Futures
We have seen that in forward contracts there are some problems such as counter party nsk, illiquidity, lack of centralisation of trading etc. The futures contract has been developed to remove the disadvantages of a forward contract. A futures contract is very similar to a forward contract in all respects except the fact that it is completely a standardised one. Hence, It is rightly said that a futures contract is nothing but a standardised forward contract.
Meaning of Futures
Futures contract is standardised and exchange-traded Futures contract is an agreement between buyer and seller to buy or sell a an asset at a certain time in future at a certain price. These are traded on recognised exchanges like NCDEX (National Commodity and Derivative Exchanges Limited), MCX (Multi Commodity Exchange of India Limited, Mumbai), NSE, BSE etc. Asset is delivered at a future date at the price fixed today. The future date is called the delivery date or final settlement date. The agreed price is called the ‘futures price’.
Thus, futures contract provides both a right and an obligation to buy or sell a standard
asset or security or currency on a specified future date at a price agreed when the contract is entered into. Futures contracts are commonly known as futures.
Futures are standardised with regard to the contract size and also the maturity period of the contract. Futures contracts require deposits of margins. Hence, default risk is avoided. Although the price of the futures is negotiable between the parties, it isregulated by the futures exchange.
There are separate futures exchanges. Each exchange has a clearing house. The clearing house arranges for delivery of asset and payment of money. Clearing house becomes the counter-party to the original parties. The original parties are the buyer and the seller. Clearing house becomes a counter-party to the buyer in delivering the asset. It becomes a counter party to the seller in making payment. Thus, clearing house is called a central counter-party.
A wide variety of commodities and financial assets from the underlying assets in futures contracts. Wheat, sugar, wool, gold, aluminium, copper, etc. are some of the commodities underlying futures contracts. Stocks, stock indices, foreign currencies, bond, etc. are the financial assets underlying futures contracts.
Example of a Futures Contract
Today, September 1, the jeweler is setting the price of jewelry to be sold in December through the catalog he is printing. His major input expense is the cost of gold, which changes from day to day in the market. Today, the jeweler sees the following prices:
Spot gold, 3,500 per gram
Gold futures for December delivery, 3,600 per gram.
For simplicity, let’s take two cases-the futures price in December is 3,800 per gram, i.e., higher than it was in September ( 3,600), or the futures price in December is * 3,250, lower than it was in September. In either case, the jeweler’s effective cost of gold is 3,600 per gram, i.e., the futures price he “locked in” during September.
To see how this works, assume on December 1 the price of gold is 3,800 a gram. In such a case, the jeweler has gained 200 per gram on the futures contract that he can use to decrease the effective cost of the spot gold he is purchasing-from 3,800 to 3,600. On the other hand, if the futures price of gold on December 1 were 3,250, the jeweler could buy spot gold for * 3,250, but he would have had a loss of 350 per gram in the futures market, resulting again in an effective cost of 3,600 for a gram of spot gold in December.
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