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Futures contracts

Updated on May 29, 2013

Futures contracts are the same kinds of contracts as forwards. They both are contracts for a product to be bought and sold at a fixed price in the future. Future contracts, however are traded on exchanges and there are some rule on how to do so (still much less regulated than the stocks and bonds markets). Usually future contracts (simply referred to as futures) are traded at an exchange separated from the stock exchange of the country and are simply called “derivatives exchanges”. This is due to the fact that derivatives are very much different from stocks (although there are derivatives of stocks also, which are also traded at derivatives). Often mercantile exchanges (where simple buy-sell contracts are made for physical products, such as agricultural and mined products) and derivative exchanges are merged, one market. Today financial futures are becoming more and more the primary products traded at these exchanges. The underlying products of financial futures are stock indexes (what the value of eg.: DJIA will be in say a year from today), foreign exchange rates (what (EURO/ US DOLLAR) will be a year from today), and especially interest rates (what T-bill interest rates will be a year from today). Most popular futures contracts are the T-bill (or its equivalent outside the U.S.), and the EUR/USD futures.

As the parties for futures contracts do not know each other, the derivative exchange (or rather the company that operates the exchange) bears responsibility for any party to a futures contract not meeting his/her obligations. To make trades easier, smoother, and the futures contracts more comparable there is a high level of standardization and a very sophisticated electronic trading and administration platform. In this sense, futures exchanges a lot like stock exchanges, although the financial products thereon are not. One such standardized characteristic is that collaterals are adjusted daily based on changes in market price for each futures (called “marking-to-market”). This is how marking-to market works: the investor must provide initial collateral upon signing the contract. This initial collateral is then modified based on the price of the contract. Thus the investor pays the price in installments during the validity of the contract, making it possible for the exchange to pay the difference between long and short positions, and to minimize the risk of non payment. Often futures contracts are made for products, whose who quality cannot be predicted with surety. Such products are sugar, coffee, or soybeans. In such cases the price serves as a reference only, which ensures, that the quality of the product falls within a range set in the futures contract.

Source

Financial Markets vol. I. Functioning of Financial Markets

Beata Majer, Julia Kiraly

International Banker Training Center LLC.

Budapest, Hungary

2000

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    • hafeezrm profile image

      hafeezrm 7 years ago from Pakistan

      Very useful information. Thanks for sharing.

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