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The clearinghouse moves money between the participants, crediting gains to the winners and charging losses to the losers. By doing this on a daily basis, the gains and losses are typically quite small, and the margin balances help ensure that the clearinghouse will collect from the party losing money. As an extra precaution, in fast-moving markets, the clearinghouse can make margin calls during the day, not just at the end of the day. Yet there still remains the possibility that a party could default. A large loss could occur quickly and consume the entire margin balance, with additional money owed.8 If the losing party cannot pay, the clearinghouse provides a guarantee that it will make up the loss, which it does by maintaining an insurance fund. If that fund were depleted, the clearinghouse could levy a tax on the other market participants, though that has never happened.

Some futures contracts contain a provision limiting price changes. These rules, called price limits, establish a band relative to the previous day’s settlement price, within which all trades must occur. If market participants wish to trade at a price above the upper band, trading stops, which is called limit up, until two parties agree on a trade at a price lower than the upper limit. Likewise, if market participants wish to trade at a price below the lower band, which is called limit down, no trade can take place until two parties agree to trade at a price above the lower limit. When the market hits these limits and trading stops, it is called locked limit. Typically, the exchange rules provide for an expansion of the limits the next day. These price limits, which may be somewhat objectionable to proponents of free markets, are important in helping the clearinghouse manage its credit exposure. Just because two parties wish to trade a futures contract at a price beyond the limits does not mean they should be allowed to do so. The clearinghouse is a third participant in the contract, guaranteeing to each party that it ensures against the other party defaulting. Therefore, the clearinghouse has a vested interest in the price and considerable exposure. Sharply moving prices make it more difficult for the clearinghouse to collect from the parties losing money.

Most participants in futures markets buy and sell contracts, collecting their profits and incurring their losses, with no ultimate intent to make or take delivery of the underlying asset. For example, the long may ultimately sell her position before expiration. When a party re-enters the market at a later date but before expiration and engages in the opposite transaction—a long selling her previously opened contract or a short buying her previously opened contract—the transaction is referred to as an offset. The clearinghouse marks the contract to the current price relative to the previous settlement price and closes out the participant’s position.

At any given time, the number of outstanding contracts is called the open interest. Each contract counted in the open interest has a long and a corresponding short. The open interest figure changes daily as some parties open up new positions, while other parties offset their old positions. It is theoretically possible that all longs and shorts offset their positions before expiration, leaving no open interest when the contract expires, but in practice there is nearly always some open interest at expiration, at which time there is a final delivery or settlement.

When discussing forward contracts, we noted that a contract could be written such that the parties engage in physical delivery or cash settlement at expiration. In the futures markets, the exchange specifies whether physical delivery or cash settlement applies. In physical delivery contracts, the short is required to deliver the underlying asset at a designated location and the long is required to pay for it. Delivery replaces the mark-to-market process on the final day. It also ensures an important principle that you will use later: The futures price converges to the spot price at expiration. Because the short delivers the actual asset and the long pays the current spot price for it, the futures price at expiration has to be the spot price at that time. Alternatively, a futures contract initiated right at the instant of expiration is effectively a spot transaction and, therefore, the futures price at expiration must equal the spot price. Following this logic, in cash settlement contracts, there is a final mark to market, with the futures price formally set to the spot price, thereby ensuring automatic convergence.

In discussing forward contracts, we described the process by which they pay off as the spot price at expiration minus the forward price, STF0(T), the former determined at expiration and the latter agreed upon when the contract is initiated. Futures contracts basically pay off the same way, but there is a slight difference. Let us say the contract is initiated on Day 0 and expires on Day T. The intervening days are designated Days 1, 2, …, T. The initial futures price is designated f0(T) and the daily settlement prices on Days 1, 2, …, T are designated f1(T),f2(T), …fT(T). There are, of course, futures prices within each trading day, but let us focus only on the settlement prices for now. For simplicity, let us assume that the long buys at the settlement price on Day 0 and holds the position all the way to expiration. Through the mark-to-market process, the cash flows to the account of the long will be

f1(T) – f0(T) on Day 1
f2(T) – f1(T) on Day 2
f3(T) – f2(T) on Day 3
fT(T) – fT–1(T) on Day T

These add up to

fT(T) – f0(T) on Day T.

And because of the convergence of the final futures price to the spot price,

fT(T) – f0(T) = STf0(T),

which is the same as with forward contracts.9 Note, however, that the timing of these profits is different from that of forwards. Forward contracts realize the full amount, STf0(T), at expiration, whereas futures contracts realize this amount in parts on a day-to-day basis. Naturally, the time value of money principle says that these are not equivalent amounts of money. But the differences tend to be small, particularly in low-interest-rate environments, some of these amounts are gains and some are losses, and most futures contracts have maturities of less than a year.

But the near equivalence of the profits from a futures and a forward contract disguises an important distinction between these types of contracts. In a forward contact, with the entire payoff made at expiration, a loss by one party can be large enough to trigger a default. Hence, forward contracts are subject to default and require careful consideration of the credit quality of the counterparties. Because futures contracts settle gains and collect losses daily, the amounts that could be lost upon default are much smaller and naturally give the clearinghouse much greater flexibility to manage the credit risk it assumes.

Unlike forward markets, futures markets are highly regulated at the national level. National regulators are required to approve new futures exchanges and even new contracts proposed by existing exchanges as well as changes in margin requirements, price limits, and any significant changes in trading procedures. Violations of futures regulations can be subject to governmental prosecution. In addition, futures markets are far more transparent than forward markets. Futures prices, volume, and open interest are widely reported and easily obtained. Futures prices of nearby expiring contracts are often used as proxies for spot prices, particularly in decentralized spot markets, such as gold, which trades in spot markets all over the world.

In spite of the advantages of futures markets over forward markets, forward markets also have advantages over futures markets. Transparency is not always a good thing. Forward markets offer more privacy and fewer regulatory encumbrances. In addition, forward markets offer more flexibility. With the ability to tailor contracts to the specific needs of participants, forward contracts can be written exactly the way the parties want. In contrast, the standardization of futures contracts makes it more difficult for participants to get exactly what they want, even though they may get close substitutes. Yet, futures markets offer a valuable credit guarantee.

Like forward markets, futures markets can be used for hedging or speculation. For example, a jewelry manufacturer can buy gold futures, thereby hedging the price it will have to pay for one of its key inputs. Although it is more difficult to construct a futures strategy that hedges perfectly than to construct a forward strategy that does so, futures offer the benefit of the credit guarantee. It is not possible to argue that futures are better than forwards or vice versa. Market participants always trade off advantages against disadvantages. Some participants prefer futures, and some prefer forwards. Some prefer one over the other for certain risks and the other for other risks. Some might use one for a particular risk at a point in time and a different instrument for the same risk at another point in time. The choice is a matter of taste and constraints.

The third and final type of forward commitment we will cover is swaps. They go a step further in committing the parties to buy and sell something at a later date: They obligate the parties to a sequence of multiple purchases and sales.

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