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Question: Is my understanding of how futures contract works correct?

Just trying to understand the basics of futures contract and its daily installments.

Consider a discrete time model where $t=0,1,2,...$. The agreed-on price is futures price and denote this as $F_t$. Denote the underlying asset's price over time as $P_t$.

The way daily installments works is:

At the end of the trading day, it is marked-to-market, so we evaluate $F_t-P_t$.

If $F_t-P_t>0,$ this amount is deposited to my margin account.
If $F_t-P_t<0,$ this amount is subtracted from my margin account.
If I face a streak of losses, then there would be a marginal call unless I replenish my margin account enough to cover further losses.

Is this correct?

What I am mainly confused is that the contract price, the price both parties of futures contract agree, is fixed, right? But the futures contract price changes over time? I don't understand what is "mark-to-market" on a daily basis. Is it the agreed price or the futures price?

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  • $\begingroup$ At the end of the trading day we evaluate $F_t-F_{t-1}$. We don't use $P_t$. (It might also make sense to evaluate $P_t-P_{t-1}$ but that is not what futures exchanges actually use. They don't necessarily have access to $P$ but they know $F$ which is an estimate of future $P$). $\endgroup$ – Alex C Nov 7 '19 at 15:50
  • $\begingroup$ But if this is an equity futures, wouldn't $P_t$ be just the stock price at @$t$, so why do we not look at the underlying? $\endgroup$ – Frank Swanton Nov 7 '19 at 15:56
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MTM is really just bookkeeping. You hold some initial margin for your book with a broker and each day your account value is updated per end of day futures values as $F_t - F_{t-1}$ for each position. The contract price, $F_t$, isn't fixed, it fluctuates daily and is what MTM is based on.

When margin requirements are breached (as a result of losses in your positions), you get a margin call where you need to deposit additional funds to meet the maintenance margin requirement on your account. These levels vary by broker, but are at minimum 50% for initial margin and 25% for maintenance margin.

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  • $\begingroup$ thanks Chris!!!! $\endgroup$ – Frank Swanton Nov 21 '19 at 15:28

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