Futures

FUTURES
A Future contract is one where two people agree on a price in the present for delivery to be affected at some point of time in the future. We had earlier defined this as a Forward contract also. When trade flourished, the number of such contracts began increasing rapidly and it was becoming increasingly difficult for people to find a counter party to trade with. Forward contracts are individualized contracts between two people who agree specifically on different clauses of their contract. If the contract has to be changed for any reason, then it can be done so by these two people alone. Such an arrangement led to considerable hardship when events did not transpire quite as had been expected. One of the parties would often fail in the commitment and this would lead to losses for the other. There was no room for redressal as the contract was between the two parties alone.
Thus was Futures born. A Futures contract was a standardized contract (as against a customised Forward contract) where the goods to be delivered, the quantity, the quality, the date of delivery and the rate were all fixed and made known to the entire market. The standardization meant that one was no longer reliant on just a one-to-one deal with another party. Instead, one could now go to the market and seek to trade in the contract suiting one’s purpose. Thus, instantly, liquidity was imparted to the market. We know as a simple rule of economics, that liquidity is the lifeblood of any market. Further, the Exchange where these contracts traded, itself began to sit in on arbitration and guaranteed the performance of the contract by both parties. This eliminated the second greatest risk of forward contracts – the counterparty risk. To ensure the performance by both parties, the exchange demanded good faith deposits of money (called the Margin) from both. This margin was held by the exchange in order to ensure that the obligation was fulfilled.
Financial Futures
Futures initially evolved as a medium to enter into trade in the commodity markets. But soon, they entered into the financial markets also. The financial markets are the most active ones in the world and the number and variety of transactions that occur are several times the transactions that occur in the other markets.
There are small differences between commodity and financial futures. The main one is the function of delivery. Commodity futures were contracts, which were completed with the delivery of the contracted goods. The wheat farmer, as in the example cited earlier, would deliver the wheat to the bread producer and collect payment. In the financial futures, there was no delivery to be made because the future contract was based on an Index of stocks. Now, one cannot really deliver a basket of stocks composing the index. Hence financial futures were all cash settled.
Index based Future Contracts.
The financial futures, as stated, were based on an Index. One must therefore understand what an index is. Everyone knows the definition of an index – it is an average of component stocks. We have popular indices in India such as the BSE Sensex and the S&P-CNX Nifty and abroad, we have indices such as the Dow Jones Industrial Averages, the Nasdaq Composite, the Footsie (FTSE) in London, the DAX in Germany, and the Nikkei in Japan etc.
A stock index represents the change in value of a set of stocks that constitute the index. It is a relative value because it is expressed as a weighted average of prices at some particular date usually called the base period. The index should represent the market and be able to represent the returns obtained by a typical portfolio of that market. An index acts as a barometer for market behaviour. It should therefore be composed of a list of well-diversified stocks. The Sensex and the Nifty are weighted by the market capitalization of the individual stocks. The Sensex consists of 30 stocks while the Nifty is composed of 50 stocks.
An Index future would therefore be representative of the trends of the market as a whole. It enables players to take a view on the market rather than the individual stocks. Granted, it would predominantly be the view on the stocks comprising the index. But we have already seen that the composition of the index is such that these stocks actually represent the likely returns that can be achieved by the majority of the stocks. Hence, the index future is actually like owning a portfolio of stocks that dominate the market.