A futures contract is exactly like a forward contract in that it too provides for the receipt or payment of a specified amount of an asset at a specified price with delivery at a specified future point in time. However, the futures contract has the following distinguishing characteristics:
- Unlike forward contracts, futures are traded on organized exchanges. The exchanges help ensure that the trading partners honor their obligations. The exchange clearinghouse actually becomes an intermediary between the buyer and seller of the contract. In essence, the clearinghouse becomes the seller for each buyer and the buyer for each seller.
- The formal regulation of futures contracts results in contracts that are standardized in nature versus customized. For example, the exchange specifies the quantity and quality of commodities traded, as well as the delivery place and date.
- A futures contract requires an initial deposit of funds with the transacting broker. This deposit is referred to as a margin account; it serves as collateral to help ensure that the parties to the contract are able to perform. Each day the contract is valued and marked-to-market. If the contract loses too much value, the holder will have to contribute additional cash to the margin account. If the margin account balance falls below a minimum balance, called the maintenance margin, the investor is required to replenish the account through what is called a margin call.
- Forward contracts represent cash amounts settled only at delivery and therefore represent future amounts that must be discounted to yield a current present value. However, future prices are marked-to-market each day. At the close of each trading day, a new futures price or settlement price is established. Therefore, the futures price represents a current versus future value, and no discounting is necessary. This new futures price is used to compute the gain or loss on the contract over time.
- The party that has written a futures contract is said to be short, and the party that owns the contract is said to be long.