rules, regulations, and a central clearing facility, the futures markets offer an element of liquidity and protection against loss by default.
Formally, a futures contract is defined as follows:
A futures contract is a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
First, let us review what standardization means. Recall that in forward contracts, the parties customize the contract by specifying the underlying asset, the time to expiration, the delivery and settlement conditions, and the quantity of the underlying, all according to whatever terms they agree on. These contracts are not traded on an exchange. As noted, the regulation of OTC derivatives markets is increasing, but these contracts are not subject to the traditionally high degree of regulation that applies to securities and futures markets. Futures contracts first require the existence of a futures exchange, a legally recognized entity that provides a market for trading these contracts. Futures exchanges are highly regulated at the national level in all countries. These exchanges specify that only certain contracts are authorized for trading. These contracts have specific underlying assets, times to expiration, delivery and settlement conditions, and quantities. The exchange offers a facility in the form of a physical location and/or an electronic system as well as liquidity provided by authorized market makers.
Probably the most important distinctive characteristic of futures contracts is the daily settlement of gains and losses and the associated credit guarantee provided by the exchange through its clearinghouse. When a party buys a futures contract, it commits to purchase the underlying asset at a later date and at a price agreed upon when the contract is initiated. The counterparty (the seller) makes the opposite commitment, an agreement to sell the underlying asset at a later date and at a price agreed upon when the contract is initiated. The agreed-upon price is called the futures price. Identical contracts trade on an ongoing basis at different prices, reflecting the passage of time and the arrival of new information to the market. Thus, as the futures price changes, the parties make and lose money. Rising (falling) prices, of course, benefit (hurt) the long and hurt (benefit) the short. At the end of each day, the clearinghouse engages in a practice called mark to market, also known as the daily settlement. The clearinghouse determines an average of the final futures trades of the day and designates that price as the settlement price. All contracts are then said to be marked to the settlement price. For example, if the long purchases the contract during the day at a futures price of £120 and the settlement price at the end of the day is £122, the long’s account would be marked for a gain of £2. In other words, the long has made a profit of £2 and that amount is credited to his account, with the money coming from the account of the short, who has lost £2. Naturally, if the futures price decreases, the long loses money and is charged with that loss, and the money is transferred to the account of the short.7
The account is specifically referred to as a margin account. Of course, in equity markets, margin accounts are commonly used, but there are significant differences between futures margin accounts and equity margin accounts. Equity margin accounts involve the extension of credit. An investor deposits part of the cost of the stock and borrows the remainder at a rate of interest. With futures margin accounts, both parties deposit a required minimum sum of money, but the remainder of the price is not borrowed. This required margin is typically less than 10 % of the futures price, which is considerably less than in equity margin trading. In the example above, let us assume that the required margin is £10, which is referred to as the initial margin. Both the long and the short put that amount into their respective margin accounts. This money is deposited there to support the trade, not as a form of equity, with the remaining amount borrowed. There is no formal loan created as in equity markets. A futures margin is more of a performance bond or good faith deposit, terms that were previously mentioned. It is simply an amount of money put into an account that covers possible future losses.
Associated with each initial margin is another figure called the maintenance margin. The maintenance margin is the amount of money that each participant must maintain in the account after the trade is initiated, and it is always significantly lower than the initial margin. Let us assume that the maintenance margin in this example is £6. If the buyer’s account is marked to market with a credit of £2, his margin balance moves to £12, while the seller’s account is charged £2 and his balance moves to £8. The clearinghouse then compares each participant’s balance with the maintenance margin. At this point, both participants more than meet the maintenance margin.
Let us say, however, that the price continues to move in the long’s favor and, therefore, against the short. A few days later, assume that the short’s balance falls to £4, which is below the maintenance margin requirement of £6. The short will then get a margin call, which is a request to deposit additional funds. The amount that the short has to deposit, however, is not the £2 that would bring his balance up to the maintenance margin. Instead, the short must deposit enough funds to bring the balance up to the initial margin. So, the short must come up with £6. The purpose of this rule is to get the party’s position significantly above the minimum level and provide some breathing room. If the balance were brought up only to the maintenance level, there would likely be another margin call soon. A party can choose not to deposit additional funds, in which case the party would be required to close out the contract as soon as possible and would be responsible for any additional losses until the position is closed.
As with forward contracts, neither party pays any money to the other when the contract is initiated. Value accrues as the futures price changes, but at the end of each day, the mark-to-market process settles the gains and losses, effectively resetting the value for each party to zero.
The clearinghouse moves money between the participants, crediting gains to the winners and charging losses to the losers. By doing this on a daily basis, the gains and losses are typically quite small, and the margin balances help ensure that the clearinghouse will collect from the party losing money. As an extra precaution, in fast-moving markets, the clearinghouse can make margin calls during the day, not just at the end of the day. Yet there still remains the possibility that a party could default. A large loss could occur quickly and consume the entire margin balance, with additional money owed.8 If the losing party cannot pay, the clearinghouse provides a guarantee that it will make up the loss, which it does by maintaining an insurance fund. If that fund were depleted, the clearinghouse could levy a tax on the other market participants, though that has never happened.
Some futures contracts contain a provision limiting price changes. These rules, called price limits, establish a band relative to the previous day’s settlement price, within which all trades must occur. If market participants wish to trade at a price above the upper band, trading stops, which is called limit up, until two parties agree on a trade at a price lower than the upper limit. Likewise, if market participants wish to trade at a price below the lower band, which is called limit down, no trade can take place until two parties agree to trade at a price above the lower limit. When the market hits these limits and trading stops, it is called locked limit. Typically, the exchange rules provide for an expansion of the limits the next day. These price limits, which may be somewhat objectionable to proponents of free markets, are important in helping the clearinghouse manage its credit exposure. Just because two parties wish to trade a futures contract at a price beyond the limits does not mean they should be allowed to do so. The clearinghouse is a third participant in the contract, guaranteeing to each party that it ensures against the other party defaulting. Therefore, the clearinghouse has a vested interest in the price and considerable exposure. Sharply moving prices make it more difficult for the clearinghouse to collect from the parties losing money.
Most participants in futures markets buy and sell contracts, collecting their profits and incurring their losses, with no ultimate intent to make or take delivery