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A futures contract is a form of forward contract, a contract to buy or sell an asset of any kind at a pre-agreed future point in time, that has been standardised for a wide range of uses. It is traded on a futures exchange. Futures may also differ from forwards in terms of margin and delivery requirements. The standardisation usually involves specifying:
- The amount and units of the underlying asset to be traded. This can be a fixed number of: barrels of oil; lengths of random lumber; units of weight (bushels of wheat, ounces of bullion); units of foreign currency ; interest rate points; Equity index points; National bonds
- the unit of currency in which the asset is quoted. Because U.S. futures exchanges have dominated the market, this is very often the US dollar (USD), even when the corresponding OTC market quotes differently (for example the Interbank market quotes in Yen per USD, whereas currency futures are quoted in USD per Yen).
- The grade of the deliverable. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API specific gravity, as well as the location where delivery must be made.
- The delivery month.
- The last trading date .
- Other details such as tick size , the minimum permissible price fluctuation.
Because they vary in price as a direct function of these variables only, a futures contract is an example of a parametric contract , and is easily combined or traded as part of more complex financial derivatives deals.
1 Margin
Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange. To minimise this risk, the exchange demands that contract owners post a form of collateralCollateral could mean: Collateral in finance means a security or guarantee (usually an asset) pledged for the repayment of a loan if one cannot procure enough funds to repay. Collateral is also the name of a 2004 action/thriller film., known as margin. The amount of margin changes each day, involving movements of cash handled by the exchange's clearing houseA clearing house is an organization affiliated with a securities or derivatives exchange that completes the transactions on that exchange by seeing to validation, delivery, and settlement. A clearing house (var. clearinghouse") may also offer novation, th.
Margin requirements are waived or reduced in some cases for hedgersHedging is a strategy, usually some form of transaction, designed to minimise exposure to an unwanted business risk. Some form of risk taking is inherent to any business activity (if there were no risk, it is likely there would be no reward). Some forms o who have physical ownership of the covered commodity or offsetting contracts for its purchase or sale.
Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading.
Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation margin , is called by the exchange. This is calculated by the futures contract, i.e. agreeing a price at the end of each day, called the "settlement" or mark-to-market price of the contract.
Margin-equity ratio is a term used by speculators, repesenting the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract itself, then they would not profit from the inherent leverageLeverage is related to torque; leverage is a factor by which lever multiplies a force. The useful work done is the energy applied, which is force times distance. Therefore a small force applied over a long distance is the same amount of work as a large fo implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.
