A futures contract is a legally binding agreement to buy or sell a commodity or financial instrument at a later date. Futures contracts are standardized according to the quality, quantity and delivery time and location for each commodity. The only variable is price. (NFA)
A physical delivery futures contract will result in the actual delivery of the underlying commodity or instrument, usually into a warehouse or settlement bank. In the cash settled future, the person who buys a futures contract will get a cash value equivalent to what the final settlement value of the futures contract is when the futures expired. It is important to note that even in the case of physical delivery futures, very few futures contracts actually go into delivery. Rather, the buyer of the futures contract will sell that futures contract before the first delivery date and buy a new future with more time to expiration.
Futures contract prices are a function of what is gained or lost by holding a futures contract instead of the actual underlying commodity or instrument. For example, if someone were to hold a silo of corn, they would need to pay storage costs and would be tying up funds that could be invested in an interest bearing account in the meantime by waiting to sell that silo of corn. The futures contract price will be higher than the cash corn price because the buyer of the futures is avoiding the storage costs and cost of carrying the corn without earning interest. Similarly, the holder of a bond will be earning interest on the bond, so the cost of a futures contract would have to be lower than the bond’s price to compensate the futures buyer for not earning the interest.
There are two components to future margin: the initial margin or performance bond and variation margin. The buyer or seller of a futures contract will be required by the futures clearing house to post a percentage of the value of the contract value of the contract to insure that they will perform if the futures price goes against the trade price. This performance bond is higher for more volatile commodities and lower for less volatile commodities. The buyer or seller of a future contract is also responsible for paying variation margin if the current price of the contract is worse than the trade price of the future. The variation margin is calculated based on the daily settlement and whoever is profiting from the future will receive variation margin and whoever is losing money from the future will have to pay variation margin.
Futures delivery occurs after a specific data as defined by the exchange. When the buyer of a futures contract decides to take delivery, he will notify the exchange on a defined notice date and will put in arrange to take delivery of the commodity or instrument on a specified delivery date. The seller of the future will be obligated to locate the commodity or instrument and make delivery.
The daily settlement price is determined by the exchange based on predefined rules as to what the closing time is and how the last trade is determined. Official settlement prices are used by the clearing house to calculate margins and to calculate cash settlement in delivery.
The value of the futures contract is its price times multiplied by the exchange-defined tick value. Unlike with securities, the contract value is not always a function of the quantity of the underlying, especially in index-based contracts like the short-term interest rate contract. Accordingly, the “notional value” of a futures contract is not used as a measure of risk.
The minimum tick size of a future contract is the minimum increment at which a contract can trade and is defined for each contract by the exchange.
The futures delivery value will be calculated by the clearing house based on pre-defined multipliers that convert the commodity or instrument being delivered to the benchmark defined by the exchange for each contract. For example, a commodity that does not meet the exact grade specifications of the contract will be multiplied by a pre-defined multiplier to convert it to an equivalent amount or grade of the contract specification. A bond with a coupon of 4% will be subject to a multiplier to make it equivalent to the 6% coupon and 7 year maturity of the bond contract specification.
Volume is defined as the number of contracts traded in a given time period. Generally, both the buy and the sell of the contract are calculated as separate in volume figures. Open Interest is the number of futures contracts that are open and not offset on a given day.
As a seller of a future, I will be obligated to obtain the defined quantity of the underlying commodity or instruments and delivery them to the pre-defined warehouse or settlement bank. If for some reason I cannot obtain the actual commodity due to shortages, I will have to pay a daily penalty until I can obtain the commodity.
As with option contracts, Clearing Houses are the issuers of futures contracts. A buyer of the futures contract buys a contract from the Clearing House and a Seller of a contract sells the contract to the clearing house. The Clearing House is responsible for settling all the trades, collecting margins, and making delivery happen. If a buyer or seller defaults on its margin payments, the Clearing House will be responsible for making the trade good to the other side.
Since Clearing Houses are the issuers of all futures contracts, substantially identical contracts that trade on different exchanges and do not clear the same Clearing House cannot be offset by trading on the separate exchanges. Rather each contract must be margined separately.
The Exchange assigns market makers to make a price in the futures contract including a settlement price on a daily basis. Market Making prices are carefully monitored according to rules designed to prevent market manipulation.