10.6.1 Key Terms And Definitions

Key Terms and Definitions

Futures contracts are exchange-traded agreements between two parties to buy or sell an underlying asset at a future date and at a predetermined price. They encompass features inherent to all forward contracts, offering a fixed price at which to trade an asset in the future.

Fundamental Positions in Futures

1. Long Position: The buyer of the futures contract, agreeing to buy the underlying asset in the future. They are said to have bought the futures contract.

2. Short Position: The seller of the futures contract, agreeing to sell the underlying asset in the future. They are said to have sold the futures contract.

Executing a Futures Contract

• The buyer does not make any payment to the seller upon entering the contract, nor does the seller deliver the asset immediately.
• Most participants offset their positions before expiration, preventing the actual delivery of the asset.
• If held until expiration without offset, the seller must deliver the underlying asset and the buyer must make payment.

Standardization in Futures

Futures are standardized regarding the quantity of the underlying asset, expiration dates, and delivery locations. Standardization allows for easier offsetting of contracts and provides the backing of a clearinghouse.

Cash-Settled Futures

Certain futures relate to underlying assets that are difficult or impossible to deliver upon contract expiration. Instead of physical delivery, cash payments are made based on the asset’s performance.

Example: Equity Index Futures

Equity index futures contracts typically involve cash settlement, where either party makes payment based on the difference between the agreed price and the actual price on the expiration date.

• If agreed price > actual price: Long pays short.
• If agreed price < actual price: Short pays long.

Margin Requirements and Marking to Market

Margin requirements serve as a financial assurance that the obligations of a futures contract are met.

Types of Margin

1. Initial Margin: The initial deposit required when the contract is entered.
2. Maintenance Margin: The minimum account balance that must be maintained while the contract is active.

Daily Settlement Process

The daily process of adjusting accounts based on the market’s movement is known as marking to market. This involves crediting or debiting the accounts of long and short positions respectively.

Marking to Market Example

• Initial Margin: $2,000
• Maintenance Margin: $1,500

Greg (buyer-long) and Leila (seller-short) both put up the initial margin of $2,000.

• Day 1: Futures gain $200: Greg is credited $200, Leila debited $200.

  • Greg’s account: $2,200
  • Leila’s account: $1,800

• Day 2: Futures drop $300: Greg debited $300, Leila credited $300.

  • Greg’s account: $1,900
  • Leila’s account: $2,100

• Day 3: Futures drop $500: Greg debited $500.

  • Greg’s account: $1,400 (below maintenance)
  • Margin Call: Greg deposits $600 to restore initial margin of $2,000.

    graph TD
	  A[Contract Initiation] -->|Initial Margin: $2,000| B[Day 1 Gain $200]
	  B -->|-'Credit Greg $200: $2,200'| C[Greg Account]
	  B -->|-'Debit Leila $200: $1,800'| D[Leila Account]
	  C -->|Day 2 Loss $300| E[Day 3 Loss $500]
	  D -->|Day 2 Loss $300| E
	  E -->|Greg's Maintenance Margin Violate| F[Margin Call]
	  F -->|Greg Replenishes $600 Balance to $2,000| G[Positions Offset / Close]

Glossary

• Long Position: The stance taken by the buyer of a futures contract to buy the underlying asset at a future date.
• Short Position: The sell-side of a futures contract, taking the stance to sell the underlying asset at a predetermined date.
• Marking to Market: The daily settlement mechanism that involves updating the accounts of the involved parties based on the movements in futures pricing.
• Initial Margin: An upfront deposit or performance bond required when entering a futures contract.
• Maintenance Margin: The minimum balance an account must maintain while a futures contract is active.
• Cash-Settled Futures: Futures wherein settlement of gains and losses is done via cash instead of physical delivery.

Key Takeaways

1. Futures contracts are standardized, exchange-traded agreements for buying or selling an asset at a future date and predetermined price.
2. Futures contracts involve a long position (buyer) and a short position (seller).
3. Standardization ensures ease of transactions and backing by the clearinghouse.
4. Cash-settled futures relate to non-physical delivery of assets, instead affecting cash payments based on performance.
5. Margin requirements include initial and maintenance margins providing a safety cushion ensuring contractual obligations are met, while the marking to market process adjusts account values daily.

Frequently Asked Questions (FAQs)

What is the main difference between futures and forwards?

Futures are standardized and traded on exchanges with a clearinghouse backing, while forwards are customizable, over-the-counter agreements without any central counterparty.

What role does the clearinghouse play in futures trading?

The clearinghouse acts as a central counterparty to both sides of a futures contract, ensuring the integrity and enforcement of the contract through the margin system and daily settlement process.

How does marking to market work?

Marking to market adjusts both parties’ accounts daily, reflecting gains or losses based on the day’s market movements to ensure margin compliance.

Can futures contracts be closed before expiration?

Yes, positions in futures contracts can be offset or closed before the expiration date by entering an opposite position in the same contract.