Futures contract
In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.
Futures contracts are traded at futures exchanges, which act as a marketplace between buyers and sellers. The buyer of a contractual right is said to be the long position holder and the selling party is said to be the short position holder. As both parties risk their counter-party reneging if the price goes against them, the contract may involve both parties lodging a [|margin] of the value of the contract with a mutually trusted third party for security. For example, in gold futures trading, the margin varies between 2% and 20% depending on the volatility of the spot market.
A stock future is a cash-settled futures contract on the value of a particular stock market index. Stock futures are one of the high risk trading instruments in the market. Stock market index futures are also used as indicators to determine market sentiment.
The first futures contracts were negotiated for agricultural commodities, and later futures contracts were negotiated for natural resources such as oil. Financial futures were introduced in 1972, and in recent decades, currency futures, interest rate futures, stock market index futures, and perpetual futures have played an increasingly large role in the overall futures markets. Retail traders increasingly use futures contracts alongside options strategies to hedge positions, manage leverage, and scale entries in volatile markets. Even organ futures have been proposed to increase the supply of transplant organs.
The original use of futures contracts mitigates the risk of price or exchange rate movements by allowing parties to fix prices or rates in advance for future transactions. This could be advantageous when a party expects to receive payment in foreign currency in the future and wishes to guard against an unfavorable movement of the currency in the interval before payment is received.
However, futures contracts also offer opportunities for speculation in that a trader who predicts that the price of an asset will move in a particular direction can contract to buy or sell it in the future at a price which will yield a profit. In particular, if the speculator is able to profit, then the underlying commodity that the speculator traded would have been saved during a time of surplus and sold during a time of need, offering the consumers of the commodity a more favorable distribution of the commodity over time.
Origin
The Dōjima Rice Exchange, first established in 1697 in Osaka, is considered by some to be the first futures exchange market, to meet the needs of samurai who—being paid in rice—needed a stable conversion to coin after a series of bad harvests.The Chicago Board of Trade listed the first-ever standardized 'exchange traded' forward contracts in 1864, which were called futures contracts. This contract was based on grain trading, and started a trend that saw contracts created on a number of different standardized futures contracts based on commodities, as well as a number of futures exchanges set up in countries around the world. By 1875 cotton futures were being traded in Bombay in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion. In the 1930s two thirds of all futures was in wheat.
The 1972 creation of the International Monetary Market by the Chicago Mercantile Exchange was the world's first financial futures exchange, and launched currency futures. In 1976, the IMM added interest rate futures on US treasury bills, and in 1982 they added stock market index futures.
Risk mitigation
Although futures contracts are oriented towards a future time point, their main purpose is to mitigate the risk of default by either party in the intervening period. In this vein, the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin. Margins, sometimes set as a percentage of the value of the futures contract, must be maintained throughout the life of the contract to guarantee the agreement, as over this time the price of the contract can vary as a function of supply and demand, causing one side of the exchange to lose money at the expense of the other.To mitigate the risk of default, the product is marked to market on a daily basis where the difference between the initial agreed-upon price and the actual daily futures price is re-evaluated daily. This is sometimes known as the variation margin, where the futures exchange will draw money out of the losing party's margin account and put it into that of the other party, ensuring the correct loss or profit is reflected daily. If the margin account goes below a certain value set by the exchange, then a margin call is made and the account owner must replenish the margin account.
On the delivery date, the amount exchanged is not the specified price on the contract but the spot value, since any gain or loss has already been previously settled by marking to market.
Margin
To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty.Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.
Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin.
Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin, however, the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. The initial margin is set by the exchange.
If a position involves an exchange-traded product, the amount or percentage of the initial margin is set by the exchange concerned.
In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as "variation margin", margin called, for this reason, is usually done on a daily basis, however, in times of high volatility, a broker can make a margin call intra-day.
Margin calls are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed out the client is liable for any resulting deficit in the client's account.
Some U.S. exchanges also use the term "maintenance margin", which in effect defines how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term "initial margin" and "variation margin".
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities' Initial Margin.
A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in their margin account.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls.
Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure the performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.
Return on margin is often used to judge performance because it represents the gain or loss compared to the exchange's perceived risk as reflected in the required margin. ROM may be calculated /. The Annualized ROM is equal to -1. For example, if a trader earns 10% on margin in two months, that would be about 77% annualized.