2-Financial Markets Page 59 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 59Futures contracts are marked to market at the end of each trading
day. Consequently, futures contracts are subject to interim cash flows as
additional margin may be required in the case of adverse price move-
ments, or as cash is withdrawn in the case of favorable price move-
ments. A forward contract may or may not be marked to market,
depending on the wishes of the two parties. For a forward contract that
is not marked to market, there are no interim cash flow effects because
no additional margin is required.
Finally, the parties in a forward contract are exposed to credit risk
because either party may default on the obligation. Credit risk is mini-
mal in the case of futures contracts because the clearinghouse associated
with the exchange guarantees the other side of the transaction.
Other than these differences, most of what we say about futures
contracts applies equally to forward contracts.Risk and Return Characteristics of Futures Contracts
When an investor takes a position in the market by buying a futures
contract, the investor is said to be in a long position or to be long
futures. If, instead, the investor’s opening position is the sale of a
futures contract, the investor is said to be in a short position or short
futures. The buyer of a futures contract will realize a profit if the futures
price increases; the seller of a futures contract will realize a profit if the
futures price decreases; if the futures price decreases, the buyer of the
futures contract realizes a loss while the seller of a futures contract real-
izes a profit. Notice that the risk-return is symmetrical for a favorable
and adverse price movement.
When a position is taken in a futures contract, the party need not
put up the entire amount of the investment. Instead, only initial margin
must be put up. Thus a futures contract, as with other derivatives,
allows a market participant to create leverage. While the degree of
leverage available in the futures market varies from contract to contract,
the leverage attainable is considerably greater than in the cash market
by buying on margin. While at first the leverage available in the futures
market may suggest that the market benefits only those who want to
only speculate on price movements. This is not true. Futures markets
can be used to reduce price risk. Without the leverage possible in futures
transactions, the cost of reducing price risk using futures would be too
high for many market participants.Pricing of Futures Contracts
In later chapters we will see how the mathematical tools presented in
this book can be applied to valuing complex financial instruments.