Page 54 - DCOM510_FINANCIAL_DERIVATIVES

Unit 4: Introduction to Future Contracts

Today, there are financial futures on debt instruments called interest rate futures, foreign exchange Notes
rate called currency futures and stock market averages called stock index futures. Financial
futures are different from commodity futures in several ways. The most important difference is
that many financial futures are not deliverable. The fact that very few contracts are actually
delivered led many exchanges to consider eliminating the delivery feature all together. Till date
this has not happened in commodity futures, but many financial futures are created as non-
deliverable instruments. Stock index futures and interest rate futures are such futures. In place of
delivery these contracts are cash settled on specific final delivery dates.

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Caution The profit or loss from a futures contract that is settled at delivery is the difference
between the value of the index at delivery and the value when originally purchased or sold. It
is important to emphasise that the delivery at settlement cannot be in the underlying stocks
but must be in cash. The futures index at expiration is set equal to the cash index on that day.

Self Assessment

Fill in the blanks:
1. If you buy a …………...... contract, you are basically agreeing to buy something that a
seller has not yet produced for a set price.

2. The future date is called the …………...... date or final settlement date.
3. Futures contracts, unlike forwards, are traded on …………......
4. …………...... paid are generally marked to market-price everyday.
5. Contract seller is called …………...... and purchaser …………......

4.2 Distinction between Futures and Forwards Contracts

The basic form of the futures contract mirrors that of the forward contract: both parties are
obligated under the terms of the contract either to deliver a specified asset or pay the specified
price of the asset on the contract maturity date. Added to this, the futures contract entails the
following two obligations, both of which help to minimise the default (or credit) risk inherent
in forward contracts.

Did u know?
1. The value of the futures contract is ‘settled’ (i.e., paid or received) at the end of each
trading day. In the language of the futures markets, the futures contract is ‘cash
settled’, or ‘mark/marked-to-market’ daily. The marked-to-market provision
effectively reduces the performance period of the contract to a day, thereby
minimising the risk of default.
2. Both buyers and sellers are required to post a performance bond called ‘margin’. At
the end of each trading day, gains and losses are added to and taken away from the
margin account, respectively. The margin account must remain above an agreed
upon minimum or the account will be closed. The margin provision prevents the
depletion of accounts, which, in turn, largely eliminates the risk of default.

The following are the distinguishing features between forwards and futures:
1. Delivery of the underlying is the hallmark of a forward contract. To the contrary the vast
majority of futures contracts even though they provide for delivery are satisfied by entering

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