Futures contracts are forward contracts with standardised sizes, dates, and underlyings that trade on futures exchanges. Futures markets offer both greater liquidity and protection against loss by default by combining contract uniformity with an organised market with rules, regulations, and a central clearing facility.
The futures contract buyer creates a long exposure to the underlying by agreeing to purchase the underlying at a later date at a pre-agreed price. The seller makes the opposite commitment, creating a short exposure to the underlying by agreeing to sell the underlying asset in the future at an agreed-on price. This agreed-on price is called the futures price, f0(T). The frequency of futures contract maturities, contract sizes, and other details are established by the exchange based on buyer and seller interest.
The most important feature of futures contracts is the daily settlement of gains and losses and the associated credit guarantee provided by the exchange through its clearinghouse. At the end of each day, the clearinghouse engages in a practice called mark to market (MTM), also known as the daily settlement. The clearinghouse determines an average of the final futures trading price of the day and designates that price as the end-of-day settlement price. All contracts are then said to be marked to the end-of-day settlement price.
As with forward contracts, no cash is exchanged when a futures contract is initiated by a buyer or seller. However, each counterparty must deposit a required minimum sum (or initial margin) into a futures margin account held at the exchange that is used by the clearinghouse to settle the daily mark to market. Futures contracts must be executed with specialised financial intermediaries that clear and settle payments at the exchange on behalf of counterparties.
