Page 52 - DCOM510_FINANCIAL_DERIVATIVES

Unit 4: Introduction to Future Contracts

futures contracts to hedge risk or speculate rather than to exchange physical goods (which is the Notes
primary activity of the cash/spot market). That is why futures are used as financial instruments
by not only producers and consumers but also by speculators.

4.1 Futures Contracts

A future contract is a standardised agreement between the seller (short position) of the contract
and the buyer (long position), traded on a futures exchange, to buy or sell a certain underlying
instrument at a certain date in future, at a pre-set price. The future date is called the delivery date
or final settlement date. The pre-set price is called the futures price.

Notes The price of the underlying asset on the delivery date is called the settlement price.
Thus, futures is a standard contract in which the seller is obligated to deliver a specified asset
(security, commodity or foreign exchange) to the buyer on a specified date in future and the
buyer is obligated to pay the seller the then prevailing futures price upon delivery. Pricing can
be based on an open outcry system, or bids and offers can be matched electronically. The futures
contract will state the price that will be paid and the date of delivery.

Did u know? Pricing can be based on an open outcry system, or bids and offers can be
matched electronically. The futures contract will state the price that will be paid and the
date of delivery.
Financial futures are not different from commodity futures except of the underlying asset, for
example, in commodity futures, a particular commodity like food grains, metals, vegetables,
etc. are traded whereas in financial futures, various particular financial instruments like equity
shares, debentures, bond, treasury securities, currencies, etc. trades. There are now a large variety
of financial futures contracts available at the various markets (centres) like Chicago, London,
and Tokyo and so on.

Did u know? The first derivative product to be introduced in the Indian securities market
is going to be “INDEX FUTURES”. In the world, first index futures were traded in U.S. on
Kansas City Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI) in 1982.
4.1.1 Nature of Futures Contracts

A futures contract gives the holder the right and the obligation to buy or sell. Contrast this with
an options contract, which gives the buyer the right, but not the obligation, and the writer
(seller) the obligation, but not the right. In other words, an option buyer can choose not to
exercise when it would be uneconomical for him/her. The holder of a futures contract and the
writer of an option, do not have a choice. To exit the commitment, the holder of a future position
has to sell his long position or buy back his short position, effectively closing the position.
Futures contracts or simply futures are exchange-traded derivatives. The exchange acts as
counterparty on all contracts, sets margin requirements, etc.
Futures contracts, unlike forwards, are traded on organised exchanges. They are traded in three
primary areas:
Agricultural Commodities

LOVELY PROFESSIONAL UNIVERSITY 47