The Futures Contract: Standardised, Cleared and Margined

A futures contract binds both sides today to trade the reference asset later at a price fixed today. The exchange fixes what one contract covers and the date it runs to, so the two sides agree on price alone. A clearing corporation then stands between them, each side posts margin before anything moves, and gains and losses settle every day rather than once at the end.

Two people can agree a price today for something that changes hands later, and the moment they do, each of them is carrying the other's promise. Carrying a stranger's promise is the whole problem, and every arrangement below is one answer to it. Standardisation, so the promise is the same shape for everybody. A party in the middle, so nobody is carrying a specific stranger. Margin, so the promise is collateralised before it is carried. Daily settlement, so the promise never grows large enough to be worth breaking.

Everything here runs on one invented reference asset. Its price today is Rs 2,000.00/-, the money to buy it costs 6.50 per cent a year, and it pays nothing at all while it is held. The absence of a payout is not decoration. A referenced thing that paid something out during the holding period would change every figure in this guide, and this worked example does not contain one.

One number does most of the work in this guide, and it is the price agreed for a year out: Rs 2,130.00/-. It is multiplied into existence rather than quoted, what it is not is set out plainly, and it is followed through to settlement. The number reads as arithmetic every time it appears. The single most damaging mistake anywhere in this subject is to read it as somebody's opinion about where the reference asset is going next.

What are the four moments every futures contract turns on?

Four moments, and they are named in this order every time. When the obligation is struck. When the money actually moves. When the reference asset moves. And what sits in the gap between them. The agreement is today and the money is later, and that one separation is what makes a contract of this kind a different object from a purchase.

Start with a stall outside one office building. In April the person running it agrees with a wholesaler what it will pay for its winter stock in October. The price is settled in April. Nobody hands over money in April and nobody hands over stock in April. The money and the stock are October's business. And every single thing that can go wrong lives in the six months in between: the wholesaler's warehouse, the stall's cash position, and the price of the same stock in September when it turns out the agreed number now looks foolish to one of them.

A futures contract is that arrangement with the six months in the middle engineered. The engineering takes the ordinary promise and asks, one question at a time, what would have to be true before a stranger would stand on the other side of it. Every answer that follows is plumbing, and none of them changes what was promised.

On the day the price is agreed, nothing has moved. No money has passed from either side to the other, no reference asset has changed hands, and neither party is better or worse off than the moment before. The stillness of day one is the point rather than an oversight, and a reader who goes looking for a payment then is looking for something that belongs to a different kind of instrument. Money will start moving on day two, and it will move on every day after that, but it will move as settlement of a change in price and never as a payment for the contract itself.

How Futures Contracts Work: what does the contract bind each side to do?

The contract binds one side to buy the reference asset at the agreed price on the agreed date, and it binds the other side to sell the reference asset at that same price on that same date. Both sides are bound from the moment the price is agreed, and neither of them acquired anything that lets them step out of it. The party bound to buy cannot decline to buy. The party bound to sell cannot decline to sell.

The side bound to buy is called the long positionThe side of a contract that is bound to buy the referenced thing at the agreed price on the agreed date.. The side bound to sell is called the short positionThe side of a contract that is bound to sell the referenced thing at the agreed price on the agreed date.. Long and short do nothing more exotic than name which end of the obligation somebody is standing at, and they carry that sense and no other.

Now the part that catches people. Neither side paid the other anything to enter. No fee, no consideration and no entry cost passes between them. A premium therefore never enters the arithmetic of a futures contract. A premium is what somebody pays to acquire something they may later choose to use. Nobody chose anything here, so nobody paid for the privilege of choosing. The absence of a premium is not a discount and it is not a feature: it is the direct consequence of both sides being bound rather than one side being entitled.

Think about what that does to the shape of the arrangement. In a purchase, one party hands over money and receives a thing, and after that neither of them is carrying the other at all. Here, no money has been handed over, no thing has been received, and both parties are carrying each other for the whole of the stretch to the final date. The obligation is symmetric. If the price of the reference asset climbs, the long position is better off by exactly what the short position is worse off by, to the rupee.

