Future Contracts....
DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS
Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity.
FUTURES TERMINOLOGY
· Spot price: The price at which an asset trades in the spot market.
· Futures price: The price at which the futures contract trades in the futures market.
· Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one- month, two-months and three months expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three- month expiry is introduced for trading.
· Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist.
· Contract size: The amount of asset that has to be delivered under one contract. Also called as lot size.
Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices.
· Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset.
· Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin.
· Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor's gain or loss depending upon the futures closing price. This is called marking-to-market.
· Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.
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