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Finance and capital markets
Course: Finance and capital markets > Unit 9
Lesson 2: Forward and futures contracts- Forward contract introduction
- Futures introduction
- Motivation for the futures exchange
- Futures margin mechanics
- Verifying hedge with futures margin mechanics
- Futures and forward curves
- Contango from trader perspective
- Severe contango generally bearish
- Backwardation bullish or bearish
- Futures curves II
- Contango
- Backwardation
- Contango and backwardation review
- Upper bound on forward settlement price
- Lower bound on forward settlement price
- Arbitraging futures contract
- Arbitraging futures contracts II
- Futures fair value in the pre-market
- Interpreting futures fair value in the premarket
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Futures margin mechanics
Understanding the mechanics of margin for futures. Initial and maintenance margin. Created by Sal Khan.
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wait do you get to keep the margin call that you put up if you do sounds like good deal and your bound to make a profit but if you don't then your pretty much paying higher price.(5 votes)
Yes, you keep the margin that you initially put up. If apples closed at $200 per 1000 lbs., both parties would go home with their $20.(4 votes)
- Hi there, I don't really understand how this eliminates the volatility of the apple price. If the margin account keeps changing and the seller (or buyer) is at risk of having to put more money in if there's a margin call why would they bother with the futures contract at all?
Does the futures contract follow the market price? Or does the market price only affect the level of the margin accounts, in which case the price at which the buyer and seller interact is fixed?
Thanks in advance :)(4 votes)
What ends up happening is the buyer will buy the apples at the spot price. However, the margin accounts are basically present to eliminate the risk in the volatility of the spot market. If the price goes up, then the seller has to transfer that amount by which the price increased to the buyer in order to cancel the changes in price.(2 votes)
So the margin is basically a down payment that adjusts over time?(1 vote)- Not really; a downpayment is typically for buyers only. Margins are for buyers and sellers. Also, your analogy to a floating downpayment would probably adjust in the same direction as the price, which is not necessarily the case for margins.
Margins are collateral required to enter into a transaction. They are determined in function to the riskyness of the commitment to ensure they will be acted upon.
Margins are adjusted when prices move to compensate for the subsequent advantage or disadvantage resulting from the transaction. If the price movement is in your favor, there is a lower risk you will reneg on your commitment and the margin requirement may be lowered. If the price moves against you, there is a higher risk you would reneg, hence you are called for further margin to keep the position open. If you can't follow, your position is closed using your margin deposit if needed.(6 votes)
- So would it be fair to say that insurance policies are a form of futures contract, with the premiums being the margin, and the insurer agreeing to "buy" the liability on any damages to the property [car, home, life, etc.] at some future date - the future date being "when the property gets damaged in a certain way."(3 votes)
Well, yes I guess you could say. The same case with Credit Default Swaps (CDSs). But I think if we get into the textbook definition of insurance, you'd find that insurance's purpose is to cover your losses only with no chance on making profit but here it's more speculative. The buyer or the seller can got out making handsome profits.(1 vote)
does the Future's Contract itself indicate whether it is for the Buyer of the Commodity or the Seller of the Commodity?
I mean, for all I know, the Future's Contract only holds information on the settlement price, the commodity detail, and the date of settlement.
How does the Exchange find out if the person holding the Future's Contract is the Seller of the Apple, or the buyer of the Apple?
Sal should explain these things.(1 vote)
A contract is either a contract to buy or a contract to sell.
If you want to be able to buy the commodity at some set price in the future, you purchase a contract to buy.
If you want to be able to sell the commodity at some set price in the future, you purchase a contract to sell.(4 votes)
- I know futures are supposed to protect against the volatility of markets. With margins, how are futures markets really different from not having a futures market if margins are triggered whenever the price of a commodity, let's say apples, goes up or down?