There is a household version worth holding on to. Two neighbours agree in March that one will buy the other's second-hand scooter in December for a fixed sum. Nobody pays anything in March. In December the seller cannot decide the scooter has become too valuable to part with, and the buyer cannot decide they no longer want a scooter. Both are bound. March has created neither a purchase nor a right. A mutual obligation with a date on it is what the two neighbours now hold, and what follows is what a market has to build so that strangers can create the same object safely.

A contract that let one side walk away in exchange for something paid up front would be a different instrument entirely, with a different name and different arithmetic, and it is covered separately.

What does standardisation actually remove from the conversation?

A plain bilateral agreement, meaning an agreement struck directly between two parties today for a price paid later, leaves everything open. How much. Of what exactly. On what date. Delivered how, and to where. Against what security, and reviewed how often. Who the other party is and whether they will still be there. Six conversations, and the price is only one of them.

StandardisationFixing every term of a contract in advance except its price. Any two contracts of the same description are then interchangeable. removes every one of those from the conversation except the price. The exchange fixes the size of one contract and what it stands on. The exchange also fixes the dates that contracts run to, and fixes how the thing is delivered or whether it is delivered at all. Two parties arriving at the screen have exactly one thing left to disagree about, and they disagree about it in public.

The exchange makes those settings under the framework of the Securities and Exchange Board of India at sebi.gov.in. Contract sizes and expiries differ from one contract to another and are changed from time to time. A contract size or an expiry written out from recollection would not be merely out of date on the day it changed, it would be wrong, and the reader would have no way of telling which.

So what does the reader get in exchange for losing five conversations? Every contract of the same description becomes interchangeable with every other one. A position can therefore be closed against anybody at all rather than against the specific party it was opened with. Interchangeability is the whole of what standardisation buys, and it is a bigger prize than it sounds.

The alternative is worth considering. If an agreement specifies a quantity nobody else uses, a date nobody else picked and a delivery arrangement written for one particular warehouse, then the only person in the world who can release a party from it is the person they struck it with. A party in that situation is not holding a position, it is holding a relationship. Standardisation converts a relationship into a line item, and a line item can be closed by anybody who is willing to take the other end of the same standard object.

Notice what standardisation does not do. Standardisation does not make the obligation smaller, safer or easier. Both sides are bound in exactly the way they were bound before, on exactly the same terms. Standardisation changes who they can be bound to and how easily they can stop being bound, and it changes nothing whatever about what was promised.

Who stands between the two sides once the price is agreed?

A clearing corporationThe party that steps into a matched contract and becomes buyer to every seller and seller to every buyer. Neither original side then faces the other.. Once the price is agreed, it steps into the middle of the matched contract and becomes the buyer to every seller and the seller to every buyer. One promise between two named parties is replaced by two promises, each facing the middle. Neither of the original two sides is carrying the other any more, and after that moment neither of them has any claim on or exposure to the other at all.

The party that actually faces the clearing corporation on a participant's behalf is called the clearing member. A participant deals through a clearing member, the clearing member faces the clearing corporation, and the chain is deliberately short and deliberately fixed. Who may be a clearing member, what they must hold and what happens when one of them fails are all set under the framework of the Securities and Exchange Board of India at sebi.gov.in, and none of it is stated here.

Stepping into the middle has a consequence a reader is rarely shown directly. A position can be closed against somebody the holder has never dealt with. After the moment of matching nobody was facing the party opened with, so no release has to be asked of them. An equal and opposite position is entered with whoever is available, and the middle nets the two against each other.

Ten shops in one shopping centre make the same arrangement in miniature. If every shop settles its dues with every other shop directly, a shop that wants to leave has to find the nine it dealt with and square up with each one. If instead every shop settles through the centre office, the shop that leaves squares up once, with the office, and the other nine are not consulted and are not affected. The office is carrying nine relationships so that no shop has to carry any.

The middle is not free and it is not magic. The middle is carrying every one of those promises itself, and that is precisely why collateral comes next. A party that steps between everybody has to be collateralised by everybody, and the order in which its own resources are used if a member fails is fixed in advance rather than decided in the moment. The order of resources and every threshold inside it are set under the framework of the Securities and Exchange Board of India at sebi.gov.in. The point worth holding on to is only that a fixed order exists and that fixing it in advance is what makes it protection rather than improvisation. The order itself, and the funding of the resources behind it, are covered separately.

