Page 132 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 6: Trading Strategies

6.6.3 Important Features of Futures Contract Notes
The important features of futures contract are given below:
 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.

 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.
 Time Spreads: There is a relationship between the spot price and the futures price of
contract. The relationship also exists between prices of futures contracts, which are on the
same commodity or instrument but which have different expiry dates. The difference
between the prices of two contracts is known as the ‘time spread’, which is the basis of
futures market.
 Margins: Since the clearing house undertakes the default risk, to protect itself from this
risk, the clearing house requires the participants to keep margin money, normally ranging
from 5% to 10% of the face value of the contract.

6.6.4 Uses of Forward and Futures Contracting
The uses of forward and futures contracting are as follows:
1. Hedging: The classic hedging application would be that of a wheat farmer forward/ futures
selling his harvest at a known price in order to eliminate price risk. Conversely, a bread
factory may want to buy wheat forward/futures in order to assist production planning
without the risk of price fluctuations.
2. Price discovery: Price discovery is the use of forward/futures prices to predict spot price
that will prevail in the future. These predictions are useful for production decisions
involving the various commodities.

3. Speculation: If a speculator has information or analysis which forecasts an upturn in a
price, then he can go long on the forward/futures market instead of the cash market, wait
for the price rise, and then take a reversing transaction. The use of forward/futures market
here gives leverage to the speculator.

6.6.5 Forward Contract vs. Future Contract

Forward contracts are private bilateral contracts and have well-established commercial usage.
Future contracts are standardised tradable contracts fixed in terms of size, contract date and all
other features. The differences between forward and futures contracts are given below:

Table 6.1: Differences between Forward and Future Contracts

Forward contracts Future contracts
1. The contract price is not publicly disclosed 1. The contract price is transparent.
and hence not transparent.

2. The contract is exposed to default risk by
2. The contract has effective safeguards
counterparty.
against defaults in the form of clearing
corporation guarantees for trades and
daily mark to market adjustments to the

accounts of trading members based on
daily price change.
3. Each contract is unique in terms of size, 3. The contracts are standardised in terms
Contd...
expiration date and asset type/quality. of size, expiration date and all other
4. The contract is exposed to the problem of features.
liquidity. LOVELY PROFESSIONAL UNIVERSITY 127
There is no liquidity problem in the
4.
5. Settlement of the contract is done by delivery contract.
of the asset on the expiration date. 5. Settlement of the contract is done on cash
basis.