Specification of a Futures Contract Finance Essay

Future market is a market where contract for future delivery of a commodity or a financial instrument are bought or sold. It also can say as the place where the supply and demand for the trading of future contracts. A future contract is an agreement between two parties to buy or sell and asset at a certain time in the future market for a certain prices. In order to make the trading possible, the exchange specifies certain standardized future for the contract. As the two parties do not necessarily need to know each others, the exchanges also provide a mechanism that gives the two parties a guarantee that the contract will be honored. There are many future markets in the whole world. Example of the few famous future market is Chicago Board of Trade (CBOT), Chicago Merchatile Exchange (EME) ,IntercontinentialExchange (ICE), NYSE Euronext (NYX) and many more. Through the market many exchanges had been done throughout the whole world, a very wide range of commodities and financial assets from the underlying assets in the various contracts. The commodities include corn, oat, rough rice, soybeans, sugar, wool, aluminium and others. While for the financial futures the underlying item can be any financial instrument like currencies, treasury bonds and stock indices. Besides, the future market also provides a medium for the complementary activities or hedging or speculation, that necessary for the sudden fluctuations in the prices that cause by the gluts and shortages. The investors who done hedging is known as the "hedgers" they do so is to maximize the value of their assets and on the other hand to reduce the risk of financial losses from the price changes. While people who use speculation are known as "speculators" they are the one who attempt to profit from prices changes in the future contracts. The main regulators in the market in United States are the Commodity Futures Trading Commission (CFTC).They responsible for the licensing futures exchanges and approving contract. No matter new or change to existing contract must be approved by the CFTC .So in order the contract to be approved the contract must have useful economic purpose. They also looks at the public interest, make sure that the prices are communicated to the public. In the same time, the futures traders will also report their outstanding positions if they are above certain levels.

The specification of a futures contract

Specification of a futures contract is a linchpin when developing the new contract. In particular, it must specify the contract size, the asset, where and when the delivery will be made. From Donald Lien (2006), the specification of contract term is one of the factors that determine the success or failure of a futures market. In short, the specification is a guideline that provides an entire view of the new delivery to the buyers. Generally, there is a few general specifications that will be specified; for instance, the type of asset, the contract size, the delivery arrangements, the delivery month, the price quotes and expiration. Indeed, the type of asset is often the primary specification. When the asset is specified, it is therefore important that the exchange stipulate the grades of the asset that are acceptable. Also, clear specification of the financial asset could make it well defined and uncertain or unambiguous, thus, it is providing a well insight for the investors. Also, the contract size and price quote are the successive important element of the specifications. The contract size specifies the amount of the asset that has to be delivered for one contract. If the contract size is relatively small, the exchange may be expensive for the investor. In addition, the investors are often concern about the price quote as well. The exchange defines how price will be quoted. For example Hull (2012) states in US, the Treasury futures prices are quoted in dollars and thirty-seconds of a dollar. In a nutshell, the specification of a contract, whatever types of the contracts, is essential nowadays. Due to the advance available of the information, the wellness of the specification of a futures contract could be act as a key competitive advantage in order to satisfy the investors' requests.

