Everything about Futures Contract

In this blog post, Vincent Kofi, pursuing M.A. in business law from NUJS, Kolkata, talks about ‘Futures Contract’.

Introduction

About 20 decades before today, the success of the agricultural revolution overwhelmed the world with satisfaction since it enabled farmers to produce more food than before. By then, a German chemist and Nobel Prize winner Fritz Haber had learned how to produce ammonium nitrate, which made crops grow healthier and mature earlier (Paull & Hennig, 2011). The ensuing challenge was that pests and severe weather conditions destroyed crops, which made dealing in agricultural products unpredictable.

Farmers, on the other hand, were jam-packed with much uncertainty. Economists offered a solution that has since become significant in many other industries, including those unrelated to agricultural products, such as in buying and selling stocks. The proposed idea has since transitioned to become what are known today as Futures Contracts.

This article digs into all one needs to know about futures contracts. First, though, it is important to understand a brief history of futures contracts.

History Précis

In Paull and Hennig’s (2011) account, at the inception years of the agricultural revolution, farmers could plant crops for six to eight months, and due to pests and adverse weather conditions, make losses. Since they primarily depended on farming, it followed that they had to replant and wait for another six to eight months before they could trade and have some money to spend. In other words, farmers could go for up to two years without making a profit.

However, later on, if weather forecast reports implied that farmers would have a good harvest in the current year, economists advised the farmers that they could sell their crops beforehand to have the money they needed and that by buying the crops ahead of harvesting, traders could make bigger profits. Motivated by their urgent need of money, farmers looked for affluent traders who were willing to commit to buying the produce before harvesting, who were also willing to pay upfront.

Relying on the weather forecast reports that the year promised a good harvest, and on the farmer’s promises, the affluent traders paid for the crops immediately, but at a lower price. The justification of a reduced price was that the traders were taking all the risk. The farmers accepted the offer because they were desperately in need of money. The farmers settled their debts by harvesting and surrendering all the crops to the traders. The contract dictated that the trader had to accept the harvest whether it was abundant or paltry. The society got used to the concept of futures and stretched it beyond agricultural products.

For instance, as Malcolm (2013) writes in his book, in 1972, the Chicago Mercantile Exchange (CME) branched into International Monetary Market (IMM), which dealt in currency futures. The IMM became a platform on which traders would gamble on the value of overseas currencies at a later date. Four years later, the IMM also introduced interest rate futures, while in 1982, the market introduced stock market index futures, and subsequently, stock futures. Later in 2001, as chronicled in Nandan, Agrawal, and Jindal’s (2015) study, the National Stock Exchange of India (NSE) introduced futures on individual securities.

At the present, the futures contracts exist on 172 securities specified by the Securities & Exchange Board of India (SEBI). Before discussing further, it is important to understand what futures contracts really are.

About Futures Contracts

Based on the history and scenarios given in the previous paragraphs, and as defined in Gorton, Hayashi, and Rouwenhorst’s (2013) article, a futures contract is a legal agreement to sell or buy a certain financial instrument or commodity at a predetermined amount at a definite time in the future.

The agreements are traditionally made on a futures exchange’s trading floor, and their contents are dependent on the underlying commodity being traded, as well as its quantity and quality. In other words, in each of the futures contract, every detail is specific—the contract has to specify the commodity’s quantity and quality, price per unit, as well as the date and means of delivery.

The agreed upon date is called the future date, the final settlement date, or the delivery. The predetermined price is called the futures price, while the price of the involved commodity on the delivery or settlement date is called the settlement price.

While some futures contracts may be settled in cash, others demand delivery of a physical commodity (Kang, Rouwenhorst, & Tang, 2014). It should be noted that saying just futures or futures contract means the same thing. For instance, a trader saying that she intends to buy sugar futures can also be understood as saying she wants to be bound by a sugar futures contract.

It thus follows and it should be understood that a futures contract is an agreement that involves two parties, i.e. one party agrees to deliver a commodity (short position), while the other agrees to receive the commodity (long position). One needs to differentiate between futures contract and an options contract to be sure he or she is being bound by what he or she intends.

According to Gorton, Hayashi, and Rouwenhorst (2013)

“A futures contract accords either party the obligation to buy or sell, while an options contract accords either party the right to buy or sell, but not the obligation”.

