Page 227 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Problems in Forward Contracting

The forward contracts are affected by the problems like: (a) Lack of centralisation of trading, (b)
Illiquidity, and (c) Counter party risk.

8.5.2 Futures Contract

The futures contract is traded on a futures exchange as a standardised contract, subject to the
rules and regulations of the exchange. It is the standardisation of the futures contract that facilitates
the secondary market trading. The futures contract relates to a given quantity of the underlying
asset and only whole contracts can be traded, and trading of fractional contracts are not allowed
in futures contracting.
The terms of the futures contracts are not negotiable. A futures contract is a financial security,
issued by an organised exchange to buy or sell a commodity, security or currency at a
predetermined future date at a price agreed upon today. The agreed upon price is called the
‘futures price’.

Types of Futures Contract

Futures contracts may be classified into two categories:
1. Commodity Futures: Where the underlying is a commodity or physical asset such as
wheat, cotton, butter, eggs etc. Such contracts began trading on Chicago Board of Trade
(CBOT) in 1860s. In India too, futures on soya bean, black pepper and spices have been
trading for long.
2. Financial Futures: Where the underlying is a financial asset such as foreign exchange,
interest rates, shares, Treasury bills or stock index.
Standardised Items in Futures

The standardised items in any futures contract are:
1. Quantity of the underlying
2. Quality of the underlying (not required in financial futures)
3. The date and month of delivery
4. The units of price quotation (not the price itself) and minimum change in price (tick-size)

5. Location of settlement

Important Features of Futures Contract

The important features of futures contract are given below:
1. Standardisation: The important feature of futures contract is the standardisation of contract.
Each futures contract is for a standard specified quantity, grade, coupon rate, maturity, etc.
The standardisation of contracts fetches the potential buyers and sellers and increases the
marketability and liquidity of the contracts.
2. Clearing house: An organisation called ‘futures exchange’ will act as a clearinghouse. In
futures contract, the obligation of the buyer and the seller is not to each other but to the
clearing house in fulfilling the contract, which ensure the elimination of the default risk
on any transaction.

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