(This article presents how futures differ from forwards, why clearing and margining matter for performance assurance, how pricing links to carry and yield curves, and how settlement conventions and market structure shape real-world hedging and trading outcomes.)
A futures contract is a standardized agreement traded on an exchange to buy or sell an underlying asset at a predetermined price on a specified future date, supported by daily mark-to-market and a central clearing house that guarantees performance. Compared with bespoke forwards, futures enhance liquidity, transparency, and risk management through margining and standardized terms.
What is a futures contract?
A futures contract obligates the buyer and seller to transact the underlying at a set price on a future date, with positions revalued daily via mark-to-market and gains/losses settled through margin accounts. Contracts are standardized for contract size, grade, delivery months, tick size, and settlement conventions, enabling deep order books and reliable liquidity.
Futures vs forward contracts
- Standardization and venue: Futures are standardized and exchange-traded; forwards are customized OTC agreements.
- Counterparty risk: Futures performance is guaranteed by the clearing house; forwards carry bilateral credit risk.
- Settlement: Futures are marked-to-market daily; forwards typically settle once at maturity.
- Liquidity and transparency: Exchanges provide centralized price discovery and public data; forwards rely on dealer quotes and bespoke documentation.
- Margining: Futures require initial and variation margin; forwards generally depend on bilateral collateral terms.
Performance of contract
Performance is ensured through daily settlement: each trading day, the exchange calculates the change in contract value and credits/debits margin accounts accordingly. This process crystallizes gains and losses progressively, reducing the build-up of large uncollateralized exposures into expiry and lowering systemic risk.
The clearing house
The clearing house novates trades—becoming buyer to every seller and seller to every buyer—thereby mutualizing counterparty risk and managing it via margin, default waterfalls, and guaranty funds. It monitors participants’ exposure in real time, enforces margin calls, and conducts default management auctions if a member fails.
Margin account
- Initial margin: A good-faith deposit calibrated to expected short-term volatility using risk models (e.g., SPAN/VAR); it is not a down payment and is returned if positions close without loss.
- Variation margin: Daily mark-to-market cash flows that settle P/L; intraday calls occur under fast markets.
- Maintenance margin: A threshold below which a margin call is triggered to restore the account to initial margin.
- Leverage and risk: Small margin supports large notional exposure; disciplined risk controls and stop-loss rules are essential.
Spot–futures relationship
Under no-arbitrage, the theoretical futures price reflects spot plus the net cost of carry over the life of the contract:
- Investment asset with no income: F0 = S0 × e^{rT}.
- With known cash income I: F0 = (S0 − PV(I)) × e^{rT}.
- With continuous yield q: F0 = S0 × e^{(r − q)T}.
For commodities with storage and convenience yield, F0 = S0 × e^{(r + u − y)T}, where u is storage/other costs and y is convenience yield.
Delivery
Physically settled futures specify delivery grade, location, timing, and procedures, with delivery notices managed through clearing. Only a small fraction of contracts typically go to delivery; most traders offset positions before first notice day to avoid logistics.
Cash settlement
Cash-settled futures resolve to a published final settlement price or index level at expiry, eliminating delivery logistics. Common in equity index, interest rate, and some commodity contracts, cash settlement ensures precise financial exposure without handling the underlying.
Pricing of futures contracts
- Cost-of-carry model: Anchors fair value to financing, storage/other costs, and income/benefits over T.
- Discrete vs continuous cash flows: Use present value for known discrete cash flows; use yields for continuous streams.
- Seasonality and basis: Commodities can deviate from simple carry due to seasonal storage, inventory tightness, and convenience yield dynamics; the basis = futures − spot converges toward zero as expiry approaches.
- Funding and collateral rates: The effective carry depends on applicable funding and collateral remuneration in the exchange margining ecosystem.
Contango vs normal backwardation
- Contango: Futures price above spot (positive basis), typical when costs of carry exceed benefits; prevalent in markets with abundant inventories and low convenience yield.
- Normal backwardation: Futures price below expected spot; in Keynes’s hypothesis, producers hedge by selling futures, offering a risk premium to long speculators. Observed when inventories are tight and convenience yield is high, pulling futures below spot.
- Dynamics: Market structure can flip with inventory cycles, seasonal demand, and shocks; convergence ensures futures meet spot at expiry.
Interest rate futures
Interest rate futures provide standardized exposure to money-market rates, government bonds, or swap-linked benchmarks, enabling hedging of duration and rate risks.
- Money-market futures: Price quoted as 100 − expected annualized rate for the contract period; small price changes imply meaningful rate moves.
- Government bond futures: Deliverable baskets with conversion factors align different bonds to the contract; the “cheapest-to-deliver” (CTD) drives pricing and hedge ratios.
- Hedging use: Asset–liability managers, treasuries, and traders adjust duration or lock forward borrowing/lending costs efficiently, often with high liquidity and minimal transaction costs.
- Pricing: Par futures price reflects forward rates embedded in the yield curve (for money-market contracts) or the CTD forward price adjusted by conversion factors and carry (for bond futures).
Practical notes and examples
- Hedge construction: Match the futures expiry to the risk horizon; size the hedge via beta/duration (equities/bonds) or unit exposure (FX/commodities).
- Rolling: For longer horizons, roll positions before first notice/last trading day to maintain exposure while avoiding delivery.
- Basis risk: Even standardized futures may not perfectly track the specific exposure; monitor and manage residual basis.
- Risk controls: Set margin buffers, use alerts for intraday calls, and stress test for gap risk around data releases/roll dates.
- Example: An importer hedges 3-month USD needs using a near 3-month currency futures; if domestic currency weakens, futures gains offset higher spot costs; if it strengthens, futures losses are offset by cheaper spot settlement.
CAIIB exam Risk Management related articles in model “F” (elective paper)
