General Theory - The Futures Contract

The Futures Contract
Forward contracts can conform to some degree of standardization, although they do not have to. They can be customized in both quantitative and qualitative terms as required by the two parties who enter into the agreement. Forwards are generally clubby "gentlemen's agreements" that are entered into away from the public setting of an exchange; if positions are traded after the deal is made, that is, likewise, a private affair. Forward contracts carry counterparty risk as no intermediary stands between the two parties, either of whom could renege on their obligation.

Futures Compared To Other Securities
Elements of a forward contract:

  1. Contains non-standardized terms,
  2. Trades over the counter and is illiquid,
  3. Has no third party guarantee,
  4. Is unregulated,
  5. Is private,
  6. Margin requirements do not exist,
  7. Bears counterparty (default) risk, and
  8. Generally held to expiration - offsetting transactions are less common.

Elements of a futures contract:

  1. Its terms are standardized in terms of quantity of goods and delivery dates,
  2. It trades on an exchange that provides pricing transparency (it is an exchange-traded obligation),
  3. It is guaranteed by a third party, the clearinghouse, there is no counterparty risk.
  4. Its traders must post a good-faith margin deposit, and
  5. It trades in a market regulated by a specific government agency.

Because futures trade in undifferentiated commodities and forwards can be tailored to whatever sort of transaction appeals to a buyer and a seller, there have been some truly unique futures contracts. Perhaps the most famous deal occurred in the 1990s, when rock star David Bowie entered into a forward agreement to sell to his record company the rights to songs he hadn't even written yet.

Offset Provisions
Most futures contracts, it might surprise you to learn, never exist long enough to be delivered against. Far more often, there is an offset, also called a reversing trade. This is a transaction that liquidates a purchase of futures contracts through the sale of an equal number of contracts of the same delivery month, or liquidates a short sale of futures through the purchase of an equal number of contracts of the same delivery month. Both must occur on the same exchange.

For example, let's consider a trader who, on June 1, takes a position to buy 40,000 pounds of live cattle in October for $500 per hundred pounds. Living in a high-rise apartment, this sophisticate has no intention of taking delivery; she bought the contract expecting to sell it before its expiry. Beef prices increase over this time and on June 15 she executes a transaction to sell 40,000 pounds of live cattle for $650 per hundred pounds. By entering into this trade, she closes out her position in terms of the underlying commodity and is not responsible for either buying or delivering a single head of cattle. This netting of positions is what makes it feasible for commodities futures to be traded as financial products, like stocks and bonds.

Clearinghouse Functions
Of course, not everyone in a public market can be trusted to always live up to her obligations. For this reason, every futures exchange has an associated clearinghouse which, for a reasonable fee, guarantees that all traders will honor its terms. The clearinghouse ensures fulfillment of every contract by acting as the buyer to every seller, then turning around to act as the seller to every buyer. The clearinghouse must, at the risk of losing its reputation in the market and its relationship to the exchange, honor every agreement. It is the middleman. The clearinghouse may be part of the futures exchange or a separate entity; the exchange or a separate group of individuals may own it.

To summarize, a clearinghouse performs the following functions, to wit:

  1. Clears and settles trades, serving as an intermediary between the two trading parties; this function ensures market integrity;
  2. In this way, it acts as a guarantor of performance

Exchange members may be clearing or non-clearing. Clearing members are members of both the clearinghouse as well as the exchange; non-clearing members are members of the exchange only. Clearing members tend to be the larger institutions. As part of their clearing responsibilities, these firms must have financial strength as they act as intermediaries between the clearing house and clients with open futures positions. To this end, these firms are required to maintain required margin based upon clients' net positions. The clearinghouse deals with clearing firms, not directly with customers Non-clearing firms trade through clearing firms and may not deal directly with the clearinghouse.

Most trades are transacted directly through clearing members. The bulk of trading through non-clearing members is by speculators trading on their own accounts.

Delivery Provisions
Although offsets are the most frequently preferred means to close a futures contract, there are some who, in the course of their business, need to take delivery of the actual commodity.

Less than 1% of all commodities end in delivery. That holds true even if we expand the definition of "delivery" to include cash settlement, in which traders make payment on the expiration date to settle any gains or losses, rather than making physical delivery. Cash settlement enables trading in interest rates or index futures, because a "
Libor" or a "Nasdaq 100" cannot be physically delivered.

Still, delivery provisions will be on the Series 3 exam, so you need to know that a basis grade is the quality of a commodity used as the standard of a futures contract. A premium or a discount would be the amount a price would be increased or decreased to purchase a better-or lower-quality commodity. These are stipulated by the exchange. For example, the CBOT does not just trade corn, it trades No. 2 Yellow corn at prevailing rates. If you want to buy a contract for No. 1 Yellow corn, you would have to pay a premium of 1.5 cents/bushel over the standard contract price for No. 2 Yellow. If you want to buy a contract for No. 3 Yellow, it would be at 1.5 cents/bushel discount below the price for No. 2 Yellow.

Market Structure
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