One further note on where these arrangements come from. The principle that a party standing in the middle of a cleared market must be collateralised and must have a pre-agreed order of resources is an international one, set out for cross-border consistency by the International Organization of Securities Commissions at iosco.org. India applies the version adopted by the Securities and Exchange Board of India at sebi.gov.in, and that is the one to read.

What is posted before anything moves, and what is that money for?

Each side posts initial marginCollateral posted before a position is carried. The money is not a payment for the contract and not a part payment of the agreed price. before the position is carried. Initial margin is collateral against the promise. The money is not a payment for the contract, it is not a part payment of the agreed price, and it is not a fee, and a reader will arrive assuming at least one of those three.

Take the three negatives one at a time. Each of them leads somewhere different if it is got wrong. Nothing was bought, so the margin is not a payment for the contract: both sides post, and a fee paid by both sides to nobody is not a fee. The agreed price of Rs 2,130.00/- is paid at the final date if the contract runs to delivery, so the margin is not a part payment of it. The margin posted is separate money that comes back when the position is closed. The party posting it still has it, so it is not a fee. Margin is collateral, in the plain sense of something set aside to make a promise reliable.

On the invented figures used here, an exposureThe value of the referenced thing that a position stands on. Here, one unit of the reference asset at its price today. of Rs 2,000.00/- carries initial margin of Rs 160.00/-. Work it rather than reading it: 8.0 per cent of Rs 2,000.00/- is Rs 160.00/-, because Rs 2,000.00/- multiplied by 0.08 is Rs 160.00/-. Nobody sets initial margin at a fixed 8.0 per cent: the figure is chosen here so that the arithmetic stays legible. A clearing corporation's actual requirement is set under the framework of the Securities and Exchange Board of India at sebi.gov.in, it differs by contract and by day, and it moves.

One contract here stands on one unit of the reference asset. One unit to a contract is a teaching simplification: the size of a contract is set by the exchange under the same framework, and it moves too. Every figure in this guide is therefore per unit, and a reader who wants the arithmetic for a real contract multiplies through by whatever the specification says.

Two words have to stay apart from here on, and mixing them is the commonest slip in this subject. Exposure is the value of the referenced thing a position stands on: one unit at Rs 2,000.00/-, so Rs 2,000.00/- of exposure. NotionalThe face amount a contract is written on, used as a multiplier. None of it changes hands. is the face amount the contract is written on, and none of it changes hands. Forty contracts struck at Rs 2,130.00/- carry Rs 85,200.00/- of notional, and not one rupee of it moves. The exposure the margin is struck on is forty units at Rs 2,000.00/-, that is Rs 80,000.00/-. Every quantity in this guide says which of the two it is.

How Futures Margin Changes Contract Risk: what does Rs 160.00/- under Rs 2,000.00/- mean?

Two limbs, and either one on its own misleads, so read them together. First limb: Rs 2,000.00/- of exposure standing on Rs 160.00/- posted is 12.50 times, because Rs 2,000.00/- divided by Rs 160.00/- is 12.50. Every rupee put down is carrying twelve and a half rupees of the reference asset.

Second limb: an adverse move of 4.0 per cent of the exposure is Rs 80.00/-, because Rs 2,000.00/- multiplied by 0.04 is Rs 80.00/-, and Rs 80.00/- is 50.0 per cent of the Rs 160.00/- posted, because Rs 80.00/- divided by Rs 160.00/- is 0.50. Read the bases carefully. The move is struck on the exposure. The share it takes is measured against the margin. The exposure and the margin are two different denominators, and the whole of the teaching lives in the fact that they are different.

The third figure closes the loop between the two limbs. Now work it in front of yourself. A move of Rs 160.00/- would take the whole of what was posted. Rs 160.00/- is 8.0 per cent of the Rs 2,000.00/- exposure, because Rs 160.00/- divided by Rs 2,000.00/- is 0.08. And 8.0 per cent is one divided by 12.50 exactly, because 1 divided by 12.5 is 0.08. The leverage and the move that exhausts the margin are the same fact written twice, and neither of them is a separate fact.

Now put the same Rs 80.00/- against both bases at once. The comparison is the thing worth carrying away. Against the Rs 2,000.00/- exposure, Rs 80.00/- is a sliver. Against the Rs 160.00/- posted, the identical Rs 80.00/- is half. Same rupees, two denominators, two entirely different feelings.