Also, if a party were to violate a contract, can't the other party turn to the courts or some other regulatory agency for appeals?(3 votes)
Future traders can actually add to intraday- volatility of a market due to flash orders.(0 votes)
- So margin is the cash balance in the user's account (initial deposit + profit/loss), and maintenance margin is the min required cash balance?(2 votes)
- If outcome is same then why buyer and seller want to worry about the contract because deal is finalize in $200.Why worry about margin because it's got transferred into counter parties which is equals to gain of one party..(1 vote)
- You misunderstand. The amount is not finalized at $200. If the price of the contract goes down to $100, then the buyer only pays $100, but then adds on an extra $100 in the margin account.(2 votes)
I have one simple question. Will the delivery price of a futures contract change within time? For example, at June 30, I signed the contract and agree to buy the products at 200 dollars at July 30. But the price goes down to 150 dollars on July 30. Should I still pay the 200 dollars? or just pay the 150 dollars but the other 50 dollars through my margins account?(1 vote)- You will end up just paying the 150 dollars. The other $50 will be paid through the margin account.(1 vote)
- I am a little confused - in Futures Contract when the delivery price is fixed how does it matter what the market price is? Isn't it like signing an agreement on whatever the market price may be the parties who have entered the contract have decided on a fixed price?(1 vote)
- The purpose of a Futures contract is to know for sure what you can buy and sell an item in the future. For example, a farmer selling orange will know he will get $2/lb a year from now no matter what, and the orange juice maker will know he can buy oranges at $2/lb no matter what. "What" could be weather related, people no longer like oranges, more farmers grow oranges and flood the market, etc.
The futures contract itself is worth money since it provides certainty to both parties. The cost someone will pay to enter into this contract will depend on the current price of oranges.(2 votes)
Video transcript
Let's think a
little bit about how margin works for a
futures contract. So let's say that the
terms of the contract are a 1,000 pounds of apples
for delivery on November 15, and we're assuming that this
is some date in the future. And right now in the
Futures Exchange, the market delivery
price, so the price at which the apples will change
hand in the future, is $200. And I've written here what
the exchange specifies for the initial and
maintenance margin, we'll talk about that
more in a second. But this essentially means that
both the buyer and the seller, for the initial margin,
have to put up $20. Sometimes it'll be specified
as an absolute dollar amount like I've just done. Sometimes it might
be a percentage of the actual delivery price. So they both have to
put up $20, and this guy has agreed to buy a
1,000 pounds of apples from this guy on
November 15 for $200. So it's essentially
$0.20 a pound. Now, let's say
that a day goes by, and the next day-- these
guys have this contract. This price right here
is fixed in their minds. But let's say, the next
day, the same contract between two other parties
trades with the delivery price of $190. Now, all of a sudden this
guy over here feels silly. He's like, man, I'm
agreeing to buy something for $200 in the future
which some other dude, all of a sudden, has
agreed to buy for $190. This guy over here
feels really smart. He agreed to sell something
for $200 the day before, and now people are
selling it for $190. So he's kind of $10
better than the people participating in the
Futures Market today. The way market to market
works with futures contracts is that the exchange
says, well, you know what? I'm afraid that this guy, if
things keep moving against him, he's not going to even
want to put up the money to buy it at $200 if he can
buy in the market at $190 or something lower. So I'm going to reset their
futures contract to a delivery price of $190, but,
to make things fair, this guy's going to
be $10 in the hole. He's getting a $10 deal. If I take the delivery
price from $200 to $190, I need to take
$10 from this guy, because he's getting
a $10 better deal. So from his margin account,
I take it from $20 to $10. And then I place the $10 in
this guy's margin account. If he's going to get
$10 less of a good price on the delivery date, than let
me give him the $10 right now. So his margin account
will go to $30. Now, this number was
18, 17, 16, or 15, this guy wouldn't
have to do anything. But right here, he's triggered
his maintenance margin. Actually, he's right at
our maintenance margin. So let's say that he goes--
that the next day, this happens a little bit more. It goes down to $185, and we
have to do the process again. This guy loses $5,
he goes down to $5, This guy will be given
$5, so he goes to $35. In order for him to essentially
reset the Futures Price, he's been given another $5. Now, this guy has only
$5 in his margin account, and the maintenance
margin is $10. So triggers a margin
call, and this guy's got to find some place to put
another $15 in his margin call. Every time you get below
the maintenance margin, it triggers a
margin call, and you have to refill your margin
account to the initial margin. So he has to add $15,
so he gets back to $20.