Q. What do you meant by the term Future ? Explain in detail various types of Futures. Also provide the mechanism of future.
Ans. Meaning of Futures: The most common type of derivatives is future contracts. In future, two parties make an agreement for rate of an asset at an agreed price on a future date. Seller in future contacts known as ‘Writer’ or ‘Shorts’ and buyer is known as ‘Longs’. These contracts are standardised contracts which contain quantity, quality (for commodities), delivery time and place for settlement. Future contracts have a maximum of 3 months trading cycle. Future contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. Future contracts are available in 162 securities as stipulated by SEBI. The value of the future contracts on individual securities may not be less than ₹2 lakh at the time of introduction for the first time at any exchange in india.
Types of Futures: Futures may be divided in two types:
(1) Commodity Futures: It is an agreement between buyer and seller to purchase and sell a particular commodity at a price at a given time. The price is specified on the date of agreement.
(2) Financial Futures: It is an agreement between buyer and seller to purchase and sell a particular security at a given price and at a given time. The price is fixed in advance on the date of agreement. The financial futures can be sub-divided in the following three types:
(i) Stock Index Futures: It is a contract which is based on the value of a stock index for the future payment of a sum of money. Stock index futures are used for headging, trading and investments.
(ii) Interest Rate Futures: In the interest rate futures, interest bearing securities are the underlying assets. It is an agreement which is based on the basis of interest rate of fixed interest securities. These are used to hedge against the risk of moving interest rate in the adverse direction.
(iii) Currency Futures: It is also known as foreign exchange future. This future is a contract to exchange one currency for another at a specified date in future at a price which is decided on the agreement date. These futures are used for hedging and speculation.
Mechanism / Mechanics of Trading: There are several basic facts that one must know to understand the futures market. This market can be easily understood if we know how the market works. The working or mechanics of Futures Trading is explained as follows:
(1) Clearing House: Each futures market has its own clearing house. This clearing house works as intermediator between the buyer and seller. All members of the exchange are required to settle their trade through the clearing house whether they have purchased or sold the derivatives. The settlement is to be made at the end of each trading session. The member has to deposit the required margin with the exchange. The deposit of amount depends upon the debit balance of the member.
The clearing house works as other party for each buyer and seller. It means clearing house works as seller to the buyer and buyer to the seller. It is due to this reason that it is the duty of the clearing house to perform on its side of each contract. This mechanism greatly simplifies the future trading. It is almost impossible to settle the huge volumes of trade without the help of clearing house. The clearing house imposes margin requirements from members and marking to market to protect its interest.
(2) Margins: When a trade makes any position in future trade whether it is long or short, it is necessary to deposit an initial margin with the exchange. The aim of collecting margin money from the client or broker is to minimise the risk of settlement default by either buyer or seller. Margin money is like a security deposit and works as a cushion against a possible future loss of value. The payment of margin ensures that the risk is limited to the previous day’s price movement on each outstanding position. Once the transaction is settled, the margin money held by an exchange is released against the settlement liability.
There are different types of margins like Initial margin, Variation Margin, Exposure Margin and Additional Margin. The intial margin is to be deposited to cover the largest potential loss in one day. It is to be deposited by both the parties before making any position in the futures contract. This margin is calculated by SPAN keeping in view the worst scenario. Variation or Mark-to-Market Margin is the daily profit or loss obtained by marking the member’s outstanding position to market.
(3) Marking to Market: Unlike the forwards contracts where settlement is done on maturity date, in futures trading, the valuation of assets is done at the end each trading day and the profit and loss is settled each day between the long and short position. This is known as Mark to Market or Marking to Market. It is the process of asset valuation. It directly determines what money the investor has lost on a particular day. It is also called as ‘Daily Settlement’. This procedure is conducted by clearing house daily which determines the value for the asset covered by futures contracts which is known as ‘Settlement Price’ and then the paper gain or loss is determined. For settlement price, the closing price of the stock on a particular day is taken into account. This process is undertaken to prevent the loss accumulation beyond affordability and thus helps clearing house in reducing its risk of guaranteeing the performance of contract. The amount of loss deducted out of one’s margin account is known as ‘Mark-to-Market’ margin.
(4) Price Limits: In general, there are no day minimum/maximum price ranges applicable for CNX Nifty future contracts. However, in order to prevent enormous order entry by trading members, operating ranges are kept at +/–10%. In respect of orders which have come under price freeze, members would be required to confirm to the exchange that there is no inadvertent error in the order entry and that order is genuine. On such confirmation, the exchange may approve such order. For futures on individual securities, the price bond is also +/–10% of the base price.
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