Futures Contract: Types, Functions
A futures contract is an agreement to either buy or sell an asset on a publicly-traded exchange. The asset is a commodity, stock, bond, or currency. The contract specifies when the seller will deliver the asset. It also sets the price. Some contracts allow a cash settlement instead of delivery.
The role of the exchange is important in providing a safer trade. The contracts go through the exchange’s clearing house. Technically, the clearinghouse buys and sells all contracts.
The exchanges make contracts easier to buy and sell by making them fungible. That means they are interchangeable. But they must be for the same commodity, quantity, and quality. They must also be for the same delivery month and location. Fungibility allows the buyers to “offset” contracts. That’s when they buy and then subsequently sell the contracts. It allows them to pay off or extinguish the contract before the agreed-upon date. For that reason, futures contracts are derivatives.
How Futures Contracts Affect the Economy
Companies use futures contracts to lock in a guaranteed price for raw materials such as oil. Farmers use them to lock in a sales price for their livestock or grain. Futures contracts guarantee they can buy or sell the good at a fixed price. They plan to transfer possession of the goods under contract. The agreement also allows them to know the revenue or costs involved. For them, the contracts reduce a significant amount of risk.
Hedge funds use futures contracts to gain more leverage in the commodities market. They have no intention of transferring any commodity. Instead, they plan to buy an offsetting contract at a price that will make them money. In a way, they are betting on the future price of that commodity. Price assessment and price forecasts for raw materials are how commodities futures affect the economy. Traders and analysts determine these values.
The most important is the oil futures contract. That’s because they set current and future oil prices. Those are the basis for all gasoline prices. Other energy-related futures contracts are written on natural gas, heating oil, and RBOB gasoline. Crude oil prices affect gasoline prices directly because 71 percent of the gasoline price is dependent on the price of crude. A rise in crude oil prices will raise the pump price as well.
Commodities contracts are also written on metals, agricultural products, and livestock. They are also written on financials such as currencies, interest rates, and stock indices. Investing in commodities futures is risky because prices are volatile and fraudulence is prevalent. Investors have to know the market very well or they risk losing their investment, quickly.
The forward contract is a more personalized form of a futures contract. That’s because the delivery time and amount are customized to address the particular needs of the buyer and seller. In some forward contracts, the two may agree to wait and settle the price when the good is delivered. A forward contract is a cash transaction. It is common in many industries, especially commodities.
A futures option gives the purchaser the right, or option, to buy or sell a futures contract. It specifies both the date and the price. Contracts on options are commonly set for a month or more. Weekly contracts are becoming popular for those who like to wager on short-term events.
Forward Rate Agreement
A forward rate agreement is an over-the-counter forward contract. It is written on a short-term interest rate. The buyer of an FRA is a notional borrower. That means the buyer commits to pay a fixed rate of interest on some amount that is never actually exchanged. The seller of an FRA agrees notionally to lend a sum of money to a borrower. Investors use FRAs to hedge interest rate risk or to speculate on future changes in interest rates.
Depending on the type of underlying asset, there are different types of futures contract available for trading. They are:
- Individual stock futures.
- Stock index futures.
- Commodity futures.
- Currency futures.
- Interest rate futures.
INDIVIDUAL STOCK FUTURES
Individual stock futures are the simplest of all derivative instruments. Stock futures were officially introduced in India on 9th November 2001. Before that, the local version of stock futures called ‘badla’ were traded which was eventually banned by the Securities Exchange Board of India in July 2001.
The Badla system: the ‘badla system’ was almost similar to the futures contracts we discussed. In simple terms- A badla trader can delay the settlement of a trade by one week for payment of a small fee. So if you bought a particular share for Rs 100 and if you are bullish on that stock, you can delay the settlement by one week if you pay a fee. This carry over can be done for any number of times. Later on, unlimited carry over facility was restricted to 90 days at a time.
Badla system had its downsides – lack of transparency, data regarding volume, rates of badla charges, open positions etc were not available. There was no margin requirement and badla charges varied from seller to seller. So, chances of manipulation were more. Badla was pure Indian version of futures but did not provide the advantages of price discovery or risk management that organized futures market provide.
STOCK INDEX FUTURES
Understanding stock index futures is quite simple if you have understood individual stock futures. Here the underlying asset is the stock index. For example – the S&P CNX Nifty popularly called the ‘nifty futures’. Stock index futures are more useful when speculating on the general direction of the market rather than the direction of a particular stock. It can also be used to hedge and protect a portfolio of shares. So here, the price movement of an index is tracked and speculated. One more point to note here is that, although stock index is traded as an asset, it cannot be delivered to a buyer. Hence, it is always cash settled.
Both individual stock futures and index futures are traded in the NSE.
It’s the same as individual stock futures. The underlying asset however would be a commodity like gold or silver. In India, Commodity futures are mainly traded in two exchanges – 1. MCX (Multi commodity exchange) and NCDEX (National commodities and derivatives exchange). Unlike stock market futures where a lot of parameters are measured, the commodity market is predominantly driven by demand and supply.
The term ‘commodity’ is a very broad term and it includes –
- Bullion – gold and silver
- Metals – Aluminum , copper, lead, iron, steel, nickel, tin, zinc
- Energy-crude oil, gasoline, heating oil, electricity, natural gas
- Weather- carbon
- Oil and oil seeds – crude palm oil, kapsica khali,refined Soya oil, Soya bean
- Cereals- barley, wheat, maize
- Fiber- cotton, kapas
- Species-cardamom, coriander, termuric etc
- Pluses – chana
- Others- like potatoes, sugar, almonds, gaur
The MCX-SX exchange trades the following currency futures:
- Euro-Indian Rupee (EURINR),
- Us dollar-Indian rupee (USDINR),
- Pound Sterling-Indian Rupee (GBPINR) and
- Japanese Yen-Indian Rupee (JPYINR).
INTEREST RATE FUTURES
Interest rate futures are traded on the NSC. These are futures based on interest rates. In India, interest rates futures were introduced on August 31, 2009.The logic of underlying asset is the same as we saw in commodity or stock futures – in this case , the underlying asset would be a debt obligation – debts that move in value according to changes in interest rates (generally government bonds). Companies, banks, foreign institutional investors, non-resident Indian and retail investors can trade in interest rate futures. Buying an interest rate futures contract will allow the buyer to lock in a future investment rate.