2-Financial Markets Page 57 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 57FUTURES AND FORWARD CONTRACTS
A futures contract is an agreement that requires a party to the agree-
ment either to buy or sell something at a designated future date at a pre-
determined price. Futures contracts are products created by exchanges.
To create a particular futures contract, an exchange must obtain
approval from the Commodity Futures Trading Commission (CFTC), a
government regulatory agency. When applying to the CFTC for
approval to create a futures contract, the exchange must demonstrate
that there is an economic purpose for the contract. Futures contracts are
categorized as either commodity futures or financial futures. Commod-
ity futures involve traditional agricultural commodities (such as grain
and livestock), imported foodstuffs (such as coffee, cocoa, and sugar),
and industrial commodities. Futures contracts based on a financial
instrument or a financial index are known as financial futures. Financial
futures can be classified as (1) stock index futures, (2) interest rate
futures, and (3) currency futures.
A party to a futures contract has two choices on liquidation of the
position. First, the position can be liquidated prior to the settlement
date. For this purpose, the party must take an offsetting position in the
same contract. For the buyer of a futures contract, this means selling the
same number of identical futures contracts; for the seller of a futures
contract, this means buying the same number of identical futures con-
tracts. The alternative is to wait until the settlement date. At that time
the party purchasing a futures contract accepts delivery of the underly-
ing (financial instrument, currency, or commodity) at the agreed-upon
price; the party that sells a futures contract liquidates the position by
delivering the underlying at the agreed-upon price. For some futures
contracts settlement is made in cash only. Such contracts are referred to
as cash-settlement contracts.
Associated with every futures exchange is a clearinghouse, which
performs two key functions. First, the clearinghouse guarantees that the
two parties to the transaction will perform. It does so as follows. When
an investor takes a position in the futures market, the clearinghouse
takes the opposite position and agrees to satisfy the terms set forth in
the contract. Because of the clearinghouse, the investor need not worry
about the financial strength and integrity of the party taking the oppo-
site side of the contract. After initial execution of an order, the relation-
ship between the two parties ends. The clearinghouse interposes itself as
the buyer for every sale and the seller for every purchase. Thus investors
are free to liquidate their positions without involving the other party in
the original contract, and without worry that the other party may
default. In addition to the guarantee function, the clearinghouse makes