Margin Requirement

In future agreement, they are no payment made by the buyer to seller, nor does the seller have to show proof of physical ownership of the asset during the agreement time. However, investor and her broker/dealer are required to deposit funds in a margin account in order to fulfill both sides of the agreement. The deposit funds in the margin account are called 'margin' or 'margin requirement'. Margin requirements oblige investors who undertake contractual obligation to deposit and maintain a minimum amount of cash or securities with their counterparties. Margin requirements in different markets serve several different goals, but in all cases margin deposits reduce counterparty losses whenever contractual obligations are not fulfilled: if the investor defaults, the counterparty at the very least retains the margin deposit." (George Sofianos, n.d.). Refer to this statement, George give the definition of the margin requirement with clearer information. He expressed that the investors who has the contractual obligation to deposit and maintain a minimum level of the cash or securities with their broker or dealer. He also elaborated that the margin requirement will minimize the risk of the counterparty whenever the contractual obligations are not fulfilled and if the investor defaults, the counterparty can at least remain constant in the margin deposit. In particular, the amount of cash required when the position is initiated- the "down payment"-is referred to as the initial margin (James T. Moses, 1992). From the article of James T. Moses, he also defined that the cash that given by the investor in the leveraged stock transaction is called margin. Moreover, he examined that the amount of cash needed to be started in the margin account is called initial margin. This system of initial (or original) margin deposits (usually a small percentage of the total value of the underlying contract) helps to maintain the financial integrity of the futures market and provides participants with the leverage that is a major feature of futures trading (Petros Jecheche, 2011). Petro Jecheche defined that the initial margin is always remain a small percentage of the total value of the future contract so that can help to control the financial integrity of the future market and give participants with the leverage.Maintenance margin requirement set a floor below which margin is not allowed to fall as long as the position remains open" (George Sofianos, n.d.). The statement that the George state that maintenance margin is set a level below which the margin requirement cannot allowed to drop as long as the position remains open. This is the balance a trader must maintain in his or her account as the balance changes due to price fluctuations. When the account goes below a predetermined minimum, the investor faces a margin call and is required to make a deposit that meets the minimum necessary.(Pedro Santa-Clara & Alession Saretto, 2004). Both authors explain how the margin call condition will occur in the margin requirement. Margin call is simply requirement for the ended margin account balance to be brought back to its initial margin level, by paying additional money. Santa and Alession examined that the investor will face a margin call when their margin account goes below a predetermined minimum level, which is below the initial margin's level.

Advantages of future contract

Future market provides an organized market for buyer and seller to trade with each other (Robert, 2000). Futures contract are traded actively in all around the world and it is traded in central market. As the trade carry out in central market, the liquidity will increases, it allow buyer and seller trade easily. It also provides flexibility of entering and exiting the market. Investor can keep looking on the movement of the market. Hence, the problem of double coincidence of wants can be easily solved. Next, futures contracts are standardized and interchangeable (Halifax, 2010). Standardization, make the price become the only factor that remains to be determined in the marketplace. Position can be reversed easily. Since future contract are interchangeable, position can be offset by making an opposite contract in the same commodity. Profits or losses from futures would offset losses or profits from the spot transaction. Besides, future contract allows the trader to hedge big amounts and make a higher return for a smaller initial outlay. Margin buying allows use of leverage. Leverage is the ability to obtain a given equity position at a reduced capital investment, thereby magnifying total return. An investor can purchase a futures contract for less outlay and benefit from a price move in the underlying instrument. This can amplify the profit for the investor. There are no premium charge is associated with futures market contracts (Eric & Gregory, 2010). It allows using a limited amount of invested funds to achieve greater gains. Furthermore, investor can protect their portfolio from a drop in value by using hedging. The main objective of hedging is to reduce the risk (John, 2010, p.47). Since the price is variable and continuous fluctuating, hedging can reduce the risk of adverse price movements in an asset. Hence, it can reduce the loss for the investor. Besides, investors no need to worry about the credit risk. It is because the transaction of future contract is backed by clearing house. Therefore, counterparty risk is reduced.

Disadvantages of future contract

Future contract may exposes to basic risk. Basic can be defined as the different between a specific cash price and a specific future price. (Allen, Richard & John, n.d.). Basic risk is the difference between the futures price and the spot price. This problem occurred when uncertain relationship between future price movement and cash price movement. According to Eric & Gregory (2010), as the portfolio increases or decreases, the futures hedge could increase by a smaller or larger amount, causing mark to market losses. Next, in the future contract, it is unable to take advantage of favorable price moves. Any losses or profits in the spot transaction would be offset by profits or losses from the futures transaction. Besides, it may expose to market risk too. Market risk is the risk of losses in positions arising from movements in market prices. Market risk is systematic risks, it cannot be eliminated through diversification. Systematic risk is risk associated with market returns (Ken, n.d.). Since the price is fluctuating and uncertainty involved, it cannot guarantee a profit to the investor. Future contract is subject to margin calls (Lynn, 1999). Margin call is the notification of the need to bring the equity of an account whose margin is below the maintenance level up above the maintenance level. Initial margin or deposit must be paid first before the investor can take a position in the futures market. When the trader closes his or her position, that deposit only will be returned. The initial and daily variation margins can cause significant cash flow burden on traders or hedgers. Due to future contracts are marked to market, investors need pay up daily variation margins. Furthermore, futures contract has standardized features and written for fixed amounts and terms (Ahamed, n.d.). The contracts cannot be customized, after certain exchange of promises or contracts. It makes the perfect hedging not possible. The future contract is tied to legal obligation. The long and short position holders have the obligation to carry out a transaction. Lower commission costs can encourage a trader to take additional trades and lead to over-trading.

