• Let us go by the example of mango pulp. The mango pulp company backs off from their commitment after a few days because they feel that they cannot purchase mangoes at the agreed price. This decision could create problems between the pulp company and the farm owner.
• Contracts are tailor-made according to the prevailing situations and made to varying sums of money and terms. These contracts can create quite a lot of confusion at a later date. Nothing gets regulated in a forwards contract.
• When all aspects in a contract like a price, quantity, and date of expiry, is fixed, and one can buy and sell the contract at any time, it is called a futures contract. Here, the contract performance and liquidity are regulated and guaranteed by someone.

The difference between forwards and futures contracts is that futures contracts are well regulated. It is an agreement where the seller promises the buyer to deliver a fixed quantity of a share or commodity or forex on a particular future date at a price decided by the parties today. The clearinghouse ensures that both parties fulfill their obligations.

How does the clearinghouse ensure this?

Both buyer and seller have to pay the clearinghouse a percentage of the total value of shares or commodity or forex, called the ‘Initial Margin money’. The contract is bound to the market on a real-time basis. The futures contract is ‘marked to market’ or, in other words, the value keeps fluctuating. Both by the buyer and the seller must maintain a certain amount of funds with the clearinghouse.

The possibility of default is nil because the stock exchange, in the case of stock futures, and commodity exchange in the case of commodity futures, has the responsibility to collect the payments and make the settlements.

All trades consists of two parts where both the buyer and seller must fulfill their obligation to the clearinghouse separately. Even if one of the parties were to default, the clearinghouse is responsible for the performance.

In a futures contract, when one has the ‘right to buy’, the clearinghouse will take a ‘sell’ position. In the same way, when one has the ‘right to sell’, the clearinghouse will take a ‘buy’ position so that the performance of the contract is guaranteed.

In a nutshell, ‘future contracts’ can be traded like shares. For example, the following features will be incorporated in the contract when ‘Infosys September Futures’ is issued by the exchange.

• Specific quantity: Every futures contract will have a ‘specified quantity’ mentioned. Let us assume it is 100 in this case.
• Specified share: If one has entered into a futures contract to buy 100 Infosys shares, 100 Infosys shares have to be delivered and not 100 reliance shares.
• Specified date: The exchange decides the month and date of delivery. Presently, the settlement of the contracts is on the last Thursday of the month.
• The clearinghouse plays a prominent role while trading in futures contracts. They do all the back-office operations and guarantees the performance of both sides. There is no risk of default, and ‘Infosys September futures contract’ becomes a standard asset traded on the exchange.

MARGIN MONEY

To enter into futures contracts, it is not necessary to bring in all the money. For example, if Infosys shares are trading at Rs. 1000, and if one would like to enter into one lot of ‘Infosys September futures contract’, each lot consisting of 100 Infosys shares, one need not bring 100*1000 rupees. Instead, one would be required to maintain a small margin with the broker. The exchange decides the margin amount, and this margin amount will fluctuate depending on the changes in daily prices. The margin of the buyer gets reduced when the price goes up, and the margin of the seller increases by an equal amount.

The margin of the buyer increases when the price goes down. And the margin of the seller reduces by an equal amount.

Let us assume you bought a futures contract of 100 shares of Infosys at the current future price of Rs. 1000 per share, and the date of the settlement being last Thursday of September. Assuming that the exchange requires a 20% margin money and so you pay a margin of Rs. 20,000, and there is a sudden crash in the price of Infosys share, and it dips to Rs. 900, you stand to lose Rs. 100 a share, – which for 100 shares is Rs. 10,000! Your initial margin of Rs.20000 got reduced by Rs.10000 due to a loss of Rs.100 per share.

To keep the contract alive, you have to maintain an Rs.18000 margin at the current price. As you now have only Rs.10000 margin in your account, you have to provide an additional Rs.8000.

There is active trading in Futures contracts. As nobody decides the price of the future, you can sell the contract to someone else once you have bought the futures contract.

Let us say that a contract bought for Rs. 1000 is now trading at Rs. 1100. You can sell it and make a profit of Rs. 100 a share. So for 100 shares, you make Rs. 10,000 profit, and the exchange will return your margin and take a margin from the new contract owner.

Here are some points that differentiate forwards and futures:-

1. In the case of a forwards contract, the size of the contract is decided by the parties involved. The exchange fixes the margin in the case of a futures contract. In the case of equity futures, the ‘lot’ size is pre-determined for each share.

2. In a forward contract, the price of the contract is decided by the parties involved. The price remains the same until the end of the contract period. In a futures contract, the price fluctuates according to the movement of price daily. ‘Marked to market' in technical terms.

3. The margin money in a forwards contact may or may not be needed, and would depend on how they agree. In the futures contract, The exchange decides the margin money. It is a percentage of the value of the contract. Both buyer and seller must pay the margin money. The requirement of the settlement of margin is a daily affair, as it is 'marked to market'.

4. There can be any number of forward contracts whereas, in a futures contract, the exchange decides the number of contracts.

5. Settlement in case of a forwards contract is over the counter (OTC). And it is through the exchange in case of a futures contract.

6. In a forwards contract, the mode of delivery can be either delivery or cash settlement. In the case of a futures contract, they are usually cash-settled.