Differently said, the holder of an options contract may choose to or not to exercise the contract. In contrast, according to the authors, in a futures contract, parties do not have any other option than fulfilling the contract on the delivery date.

There are two options when it comes to the settlement date of the futures contract.

  • One, if the contract involved shares or a commodity, the seller delivers the shares or the commodity to the buyer.
  • Otherwise, two, in case the future is cash-settled, such as in the scenario of stock futures in India, the futures trader who made a loss transfers cash to the trader who made a profit (Kang, Rouwenhorst, & Tang, 2014).

If the results of the contract do not appeal to either party or if one does not wish to continue being bound by the agreement, there is a way out—to exit from an existing futures contract before its delivery date, either party can offset its position by either buying back a short position or selling a long position, respectively. This will successfully close out the futures position alongside its contract obligations.

Many investors across the world and increasingly in India are highly leveraging futures. Futures contracts happen by the trader putting up a small percentage (typically 10-25%, or lower) of the underlying contract’s value as margin, yet he or she can ride on the contract’s full value as it moves backward and forward (Khan, 2013).

The money the trader puts up is a performance bond rather than a deposit on the underlying contract. The contract’s actual value is only transacted on those infrequent occasions during delivery. Comparatively, a stock investor has to generally put up 100% of his or her stocks’ value. What is more, a party that invests in futures does not pay interest on the variance between the margin and the value of the full contract. As established in the section that follows, the futures contract in India is vastly standardized.

Contents of a Futures Contract

Deducing from the description so far, it is apparent that a futures contract is highly standardized. As reported in Rajamohan, Vethamanikam, and Vijayakumar’s (2014) study, the contract must specify the underlying instrument or asset, which would be tangible (i.e. a petroleum product) or intangible (i.e. a share or stock). The contract specifies the type of settlement involved as either a physical or cash settlement.

In the present-day India, a higher proportion of stock futures are settled in cash. Accordingly, the contract specifies the currency that will be used to settle the futures. The contract stipulates the underlying asset’s amount and units, which would the volume of a commodity (i.e. liters of diesel), number of shares, and units of foreign currency (USD or KES), among other details. The contract must stipulate the grade of the deliverable.

When the agreement involves bonds, the contract specifies the exact volume of bonds that will be delivered. If the agreement deals with physical commodities, then the contract determines the underlying goods’ quality, as well as the means and site of delivery. The contract also indicates the month on which the commodity will be delivered and the last date on which the trading will be winded up. The SEBI regulates trading in futures by protecting against the traders controlling the market unethically and illegally, and to stop fraud in the futures market. It is important to understand that either participant in a futures contract can be a hedger or a speculator as described in the section that follows.

Suggested Reading: Forward Contracts

Hedging and Speculating

As already stated, a futures contract has a party assuming the short position, and another, the long position. It is also important to understand that the futures participants fall into two basic categories—hedgers and speculators.

In other words, sellers and buyers in futures contracts would be hedgers or speculators at any given point in time. Generally, hedgers use futures to protect themselves against inauspicious future price fluctuations in the underlying cash commodity (Das & Chakraborty, 2015). The justification of hedging is founded on the established propensity of cash prices and values of futures to change in tandem. In most cases, hedgers are individuals or businesses that at one instance or another buy or sell the underlying cash commodity.

Using a petroleum products dealer for illustrative purposes, if petroleum prices increase, the dealer has to pay the refinery or the supplier more money. To protect himself against higher petroleum prices, the dealer can ‘hedge’ his risk vulnerability by buying enough petroleum products futures contracts to cover the volume of the products he projects to buy. Because cash and prices for futures have an inclination to move in tandem, the position of futures will profit if petroleum prices increase enough to counterpoise cash petroleum losses.

Speculators include independent investors and traders. In the case of speculators, futures have significant benefits over other form of investment. If a trader makes a good judgment, he or she can get more and faster returns in the futures, since on average, for instance, prices for futures tend to adjust faster than stock or real estate prices (Das & Chakraborty, 2015). Then again, if the trader makes a bad judgement pertaining futures markets, he or she can make bigger losses compared to other forms of investments.