A four per cent move in the referenced thing takes half of what was put down. The ratio between the move and the margin, not the exposure and not the notional, is what makes this contract different to hold. The 8.0 per cent matters more here than anywhere else, and it is a teaching figure rather than a requirement. A clearing corporation's actual requirement is set under that same framework, and it moves. The relationship between the two limbs survives whatever the real figure turns out to be. Halving the margin percentage doubles the leverage and halves the move that exhausts the margin. Doubling it reverses both. The arithmetic linking them never changes.

One more thing is worth stating outright. Nobody can say whether a 4.0 per cent move will happen, or how often one occurs. An answer to either would need a history and a distribution, and neither is arithmetic. The conditional statement is complete on its own: if the move is 4.0 per cent of the exposure, half of what was posted is gone.

When does money actually move on a futures position?

Every day. Gains and losses on the position are settled against the margin balance at the end of each day rather than accumulating until the final date. Settling the day's change every day is called daily settlementPaying and collecting the day's change in the contract price every day, instead of settling the whole change once at the end., and it is the single arrangement that most changes what carrying one of these feels like.

Daily settlement keeps the promise from ever growing. In an arrangement settled once at the end, the amount owed builds up quietly over months until it is large enough that one side might genuinely prefer not to pay. In an arrangement settled daily, the largest amount ever owed between two settlements is one day of movement, and the collateral posted is sized against that rather than against a year of it.

Two days are worked here in whole rupees. A long position is agreed at Rs 2,130.00/-. The margin balance starts at Rs 160.00/-. On the first day the contract price falls to Rs 2,110.00/-, so the change is Rs 2,110.00/- less Rs 2,130.00/-, which is minus Rs 20.00/-. The Rs 20.00/- leaves the long position's margin balance, and the balance becomes Rs 160.00/- less Rs 20.00/-, that is Rs 140.00/-. On the second day the contract price rises to Rs 2,150.00/-, so the change is Rs 2,150.00/- less Rs 2,110.00/-, which is plus Rs 40.00/-. The Rs 40.00/- comes back, and the balance becomes Rs 140.00/- plus Rs 40.00/-, that is Rs 180.00/-.

A build and a total together owe the reader a reconciliation, so the sum checks both ways. Adding the daily changes: minus Rs 20.00/- plus Rs 40.00/- is plus Rs 20.00/-. Taking the two ends directly: Rs 2,150.00/- less Rs 2,130.00/- is plus Rs 20.00/-. The balance agrees too: Rs 160.00/- plus Rs 20.00/- is Rs 180.00/-, which is what the second day left behind. Daily settlement changes when the money moves and it does not change how much of it moves in total.

Daily settlement does something less comfortable to the holder's cash: money leaves on a bad day whether or not the position is closed, so a position that finishes exactly where it started can still have taken cash out along the way and put it back. On the two days above, Rs 20.00/- was actually gone at the end of the first day. The Rs 20.00/- was not a paper loss, a notional adjustment or a mark that could be argued with. The money had left the balance, and if the balance had been thin it would have had to be topped up before the second day could be carried.

How the statement recording all of this is read line by line, and the account of the money moving end to end across a longer stretch, are both covered separately.

How does the agreed price relate to today's price for the reference asset?

By one multiplication and one addition, and by nothing else at all. Take the spot priceThe price for buying or selling the referenced thing for immediate delivery, as opposed to on a later date. of the reference asset, Rs 2,000.00/-. Financing costs 6.50 per cent a year. Multiply: Rs 2,000.00/- times 0.065 is Rs 130.00/-, and that is the carryThe cost of holding the referenced thing from today until the agreed date. Here it is the cost of the money borrowed to buy it.. Add: Rs 2,000.00/- plus Rs 130.00/- is Rs 2,130.00/-, and that is the agreed price for one year out.

Read the middle bar again. The carry is not a growth rate, a projection or an increment somebody expects: it is the cost of the money for a year. Somebody who wanted the reference asset in a year's time could go and buy it today for Rs 2,000.00/- and borrow that Rs 2,000.00/- for the year, and by the agreed date they would have the reference asset and a debt of Rs 2,130.00/-. Rs 2,130.00/- is what that route costs. Anybody offering to sell forward for less is handing money to whoever takes the other side and does exactly that.