Conclusion

The future market is a global marketplace, initially created as a place for farmers and merchants to buy and sell commodities for either spot or future delivery. Now, future market developed into a market where contract for future delivery of a commodity or a financial instrument are bought or sold. Future market provides liquidity where buyer and seller trade future contract easily. Futures markets are the market which prefers buy and sell futures contracts rather than buying and selling in physical commodities. Futures contract is one of the derivatives that traded in the futures market. Thus, the specification of a futures contract is used to acknowledge the investors as a guideline. Also, there are some of the fundamental requirement such as the margin requirement is must be followed by the traders and brokers in order to having the future agreement. Besides, there are two most important players in the futures market, hedgers and speculators. A hedger tries to maximize the value of their assets and on the other hand to reduce the risk of financial losses from the price changes. Inversely, the speculator will try to profit from the risks by buying or selling now in anticipation of rising or declining prices. Buying and selling in the futures market seems to be risky and complicated. Future contract may exposes to basic risk and market risk. However, since future contract are interchangeable, position can be offset by making an opposite contract in the same commodity. This was done to lessen the risk of waste and scarcity as well as losses or profits from the spot transaction. Futures contracts' accounts are credited or debited depending on profits or losses incurred every day. The futures market is also characterized as being highly leveraged due to its margins; although leverage works as a double-edged sword. It is significant to understand the arithmetic of leverage when calculating profit and loss, as well as the minimum price movements and daily price limits at which contracts can trade. The most common strategies used when trading on the futures market are "Going long," "going short," and "spreads". There are some important terms in the future contract. The most important is margin. Margin is the minimum level of cash that should occur in the margin account in order to reduce the risk of the investors. There are several ways to take part in the futures market. However, all of them involve risk. If we decided to trade in commodities, we can trade by using own account, a managed account or join a commodity pool.

Recommendations

Generally, the futures market exists of a few discontented characteristics. There is some of the example that should be improved in order to enhance the efficiency and effectiveness for the futures market in order to offer the traders a better service in the following: Underlying data Futures market regulators have to promote improvements time to time about the accessibility and quality of information on commodities which are related to commodity futures so that the future market's uncertainty can be minimized. The investors also can understand the future market's fundamentals by more information. In the same time, the regulator can also encourage the data providers to provide and improve the level of detail for the published data. For example, it might be possible for certain data suppliers to publish not only aggregate inventory and storage data but regional data too. Besides, futures market regulators must promote the transparency in the underlying market. Futures market regulators should encourage market investors to publish appropriate information as soon as possible. Furthermore, futures market regulators should encourage private sectors that collect important fundamental commodity information to adopt best practices and also evaluate what improvements are suitable to ensure that the fundamental cash market data and recommendations for improvements could be enhanced. OTC data Futures market regulators should also examine what improvements are suitable to improve the access to and the usefulness of, OTC derivatives market data and develop recommendations for improvement. This is because Over-The-Counter is an important market for trading the future contract. The OTC market consists of many buyers and sellers because of its system which is easy buy and sell system. So, OTC data is considered significant in the future market because it contain a lot of securities' information. Data dissemination Disseminators of cash market data are relied upon by markets and commercial users. Where appropriate, ways in which the reliability of this market data could be improved should be considered. For instance, the requiring accountability for false and misleading data, the encouraging the development of best practices and the increasing of transparency of methodologies are the example of the ways for the improvement.

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