Futures contracts – Finance for everyone

A futures contract is a transaction agreed between two counterparties (buyer and seller) on an organized and regulated market called “futures market”.

AND a futures contract represents an obligation to buy (for the buyer), sell (for the seller) the underlying asset at today’s set price but for delivery and payment in the future.

The underlying asset can be a physical product (raw materials), a financial instrument (stocks, bonds, interest rates, exchange rates) or even a stock market or a climate index…

Mechanism of futures markets

Originally designed for agricultural marketsthe primary role of futures contracts is to minimize the risks of losses associated with price fluctuations of the asset to which they relate (the role of ” blanket“).

A corn producer who fears a drop in corn prices between now and his harvest can sell corn futures contracts to secure the sale price in advance. Of course, they will pay more for their contracts if they demand a high selling price and if the downside forecasts are significant.

Opposite the professionals of the basic product (in the mentioned case, farmers) are other operators who have different interests or expectations. They may be pure speculators who intervene in the hope of profiting from market movements.

They have an important role for the proper functioning of markets because they support liquidityenabling the implementation of large orders with minimal price fluctuations.

Futures quotes therefore represent at any time a consensus on the levels that the prices of the underlying product will reach on a certain date.

Delivery or Unroll Location

In the futures market, you can very well take a short position before buying, because the settlement, but especially the delivery, will take place later in the future.

To fulfill its sales commitment, then it will be sufficient to acquire the underlying product in the “physical market” before the maturity date stipulated in the futures contract so that it can be delivered. If you ultimately do not wish to deliver the product, you must “unwind” your sell position by following it with a buy position on the same futures contract prior to expiration.

Because the contracts traded in the futures market are standardized (size, maturities, etc.), they are “fungible,” making it simple to buy back or sell them during their lifetime. In this case, the position is canceled and the investor is released from his original obligations.

In practice, few participants hold their position until delivery in the futures market. They exit their position before expiration: a sale followed by a purchase or a purchase followed by a sale of the same underlying asset then results in a profit or loss.

Although the raw materials are therefore, the futures market is more similar to the financial market (used as a hedging or speculative instrument) than the actual physical market.

In addition, a number of futures contracts provide for settlement not by “physical” delivery of the underlying asset, but by cash settlement of the profit (or loss) generated. This is especially true for stock index futures contracts.

System of financial guarantees

In regulated markets (such as the Euronext derivatives market), trading of futures contracts benefits from the services of a clearing house.

Clearing house is a financial institution that ensures the registration of transactions and guarantees the successful completion of transactions to its members. It systematically intervenes between the buyer and the seller, for whom it becomes the only counterparty. This allows each party to subsequently carry out the opposite operation (sale or purchase) without having to find the other party of the original market or obtain its consent.

In order to guarantee the financial security of itself and its interested parties, the clearing center (so-called LCH SA for Euronext derivatives markets) requires financial intermediaries who are its members cover deposit (or a bond) to cover the risk of putting the investor in trouble in the event of an adverse price change.

Every evening, the risk is reassessed according to price developments during the session and an additional “margin call” is made to operators whose risk has increased.

The intermediary member of the clearing center pays him the corresponding amounts. An amount at least equal to the amount requested by the clearing center is blocked by the intermediary on the client’s account.

Leave a Comment