Laws and Regulations

Futures contract is a type of contract, and like all contracts, it is primarily regulated by the Indian Contract Act of 1872, which collated the principles of common law. The Act offers a mechanism for execution of rights and duties of parties involved in the futures contract. There are other sectoral laws such as the SEBI Act, according to which not every commodity is appropriate for futures trading. Based on the SEBI, for a commodity to be suitable for a futures contract, it needs to have the right demand and supply conditions (Kashyap & Tomar, 2013).

In other words, its volume and marketable surplus need to be large. The commodity involved in futures contracts has to be free from extensive control from government regulations or any other bodies that would impose restrictions on its supply, distribution, and prices. The Act also stipulates that the commodity’s prices must be volatile to make it possible for hedging through futures price risk. Resultantly, there would be a call for hedging facilities.

It is also required that the commodity be homogeneous or, otherwise, it must be possible to stipulate its standard. As already established in herein, a standard is required for the futures exchange since futures is a standardized contract. The SEBI Act also demands that the commodity be storable, without which arbitrage would not be likely and there would be no connection between spot and futures markets.

Even with the requirements discussed above, based on the Notifications dated 1.4.2003, there is no prohibition on futures trading in any commodity. However, according to Kashyap and Tomar (2013), futures trading in any commodity is subject to the Government of India’s approval. Presently, the government regulates 113 commodities, which means the 113 commodities have been notified under the 15th section of the Forward Contracts (Regulation) Act.

Agricultural products are among the commodities approved for futures contracts. According to Rajamohan, Vethamanikam, and Vijayakumar (2014), when the products are traded at the Exchanges, the futures contract is classified under Compulsory Delivery Contracts. This means that every outstanding position on the due date of the contract must result in compulsory delivery. If either party in the futures contract fails to give or take the commodity on the stipulated delivery date, it will be penalized as set in the Bylaws, Rules and Regulations of the Exchanges.

If the seller shows the intention to avail the commodity on the delivery date, then the buyer does not have a choice other than to accept the delivery or be penalized. Therefore, it is important that ahead of being bound by the futures contract, both the seller and the buyer agree on the delivery logic since terms would be different depending on the commodity and on the exchange. Regardless, even when buyers and sellers comply, they can still make losses depending on other factors.

Gains and Losses

Futures contracts’ gains and losses are computed and credited or debited daily to the brokerage account of each market participant. Illustratively, if a speculator were to make a profit of USD 1,000 due to a price change in a day, the amount would be credited to his or her brokerage account immediately. If the money is required to do something else, it can be withdrawn. Likewise, due to a price range that results in a loss worth USD 1,000, the involved participant’s account will be debited for a similar amount.

The process of computing and debiting or crediting each participant, as confirmed in Agarwalla, Jacob, and Varma’s (2014) study, is called daily cash settlement, and it is a significant feature of futures trading. It is also important to note that when a party makes a loss on a futures position, he or she may be contacted to deposit additional funds immediately.

Advantages of Trading Futures

Trading futures have some advantages that do not come with investing in other alternatives, including real estate, stocks, bonds, collectibles, options, and accounts. For instance, a futures market’s existence and the utility makes it possible for hedgers to shift risks to speculators (Alavei & Olsson, 2015). The market gives traders a resourceful idea of the probable value of an index or futures price of a stock. It is also worth noting that depending upon current futures price, trading futures would be helpful in determining the demand of the futures, as well as the supply of the shares.

Besides, because trading futures is grounded on margin trading, it makes it possible for small speculators to enter into futures contracts and transact in the futures market by paying a low margin rather than the total value of physical holdings (Cheng & Xiong, 2013).

Trading futures in India has a high leverage, which attracts many investors since the motivation to investing is the potential for huge profits in a short time span (Das & Chakraborty, 2015). In other words, trading futures has a high leverage because it can be very profitable. The market is so profitable because for an investor to enter into a futures contract, he or she only have to raise a small percentage of the total value of the contract, which, as already established in this article, is traditionally 10-20%) or lower.

This follows that as an investor, one can trade a huger amount of the security compared to if he or she bought it outright. This also implies that if the investor has projected the market trend properly, his or her profits will be nth-fold, i.e. 10-fold if he or she put up a deposit of 10%. Undoubtedly, as opposed to trading physical delivery in stocks, this is an outstanding return.

