Question

Define a futures contract. Describe the basic principles behind the use of futures contracts to manage risk exposures.

Answer 1

A futures contract is a standardized legal agreement between two parties to buy or sell a particular asset or commodity or security at a specified period in time at a predetermined price. These contracts are standardized in terms of quantity and quality of underlying to facilitate trading on futures market easier. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

A futures contract helps parties hedge different kinds of risk exposures such as price risk, risk of default by either party. Futures are often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price change, this is facilitated by the price fixed in the contract which is agreed upon by both parties at the beginning of the contract. The default risk is mitigated by the margin requirement of the contract where each party is required to put up initial cash, or a performance bond, known as the margin.

To mitigate the risk of default, the product is marked to market on a daily basis where the difference between the initial agreed-upon price and the actual daily futures price is re-evaluated daily. This is sometimes known as the variation margin, where the futures exchange will draw money out of the losing party's margin account and put it into that of the other party, ensuring the correct loss or profit is reflected daily. If the margin account goes below a certain value set by the exchange, then a margin call is made and the account owner must replenish the margin account.

On the delivery date, the amount exchanged is not the specified price on the contract but the spot value,since any gain or loss has already been previously settled by marking to market.