The reference asset here pays nothing while it is held, and that is precisely why the agreed price sits above the spot price. A referenced thing that did pay something out during the holding period would have that payout subtracted from the carry, and if the payout were large enough the agreed price could sit below the spot price instead. The reference asset here pays nothing, so that case cannot be worked on these figures without breaking every other number. The direction is named, and the worked case belongs with a reference asset that pays.

How a contract price moves once the position is running is easy to state loosely and get wrong. One caution follows. Suppose the spot price falls from Rs 2,000.00/- to Rs 1,920.00/-, a gap of Rs 80.00/- which is 4.0 per cent of the Rs 2,000.00/- exposure, with a full year still to run. The agreed price for the same date does not fall by Rs 80.00/-. The agreed price falls to Rs 1,920.00/- times 1.065, that is Rs 2,044.80/-, so from Rs 2,130.00/- it has fallen by Rs 85.20/-. The carry applies to the new spot price as well, so the contract price moves by more than the spot price does while there is still time left to run.

The Hedge Ratio: how many contracts does a position need against one unit held?

The hedge ratio is the number of contracts carried against each unit of the thing being offset. Nothing more complicated than that: it is a count on top and a count underneath. On the figures used here the ratio is 1.00, and it is 1.00 by construction rather than by estimation. There is one reference asset, one unit of it is held, and the contract stands on that same reference asset. One contract against one unit is 1 divided by 1, which is 1.00.

The ratio of 1.00 is an uninteresting number here, and it is worth saying plainly why. A ratio of 1.00 falls out because the thing held and the thing referenced are the same thing, and nothing had to be measured to arrive at it. The moment the thing held and the thing referenced differ, even slightly, the ratio stops being 1.00 and stops being free. Somebody now has to work out how much the referenced thing tends to move when the held thing moves. Estimating that relationship is a different question, and it is covered separately.

A household version: where a buyer has agreed to take exactly one sack of rice in October and enters one contract that settles against exactly one sack of the same rice in October, the count is one against one and there is nothing to estimate. Where the agreement is instead for one sack of a different grade, or nine tenths of a sack, or a sack in a different month, somebody has to decide how many contracts stand in for it, and that decision is an estimate rather than a count.

Hedge Effectiveness: what share of a movement is offset, and what is missing here?

Hedge effectiveness is the share of the held thing's movement that the contracts actually offset. Effectiveness answers the question the ratio does not: not how many contracts, but how much of the movement they took care of. A share is written as a percentage, and like every percentage here it needs its base named.

Held to the final date, on the same reference asset, with a ratio of 1.00, the offset here is complete. A unit held and a unit sold forward cancel rupee for rupee at that moment: whatever the unit held gains, the contract loses, and the two arrive at nil between them. The completeness is an artefact of one referenced thing and no history, not a result, not a measurement and not a claim about what offsetting achieves in general.

Naming what is absent is the honest part: there is no historical series here, no distribution and no realised outcome of any kind. An effectiveness figure that meant anything would need at least the movements of the held thing and the contract over some stretch of time, and a way of comparing them, and a period over which the comparison was struck. None of those exists here, so no measured effectiveness figure is reported at all, and the 100 per cent above is arithmetic on an identity rather than a measurement of anything.

And the moment matters. A loose account teaches something false right here. The offset is exact at the final date. Before that date it is not. With a year still to run, a spot price falling from Rs 2,000.00/- to Rs 1,920.00/-, a gap of Rs 80.00/-, moves the contract price from Rs 2,130.00/- to Rs 2,044.80/-, a gap of Rs 85.20/-. The two do not cancel: the contract has moved by more than the unit held. A one-for-one offset cancels rupee for rupee at the final date and is over-complete before it, so any statement about an offset has to name the moment it is being made at. A flat net line drawn with no moment named would teach an equality that holds on exactly one day.

The two measures taken one against the other, and the reason a real ratio is rarely 1.00, are covered separately and at the depth they deserve. This guide owes them the naming, the arithmetic that exists, and an honest account of the arithmetic that does not.

How to analyse a Futures Contract never seen before?

Six questions, in this order. Every mechanism they touch is set out above. A fixed reading routine is worth more than a clever one: nothing gets skipped because it looked obvious.

