What is futures contract?

Vishwajeet Bhandigare
/ Categories: Knowledge
What is futures contract? 526 0

Futures contract is nothing but a standardised version of forward contract. It is just as the name suggests, two parties get into a contract to buy or sell an underlying asset at a fixed price at a certain future date. However, there are differences between the forward contract and futures contract but the idea behind them is the same. We will discuss the differences between them thoroughly.   

Understanding futures  

Market participants such as hedgers and speculators make use of futures contracts. Let us build a case study example to consolidate the concept. Let us assume that a stock ABC Ltd is trading at Rs 100 on BSE. And you have bought 100 shares of ABC at Rs 80. Based on your due diligence, you believe that the stock price may see a serious correction for the short term, and so, you want to hedge that downside risk. And so, you sell a futures contract (short position) for a lot of 100 shares at Rs 80 with an expiry of 30 days. That makes a total notional amount of Rs 8,000. You are not required to make an upfront payment of Rs 8,000. However, some percentage margin is to be deposited for fluctuating prices, which is called as initial margin. Someone else, who is bullish on the stock will buy the futures contract (long position). Here, Rs 80 is referred to as futures price. If the price falls below Rs 80, the short position will earn a profit, and if the price goes up, the long position will earn. As the prices fluctuate continuously, one party will always earn or lose on a daily basis and hence, the transactions are settled on a daily basis by clearing house in exchange. If you make a loss, you must put money to revive the initial margin, which is called a maintenance margin.   

Difference between forward and futures contract: 

 

Forward contract  

 

Futures contract  

  

 
   

It is the over-the-counter product (OTC)  

It is traded on the exchange 

   

It is a customised product. (customised prices, quantity, dates 

It is a standardised product (fixed prices, quantity, and dates for everyone) 

   

High counterparty risk 

Minimum counterpart risk 

   

It is not highly regulated  

Highly regulated (e.g. SEBI) 

   

Settlement is done on expiry date 

Settlement happens on daily basis 

   

Does not have a clearing house 

Every exchange has its own clearing house.  

   

Low liquidity 

High liquidity  

   

No margin required  

Compulsory margins are required  

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