Page 56 - DCOM510_FINANCIAL_DERIVATIVES

Unit 4: Introduction to Future Contracts

Profits and losses of futures contracts are settled everyday at the end of trading, a practice called Notes
‘marking the market’. Daily settlements reduce the default risk of futures contracts relative to
forward contracts. On a daily basis, futures investors must pay over any losses or receive any
gains from the day’s price movements. An insolvent investor with an unprofitable position
would be forced into default after only one day’s trading, rather than being allowed to build up
huge losses that lead to one large default at the time the contract matures (as could occur with a
forward contract). Futures contracts can also be closed out easily with an ‘offsetting trade’.

Example: If a company’s long position in $ futures has proved to be profitable, it need
not literally take delivery of the $ at the time the contract matures. Rather, the company can sell
futures contracts on a like amount of $ just prior to the maturity of the long position. The two
positions cancel on the books of the futures exchange and the company receives its profit in cash.
These and other differences between forwards and futures are summarised below in Table 4.1:

Table 4.1: Distinction between Forwards and Futures

Criteria / Factors Forwards Futures
1. Trading Traded by telephone or telex (OTC) Traded in a competitive
arena (recognised
exchange)
2. Size of contracts Decided between buyer and seller Standardised in each
futures market
3. Price of contract Remains fixed till maturity Changes everyday
4. Mark to Market Not done Marketed to market
everyday
5. Margin No margin required Margins are to be paid
by both buyer and
sellers
6. Counter Party Present Not present
Risk
7. Number of There can be any number of Number of contracts in
contracts in a contracts a year is fixed.
year
8. Frequency of 90% of all forward contracts are Very few future
Delivery settled by actual delivery. contracts are settled by
actual delivery
9. Hedging These are tailor-made for specific Hedging is by nearest
date and quantity. So, it is perfect month and quantity
contracts. So, it is not
perfect.
10. Liquidity Not liquidity Highly liquid
11. Nature of Over the Counter Exchange traded
Market
12. Mode of Specifically decided. Most of the Standardised. Most of
Delivery contracts result in delivery the contracts are cash-
settled.
13. Transactional Costs are based on bid-ask spread Include brokerage fees
Costs for buy and sell others

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