Trading futures in India can bring about profit in bull as well as bear markets. While trading futures, it is both easy going short (or selling) and going long (i.e. buying), which is advantageous. It then follows that if a participant makes the right choices, he or she can make money regardless of whether the prices appreciate or depreciate (Nandan, Agrawal, & Jindal, 2015). Thence, entering into futures contracts gives participants the prospect of profiting from any possible economic scenario. In other words, it does not matter whether the Indian economy is undergoing inflation or deflation, depression or blast, or whether there are droughts, hurricanes, or famines—investors who enter into futures contracts always have an opportunity to make a profit.

Anyone trading futures also need to know that the market is associated with high liquidity. More specifically, it is important to be aware that the high liquidity is as a result of the large number of contracts traded on a daily basis. The high liquidity ensures that participants can place orders very fast because the market has buyers and sellers of futures contracts always.

Lastly, trading futures is advantageous because they require lower transaction costs, particularly in terms of relative commissions. In India, an investor’s commission for trading a futures contract is 0.10-0.20% (Das & Chakraborty, 2015). In addition, individual stocks usually attract a commission of about 1% in buying as well as selling. Even with all these advantages, trading futures contracts would be risky as discussed below.

Risks of Trading Futures

The primary risk associated with trading futures contracts is rooted in the temptation to speculate unreasonably because of a high leverage factor. Although one would be lucky doing this, excessive speculation amplifies the extent of losses. Jarrow, Protter, and Pulido (2015) warn that this kind of contract can be risky without adequate knowledge because derivative products are somewhat more complicated compared to stocks or tracking an index. Without the appropriate knowledge, one would make huge losses easily. In addition, futures are derivative commodities whose value hinges largely upon the underlying indices or stocks’ price. Nevertheless, the pricing is not that straightforward—there is a variance between the underlying asset’s prices in the derivatives segment and in the cash segment.

Without an understanding of futures contracts’ two simple pricing models, trading futures can be very risky. With the understanding of the expectancy model and of the cost of carry model, an investor can be able to approximate how a stock futures’ price or index futures contract would behave (Alavei & Olsson, 2015). However, it is important to know that these models just give an investor a platform on which to build his or her understanding of futures prices. Even then, an investor who knows these pricing models and theories knows what to expect from the price of an index or stock of a futures.

What are your views on this? Feel free to comment below & share the article.
 

References:
Agarwalla, S. K., Jacob, J., & Varma, J. R. (2014). High Frequency Manipulation at Futures Expiry: The Case of Cash Settled Indian Single Stock Futures. Indian Institute of Management, Ahmedabad, India Working Paper, (2014-02), 01.

Alavei, D., & Olsson, T. (2015). Trading CDS Indices vs. Equity Index Futures–A pairs trade.

Cheng, I. H., & Xiong, W. (2013). Why Do Hedgers Trade So Much? (No. w19670). National Bureau of Economic Research.

Das, J. K., & Chakraborty, G. (2015). The Hedging Performance of Commodity Futures in India: An Empirical Study on Some Agricultural Commodities. International Journal of Information, Business and Management, 7(3), 162.

Gorton, G. B., Hayashi, F., & Rouwenhorst, K. G. (2013). The Fundamentals of Commodity Futures Returns. Review of Finance, 17(1), 35-105.

Jarrow, R., Protter, P., & Pulido, S. (2015). The effect of trading futures on short sale constraints. Mathematical Finance, 25(2), 311-338.

Kang, W., Rouwenhorst, K. G., & Tang, K. (2014). The Role of Hedgers and Speculators In Liquidity Provision To Commodity Futures Markets. Yale International Center for Finance Working Paper, (14-24).

Kashyap, A. K., & Tomar, A. S. (2013). Corporate Governance in Indian Capital Market: An Appraisal. law Review, 129, 157.

Khan, M. Y. (2013). Indian financial system. Tata McGraw-Hill Education.

Malcolm, J. P. (2013). Financial Globalization and the Opening of the Japanese Economy. Routledge.

Nandan, T., Agrawal, P., & Jindal, S. (2015). An Empirical Investigation of Mispricing in Stock Futures at the National Stock Exchange. Indian Journal of Finance, 9(9), 23-35.

Paull, J., & Hennig, B. (2011). A world map of organic agriculture. European Journal of Social Sciences, 24(3), 360-369.

Rajamohan, S., Vethamanikam, G., & Vijayakumar, C. (2014). Commodity futures market in India. International Journal of Advanced Research in Management and Social Sciences, 3(10), 52-58.

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