Financial Derivatives - Future Contract with P&L and Payoff Matrix 2022

What are futures contracts ?

Futures contracts are standardised forward contracts that trade on exchanges. Because futures contracts trade on exchanges they are heavily standardised and regulated. Derivatives exchanges in the United States are regulated by the Commodities Futures Trading Commission (CFTC). Or we can say, A futures contract is an agreement to either buy or sell an asset on a publicly-traded exchange. The contract specifies when the seller will deliver the asset, and what the price will be. The underlying asset of a futures contract is commonly either a commodity, stock, bond, or currency.

Futures markets are exactly like forward markets in terms of basic economics. However, contracts are standardised and trading is centralised (on a stock exchange). There is no counterpart in futures markets, unlike in forward markets, increasing the time to expiration does not increase the counter party risk. Futures markets are highly liquid as compared to the forward markets.

Two positions one can take in a futures contract

One can take Long and Short positions in futures contract.

Having a “long” position in a security means that you intend to buy the security in future. Investors maintain “long” security positions in the expectation that the stock will rise in value in the future. The opposite of a “long” position is a “short” position.

A "short" position means that you intend to sell the security in future. Investors maintain short position in an expectation that the price of the stock will decrease in value in future.

Features of futures contract:

• Contract between two parties through Exchange.
• Centralised trading platform i.e. exchange
• Price discovery through free interaction of buyers and sellers
• Margins are payable by both the parties
• Quality decided today (standardised )
• Quantity decided today (standardised)

Limitations of futures contracts

• Some investment strategies can lead to high risks due to the leverage provided by future contracts
• It usually follows set standards for defined amounts and terms giving less flexibility options in investing
• Only partial hedging is facilitated by future contracts
• The consequence of low commission charges can be over-trading by traders

 What are the payoffs and profits for a long futures holder?

A payoff is the likely profit loss that would accrue to a market participant with change in the price of the underlying asset. Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits, for the buyer and the seller of futures contracts, are unlimited. Further, the profits of one party is exactly equivalent to the losses of the other party.

The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside.

Conditions

• Payoff  : Long Position : St - F
• Positive payoff  : St > F
• Negative Payoff  : St < F
• Zero Payoff  : St = F
• P&L at expiration : St - F
• Break-even Point : St = F 

What are the payoffs and profits for a short futures holder?

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month nifty index futures contract when the nifty stands at 11600. The underlying asset in this case is the nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses.

Conditions

• Payoff  : Long Position : F - St
• Positive payoff  : St < F
• Negative Payoff  : St > F
• Zero Payoff  : St = F
• P&L at expiration : F - St
• Break-even Point : St = F 

Pricing of a futures contract depends on the characteristics of underlying asset. There is no single way to price futures contracts because different assets have different demand and supply patterns, different characteristics and cash flow patterns. This makes it difficult to design a single methodology for calculation of pricing of futures contracts.

Market participants use different models for pricing futures. Here, our discussion is limited to only two popular models of futures pricing - Cash and Carry model and Expectancy model which will be discussed in the next blog.

Numerical Examples : Financial Derivative - Forward Contracts with PAYOFF Matrix 2021

Conclusion

The existence and the utility of a futures market benefits a lot of market participants. It allows hedgers to shift risks to speculators. It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be. Based on the current future price, it helps in determining the future demand and supply of the shares. Since it is based on margin trading, it allows small speculators to participate and trade in the futures market by paying a small margin for the purchase of the contract instead of the entire value of physical holdings. However, you must be aware of the risks involved too. The main risk stems from the temptation to speculate excessively due to a high leverage factor, which could amplify losses in the same way as it multiplies profits. Further, as derivative products are slightly more complicated than stocks or tracking an index, lack of knowledge among market participants could lead to losses.

Related Links:

Financial Derivatives - Concepts, Types, Examples and Risk 

Financial Derivatives - Future Terminologies with example 2021 

Financial Derivative - Forward Contracts with PAYOFF Matrix 2021 

Financial Derivatives - Future Contract with P&L and Payoff Matrix 2021