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I thought I had understood futures contract. But it seems the daily settlements betray my understanding.

Futures contract provides price & product safety to involved two parties. E.g. Wheat Farmer and Baker

It seems Futures contract poisitions (long, short) are credit/debit accordingly based on current market price using daily settlement.

If the price is locked then why is this daily settlement doing? The profits and losses of a futures contract depend on the daily movements of the market for that contract and are calculated on a daily basis..

  1. Are we talking about Famer and Baker here or about the traders who bid and trade on futures available in the exchanges?
  2. Or else, futures contract is not observed as an independent element but that has an effect pre/post transaction. e.g. Famer agreed to sell Wheat for 4 dollar per bussel in 1 years time. In one years time market price is 5 dollar. If he had sold wheat in the market he would have earned extra 1 dollar. But it doesn't mean he is at a loss. Is he? On the other hand Baker may choose to keep the wheat for bread production or sell it to get 1$ profit.

I just want to understand who is affected by daily settlement - the farmer/baker or traders.

In terms of interest-rate/credit/bond futures, I guess this could even be more confusing - unless I figure it out now with commodity aspect.

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2 Answers 2

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I try to answer your questions in the order asked:

  • If the price is locked then why is this daily settlement doing? This mechanism is in place in order to reduce counterparty and credit risk. Each exchange maintains its own clearing house and each exchange member is obligated to clear their trades with the clearing firm at the end of each day. In turn the exchange member, settles their client accounts daily as well. The reason is that in case of a default at maximum one day's worth of price movement multiplied by the amount of defaulted contracts and contract multiplier is at risk. This makes it much less risky for the clearing house as well as for brokers and all market participants, evidenced through the fact that so far not one clearing house has gone into default.

  • Are we talking about Famer and Baker here or about the traders who bid and trade on futures available in the exchanges? We are talking about everyone involved in the chain. If a farmer or baker were to receive one large sum at contract expiration and somewhat the payment fell through because someone defaulted in between this would cause serious economic damage no matter whether the payment is eventually made or not. Thus, daily settlement reduces risk for everyone. Equally traders (well the brokerage houses that employ traders) benefit from reduced risk through daily settlement. It really is a good system in place and so far I have not heard of serious contenders that challenged this specific mechanic.

  • You need to familiarize yourself with the purpose of engaging in futures trades. There are speculators that simply buy and sell and there are hedgers. Farmers and bakers would belong to the hedger category. There have been well-covered scandals where commodity houses or commercial players heavily engaged in speculation (copper scandal at Sumitomo) but general commercial players engage in futures markets in order to hedge exposure. So, a baker would buy long futures contracts to lock in a price he would be paying at a future delivery date. Equally, a farmer would sell a futures contract that obligates him to deliver the underlying at a future date for a certain price in exchange. Keep in mind that anyone can trade futures, not just hedgers, hence the category "speculators". Depending on whether market participants buy/sell futures to open new positions or close positions, "open interest" in such futures contracts increases or decreases.

I recommend you read up on some futures basics such as in Hull "Options, Futures & Other Derivatives". You need to understand that daily settlement has nothing to do with the final contract settlement, regardless of whether it is cash settled or whether physical goods change hands.

I hope this answers your questions.

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Greately appreciate the explanations. It has come down to three things for me. 1. (in Farmer/Baker case) Baker pays all cash upfront and Farmer has to deliver wheat in 1 year. Here I do not see why Farmer has to do any settlements with regards to current market price, when all he has to do is deliver the Wheat in 1 year (as days passed by, nearing 1 year). 2. Both Farmer/Bakers exchanges cash and Wheat in 1 year where they are only holding to a paper released to them by exchange when signing up for the futures contract. –  bonCodigo May 14 at 9:00
    
In this scenario - it looks like there's counter-party risk. Therefore both parties may be required to settle a bit of contract value based on the days passed on the contract. However I am still doubtful why current market price has to come in between it when a price is already locked, all Farmer and Baker have to pay is a fraction of locked price. In the event agreed goods are delivered by Farmer, he will be given back his settlements he did over the 1 year of time along the contract agreed price paid by buyer - the Baker. –  bonCodigo May 14 at 9:00
    
3. Anyone else (speculators, arbitrageures, other traders apart from hedgers) who buys the futures contract will be interested in making a buck out of a futures contract and then roll it over. In this 3rd case I understand the need for daily settlement. However I still have to read alot more to see the clear mechanics of why current market price of underlying is involved in daily settlement instead of being a fraction of locked-future's price. –  bonCodigo May 14 at 9:04
    
As mentioned, please first familiarize yourself with the basics of futures contract. You already start off on the wrong foot: There is no all cash upfront payment. Futures contracts entail a margin bond. –  Matt Wolf May 14 at 9:20
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@bonCodigo, no, you don't have to take anything for face value. But if you want to understand it then you need to grab a book, sit your bum down and really work through the chapters like everyone who started out in this field and wants to be serious about it. –  Matt Wolf May 14 at 10:16

The daily mark-to-market reduces the counterparty risk by making sure every day that the counterparties can pay for their losses. For a forward contract, on the other hand, there is no daily mark-to-market and one simply have to trust that the counterparty can pay up (or deliver/take delivery of goods) at settlement.

Lets consider the Farmer. Yes, his price is locked by the futures contract but he might not actually have the crop right now. For example, he might want to lock in the price of next years crop. However the crop might go bad or the machinery breaks down so he might not have any crop to deliver. He then needs to buy the crop in the spot market to honor his contract or buy back the contract he sold in the market. This may realize a loss for him which he may or may not be able to take. So we can either trust that he can do it, or we can make sure he can do it by mark-to-market his accounts every day.

Lets consider the Baker. He might have locked in the price of wheat but the spot price has since plunged, bringing down the price of bread, and taking delivery on his contract will mean that he can't produce bread at a profit. By selling his contract in the market he realizes the same loss. If he doesn't have enough funds this will take him out of business and he hence might default.

By making sure that all accounts can meet the daily financial requirements of the contract, the mark-to-market is an important tool to reduce the magnitude of a counterparty default regardless if we are talking about farmer/bakers or traders.

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Let's not narrate the question into Futures Risk vs Forward Risk. Futures have no counterparty risk - because of the regulated paper market and traded in exchanges. Fine. But there's basis risk coming from price fluctuations. The more I read, it seems like the people who trade Futures contract are not the ones who really not the Farmer and Baker. One of the reasons which confused me was that there are financial traders who trade futures contracts belonged to other people like Farmers and Bakers. –  bonCodigo May 14 at 3:36
    
Then there are arbitrageurs who are interested in futures which are not rolling over but deliverying - if futures price lower than market price. My main question: This daily settlement is not for Farmer and Baker but for those traders who trade them. Price is locked for Farmer and Baker. But for those who trades in Exchanges - they have to fill for margin calls and maintain it until the expiry or last trade date. Is that correct view? –  bonCodigo May 14 at 3:38
    
Lets consider the Farmer and Baker. Yes, the prices are locked but they might not actually have the crop right now. For example, the Farmer might want to lock in the price of next years crop. However the crop might go bad, the machinery breaks down so he might not have any crop to deliver. He then needs to buy the crop in the spot market to honor his contract or buy back the contract he sold in the market. This may realize a loss for him which he may or may not be able to take. So we can either trust that he can do it, or we can make sure he can do it by mark-to-market his accounts every day. –  RRG May 14 at 4:58
    
Thanks for the efforts on explaining things to me. I upvoted your answer. –  bonCodigo May 14 at 11:56

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