Introduction to Corporate Finance

23: Introduction to Financial Risk Management

(sale) position also changes – and one party’s gain is the other party’s loss. By requiring each contract’s

loser to pay the winner the net amount of this change each day, futures exchanges eliminate the possibility

that large, unrealised losses will build up over time. In a forward contract, on the other hand, there are

no cash flows until termination of the contract.

example

As an example of marking-to-market, consider the
gold futures discussed previously. Recall that the settle
price for the October 2015 contract was $1,138.10
per troy ounce. If the settle price on the next business
day is $1,138.70/oz, the person with the long position
will receive $0.60/oz (the new futures price minus the
original futures price), or a total of $60.00 per contract
($0.60/oz × 100 troy ounces). The person with the
short position must pay $0.60/oz. In effect, the new
contract with a futures price of $1,138.70/oz replaces

the original contract. The party with the long position

is compensated (and the person with the short

position must pay) for the increase in the futures price.

This type of daily settlement takes place on every

trading day until delivery takes place. It is important

to note that the party with the long position ultimately

ends up paying a total of $1,138.10/oz, and the party

with the short position receives a total of $1,138.10/

oz upon delivery if each party holds his or her contract

until maturity.

When taking a position in a futures contract, the investor must deposit a minimum dollar amount

called the initial margin, which varies by contract, in a margin account. The investor deposits gains in or

withdraws losses from this account. Each exchange has margin requirements, and brokerage companies

may require additional margin above the minimum specified. If losses deplete the margin below the level

needed to maintain an open position, the maintenance margin, the investor must deposit additional funds

in the account to bring the account back to the initial margin. Failure to deposit additional funds before

the next day’s trading results in the position being closed out by the exchange.

In addition to these distinctions, futures differ from forward contracts in two other important

respects. First, futures contracts are designed to have a low enough value that will appeal to a retail

market of individuals and smaller companies, whereas most actively traded forward contracts have

minimum denominations of $1 million or more. For example, in Australia, the SFE SPI 200 futures

contract is generally one of the most heavily traded contracts. It is valued at $25 per index point.^6 This

small contract size is rarely a problem for futures traders, however, as those wishing to hedge large

exposures can simply purchase multiple contracts. Second, most forward contracts are settled by actual

delivery, but this rarely occurs with futures contracts. Instead, futures market hedgers will execute an

offsetting trade to close out their position in the futures market whenever they have closed out their

underlying commercial risk through delivery in the normal course of business.

The ability to close out a position by taking an offsetting position is referred to as fungibility. Fungibility is

made possible because the counterparty in a futures contract is the clearinghouse and because futures contracts

are settled daily. If an investor were to take a long position in a futures contract and subsequently take a short

position in the same contract, the contracts would cancel each other out for two reasons: (1) after marking-to-

market, the futures prices of the two contracts would be the same; and (2) the clearinghouse is the counterparty

to both contracts. It is important to note that unless buyers or sellers close out their positions, they are required

to make or take delivery of the underlying asset.

6 Details of this contract can be viewed at http://www.asx.com.au/products/index-derivatives/asx-index-futures-contract-specifications.htm.

initial margin

The minimum dollar amount

required of an investor when

taking a position in a futures

contract

margin account

The account into which a

futures contract investor must

deposit the initial margin

maintenance margin

Margin level required in a

futures contract to maintain

an open position

fungibility

The ability to close out a

futures contract position by

taking an offsetting position