Futures

Q3.1: What is “price–time priority”?
A: A market has price–time priority if it gives a guarantee that every order will be matched
against the best available price in the country, and that if two orders are equal in price, the
one which came first will be matched first.
Forward markets, which involve dealers talking to each other on phone, do not have
price–time priority. Floor–based trading with open–outcry does not have price–time priority.
Electronic exchanges with order matching, or markets with a monopoly market
maker, have price–time priority.
On markets without price–time priority, users suffer greater search costs, and there is
a greater risk of fraud. ••

Q3.2: What is a futures contract?
A: A futures contract is a forward contract which trades on an exchange. ••

Q3.3: How does the futures market solve the problems of forward
markets?
A: Futures markets feature a series of innovations in how trading is organised:
• Futures contracts trade at an exchange with price–time priority. All buyers and sellers
come to one exchange. This reduces search costs and improves liquidity. This
harnesses the gains that are commonly obtained in going from a non–transparent
club market (based on telephones) to an anonymous, electronic exchange which is
open to participation. The anonymity of the exchange environment largely eliminates
cartel formation.
• Futures contracts are standardised – all buyers or sellers are constrained to only
choose from a small list of tradeable contracts defined by the exchange. This
avoids the illiquidity that goes along with the unlimited customisation of forward
contracts.

• A new credit enhancement institution, the clearing corporation, eliminates counterparty
risk on futures markets. The clearing corporation interposes itself into
every transaction, buying from the seller and selling to the buyer. This is called
novation. This insulates each from the credit risk of the other. In futures markets,
unlike in forward markets, increasing the time to expiration does not increase the
counterparty risk.
Novation at the clearing corporation makes it possible to have safe trading between
strangers. This is what enables large–scale participation into the futures market –
in contrast with small clubs which trade by telephone – and makes futures markets
liquid.

Q3.4: What is cash settlement?
A: The forward or futures contracts discussed so far involved physical settlement. On 31
Dec 2001, the seller was supposed to come up with 100 tolas of gold and the buyer was
supposed to pay for it.
In practice, settlement involves high transactions costs. This is particularly the case
for products such as the equity index, or an inter–bank deposit, where effecting settlement
is extremely difficult or impossible.
In these cases, futures markets use “cash settlement”. Here, the terminal value of
the product is deemed to be equal to the price seen on the spot market. This is used to
determine cash transfers from the counterparties of the futures contract. The cash transfer
is treated as settlement.
Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on
31 Dec 2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty
spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has
made a loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty applied to a transaction
of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation
organises a payment of Rs.3,000 from S and a payment of Rs.3,000 to L. This is called
cash settlement.
Cash settlement was an important advance, which extended the reach of derivatives
into many products where physical settlement was unviable. •• Also see: Garbade & Silber
(1983).
Q3.5: What determines the price of a futures product?
A: Supply and demand on the secondary market determines the futures price.
On dates prior to 31 Dec 2000, the “Nifty futures expiring on 31 Dec 2000” trade at
a price that purely reflect supply and demand. There is a separate order book for each
futures product which generates its own price.
Economic arguments give us a clear idea about what the price of a futures should be.
If the secondary market prices deviate from these values, it would imply the presence of
arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is
nothing innate in the market which forces the theoretical prices to come about. ••
Q3.6: Doesn’t the clearing corporation adopt an enormous
risk by giving out credit guarantees to all brokerage firms?
A: Yes, it does.
If a brokerage firm goes bankrupt with net obligations of Rs.1 billion, the clearing
corporation has a legal obligation of Rs.1 billion. The clearing corporation is legally
obliged to either meet these obligations, or go bankrupt itself. There is no third alternative.
There is no committee that meets to decide whether the settlement fund can be utilised;
there are no escape clauses.
It is important to emphasise that when L buys from S, at a legal level, L has bought
from the clearing corporation and the clearing corporation has bought from S. Whether S
lives up to his obligations or not, the clearing corporation is the counterparty to L. There
is no escape clause which can be invoked by the clearing corporation if S defaults. ••

Q3.7: How does the clearing corporation assure it does not
go bankrupt itself?
A: The futures clearing corporation has to build a sophisticated risk containment system
in order to survive.
Two key elements of the risk containment system are the “mark to market margin”
and “initial margin”. These involve taking collateral from traders in such a way as to
greatly diminish the incentives for traders to default.
Electronic trading has generated a need for online, realtime risk monitoring. In India,
trading takes place swiftly and funds move through the banking system slowly. Hence
the only meaningful notion of initial margin is one that is paid upfront. This leads to the
notion of brokerage firms placing collateral, and obtaining limits upon the risk of their
position as a function of the amount of collateral with the clearing corporation. •• Also see: Shah & Thomas
(1999b).

Q3.8: Can we concretely sketch the operations of one futures
market?
A: On 1 January, an exchange decides to trade three gold futures contracts with expiration
31 Jan, 28 Feb and 31 Mar respectively. The three futures contracts all trade at the same
time, with three distinct prices. Traders can buy/sell all three contracts as they please. All
through January, no settlement takes place. Positions are netted; i.e. if a person buys 100g
of 31 Jan gold and then (a few days later) sells off 100g of 31 Jan gold, his net position
drops to 0.
Trading for the January contract stops on 31 Jan. All net open positions on this con
tract, as of the close of trading of 31 Jan, have to do settlement on 2 February (T+2
settlement). A buy position (as of close of trading on 31 Jan) has to bring money on 2
Feb, and a sell position (as of close of trading on 31 Jan) has to bring gold on 2 Feb.
On 1 Feb, when trading commences, the exchange announces the start of trading on
a new contract, one which expires on 30 Apr, thus ensuring that three contracts always
trade at any one time.
Similarly, on 28 Feb, trading for the Feb contract stops. On 1 March, a new 31 May
contract is born. On 2 March, open positions of the Feb contract are settled. ••

Q3.9: Why is the equity cash market in India said to have
“futures-style settlement”?
A: India’s “cash market” for equity is ostensibly a cash market, but it functions like a
futures markets in every respect.
NSE’s “EQ” market is a weekly futures market with tuesday expiration. The trading
modalities on NSE from wednesday to tuesday, in trading ITC, are exactly those that
would be seen if a futures market was running on ITC with tuesday expiration. On NSE,
when a person buys on thursday, he is not obligated to do delivery and payment right
away, and this buy position can be reversed on friday thus leaving no net obligations.
Equity trading on NSE involves leverage of seven times. Like all futures markets, trading
at the NSE is centralised and there is no counterparty risk owing to novation at the clearing
corporation (NSCC).
The only difference between ITC trading on NSE, and ITC trading on a true futures
market, is that futures contracts with several different expiration dates would all trade at
the same time on a true futures market; this is absent on India’s “cash market”. ••