it will be easy for you to understand. For now, once you see the difference between them.

Futures contracts move up and down with the underlying asset In our example with the ABC jeweler, there was a forward contract between ABC and XYZ on an asset, i.e., gold and its price. Instead of gold as an asset in a futures contract, gold can only be a “future of gold” and gold will be its underlying. Now whenever the price of gold is up or down, the price of the asset i.e. “Gold Future” will also be up or down.

A similar contract We saw that in the example with the ABC jeweler, the agreement between ABC and XYZ was 15 kg of gold. But this agreement could have been of 14.5 kg or 15.5 kg or 15.2 kg also i.e. this agreement could be changed according to the convenience of both the parties. But this does not happen in futures contracts, this agreement is the same for everyone and they are available in the market.

Futures contracts can be sold and bought in the market – Futures contracts can be sold and bought by anyone. Even if I have entered into a futures contract with someone else, here I can exit that contract at any time, if there is someone in the market to buy my contract. Whereas in a forward contract, I would be required to fulfill my contract even if my opinion about my asset or its value has changed.

The futures market is governed by regulations – the futures market and the financial derivatives market are regulated by a regulatory authority or regulatory authority. In India this work is done by SEBI (Security and Exchange Board of India). Since it is controlled, there is less scope for manipulation in this market.

Futures contract has a fixed time frame – All types of futures contracts are determined by some or the other time frame. If we look at the example of ABC Jeweler and XYZ, there this contract was for 3 months but if the same contract is done in a futures market, then there are contracts available for different durations like 1 month 2 months 3 months. When the contract expires, it is called expiry.

Cash Settlement – ​​A futures contract is settled in cash. This means that only the difference between the two prices has to be paid in cash. There is no transfer of any physical asset from one place to another and it is under the supervision of the regulatory authority governing the cash settlement market.

Let’s look at all these points as a table

Forward Contract	Futures contract
trading of contract is done under OTC  (over the counter)	it could be done under exchanges
contract has been made according to need	Futures contracts are always the same
Big risk associated with the front party	no risk from front party
market not controlled	SEBI controlled
Contracts cannot be transferred to anyone else	Contracts can be transferred to anyone, sell buy possible
only a specified time period	Different time period contracts possible
Cash and physical settlement possible	cash settlement only

Here you should know another very important thing, that is the difference between spot price and futures price. The price at which any asset is sold in the general market is called the spot price. For example, when we consider gold as an underlying asset, we are talking about two prices of gold – one price at which gold is being sold in the general market, which is called the spot price and the other price at which gold futures is sold. The market is selling what we will call the futures price. Usually spot price and futures price move together, one is up or down and the other is also up or down.

Now let’s understand some more important things about futures contracts.

Some more important things

Before delving deeper into futures contracts, there are a few more things you need to know. Although we will know these things in more detail later, here let us understand them broadly.

Lot Size – As we have mentioned earlier that futures contracts are the same for everyone, so certain things are certain in them. One such thing is lot size. The lot size tells us the minimum amount you are negotiating in each trade. The lot size is different for each asset but the same in one asset.

Contract Value or Contract Price – In the example ABC and XYZ, ABC had contracted to buy 15 kg of gold at Rs 2450 per gram i.e. Rs 24,50,000 per kg. At this price, 15 kg of gold was priced at Rs 3.675 crore, so here the contract value was Rs 3.675 crore, meaning quantity (15 kg) and the multiple of price (24,50,000) (quantity × price). Since futures contracts are the same ie there are fixed quantities, the contract value of a futures agreement will be lot size × price

Margin – In the example of ABC and XYZ, there was an agreement between them on 9th December 2014 which was to expire on 9th March 2015. Both the parties made promises to each other for the deal but other than that no other transaction took place.

But this is not the case in futures contracts. In a futures agreement, as soon as you make a deal, both parties deposit some money. You can think of it as something like a token or an advance. This money is deposited with the broker and is a fixed percentage of the deal price. This amount is called the margin amount or margin. This is a very important feature of a future deal.

Expiry – As we know that futures deals are for a fixed period of time. The day on which this agreement expires is called expiry. Remember that the day this deal expires, the new deal starts getting on the exchange the same day.

In the next chapter, we will look at examples of futures trading.

Highlights of this chapter

• If you have a definite opinion about the price of an asset, then you can make profit in the forward or futures market.
• An improved form of a forward contract is a futures contract.
• Futures prices generally move up/down with the price of the underlying asset.
• Futures contracts can be bought and sold.
• The terms of every futures contract are the same so that the settlement can be done on pre-determined terms.
• A futures contract is for a fixed period of time and can be available for different time periods.
• Most futures contracts are settled in cash.
• SEBI regulates futures contracts in India.
• The minimum quantity of a futures contract is called lot size.
• Contract Value = Lot Size × Future Price
• To enter into any futures agreement, you have to deposit a certain percentage of the transaction price which is called margin.
• Every futures contract expires on a certain date and at the same time new futures contracts are available in the market.