1. What does one contract stand on, and how much of itThe units and the quantity are read first. This is the row that turns every per-unit figure of the kind worked here into the figure for an actual position.
2. What date does it run toRead the date and the calendar it follows. Everything else on the sheet is conditional on this one line.
3. What is the agreed price, and what is the price for immediate delivery todayRead both, and read them as two separate numbers rather than one number and a deviation from it.
4. What is posted, and what would a move of one per cent in the referenced thing do to thatThe amount posted is read, and then divided into. In this guide a one per cent move of the Rs 2,000.00/- exposure is Rs 20.00/-, which is 12.5 per cent of the Rs 160.00/- posted, and that percentage is the one to carry away.
5. Does it end in delivery of the thing or in cashRead which, because the two lead to completely different last weeks.
6. Who is on the other side of the position once it is doneWhether a clearing corporation stands in the middle is the thing to read, because that answer changes whose promise is being carried.

The first, the second, the fifth and half of the third are read off the exchange's own specification under the framework of the Securities and Exchange Board of India at sebi.gov.in, and never from recollection.

How does somebody actually read one of these in the room?

Four habits, and every one of them is a direct consequence of something above rather than general advice. Almost every confusion in this subject is two numbers measured against two different denominators and reported as though they shared one, so the single most useful move is to name the base of every percentage out loud before writing it down.

1. Write the exposure and the margin on the same line, alwaysA treasurer looking at a position sees Rs 2,000.00/- of exposure and Rs 160.00/- posted, and writes both. Either figure alone is a different story: the exposure alone sounds enormous next to what was put down, and the margin alone sounds trivial next to what it is standing under. The pair is the only honest unit.
2. Convert a move into a share of the margin before reacting to itA one per cent move of the Rs 2,000.00/- exposure is Rs 20.00/-, which is 12.5 per cent of the Rs 160.00/- posted. That conversion takes two seconds and it changes what a small-sounding number means. A lender assessing somebody who carries positions of this kind does the same conversion, because what matters to a lender is how quickly a balance has to be topped up.
3. Ask when the cash actually leaves, not just how the position endsThe two-day path above ends up Rs 20.00/- ahead and still took Rs 20.00/- out of the balance at the end of the first day. An analyst reading a set of accounts that contains positions like these looks for the days money moved, not only the position at the reporting date, because a business can be right about a position and still run out of cash carrying it.
4. Read the specification for the rows left empty hereContract size, expiry, margin method and delivery method are read from the exchange's own specification under the framework of the Securities and Exchange Board of India at sebi.gov.in. Anybody working from recollection on those four rows is working from something that changes without telling them.

Notice what none of those four habits is. None of them is a view about whether to hold any of this, and none of them says a position is good, bad, cheap or attractive. All four are reading habits, and reading something carefully is a completely separate act from deciding to carry it.

What can no general account of this contract answer?

A reader who has followed the arithmetic this far will have one more question, and it is a fair one: should I hold one of these? No general account written for everybody can answer that question for anybody. Not as a hedge, and not because the answer is hard: the answer turns on facts about one person that a general account does not have.

Name instead what would have to be known before anybody could answer it. First, what the position exists to do, meaning what it is standing against and why that thing needs standing against. Second, what is already held: a position taken against something held is a different object from the same position taken on its own. Third, what has been posted, and where the money to top it up would come from. And fourth, what happens on the day the money moves, and on a contract of this kind that is every day.

An answer would need an outcome, a track record, a probability or a distribution, and not one of those is arithmetic. There is one invented reference asset, one invented price, one invented financing rate and one invented margin percentage, and the arithmetic on them is worked through in full. The arithmetic is true of the figures it is worked on, and it says nothing at all about what any of this does for anybody.

And the last point is the one most worth carrying away. Understanding how a contract works is not a reason to hold one. The two things feel connected because the effort of understanding something makes it feel like a possession, and they are not connected at all. A drawn payoff is a description of an obligation. A payoff drawing is not a prediction, not a claim about how the obligation turns out, and not a suggestion that anybody enter into it.

The reference asset, its spot price of Rs 2,000.00/-, its financing rate of 6.50 per cent a year, the initial margin of 8.0 per cent and the two-day settlement path are invented.
Educational material. Not advice on any investment, tax, budget or market position.