28 January 2010
What is a futures contract? A future is an exchange-traded contract between a buyer and seller and the clearinghouse of a futures exchange to buy or sell a standard quantity and quality of a commodity at a specified future date and price. The clearinghouse acts as a counterparty in all transactions and is responsible for holding traders’ surety bonds to guarantee that transactions are completed.
Like forward contracts, futures contracts are used to lock in the interest rate, exchange rate or commodity price. But, futures contracts are organized in such a way that the counterparty risk of default is always completely eliminated because the clearinghouse steps in between a buyer and a seller, each time a deal is struck in the pit. The clearinghouse adopts the position of the buyer to every seller, and of the seller to every buyer, i.e. the clearinghouse keeps a zero net position. This means that every trader in the futures markets has obligations only to the clearinghouse, and has strong expectations that the clearinghouse will maintain its side of the bargain as well. The credibility of the system is maintained through the requirements of margin and daily settlements. The margin is a deposit in the form of cash, goverment securities, stock in the clearing corporation or letters of credit issued by an approved bank. The main purpose of the margin is to provide a safeguard to ensure that traders will honor their obligations. It is usually set to the maximum loss a trader can experience in a normal trading day. Daily settlements, called making to market, involve debiting the cash accounts of those whose positions lost money for the day and crediting the cash accounts of those whose positions earned money.
However, the elimination of default risk has a cost. Futures contracts are standardized with respect to quantities and delivery dates and limited to frequently traded financial assets. Therefore, available futures contracts may not correspond perfectly to the risk to be hedged, thereby leaving hedgers with basis risk and correlation risk, which cannot be fully eliminated
What are standard options? Options are more flexible than forwards and futures because they protect the buyer against unfavorable outcomes, but allow him to enjoy the benefits associated with favorable outcomes. This price to be paid for this win–win position is called the option premium. A standard or a vanilla option is a security that gives its holder the right to buy or sell the underlying asset within a specified period of time, at a given price, called the strike price, striking price or exercise price. The right to buy is a call and the right to sell is a put. A European style option can be exercised only on the last day of the contract, called the maturity date or the expiration date. An American style option can be exercised at any time during the contract’s life.
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