122.Futures: specifics of futures and how futures work.

Futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date, the delivery date, making it a type of derivative instrument.

There are two parties to every futures contract - the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short".

Each futures exchange has its own clearing house. A clearing house acts as an intermediary in futures transactions. It guarantees the performance of the parties to each transaction. The main task of the clearing house is to keep track of all the transactions that take place during a day, so that it can calculate the net position of each of its members.

While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also (variation margin). The exchange will draw money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market.

Very few of the futures contracts that are entered into lead to delivery of the underlying asset. Most are closed out early. Nevertheless, it is the possibility of eventual delivery that determines the futures price.

The decision on when to deliver is made by the party with the short position. When he(she) decides to deliver, his broker issues a notice of intention to deliver to the exchange clearing house. This notice states how many contracts will be delivered and, in the case of commodities, also specifies where delivery will be made and what grade will be delivered. The exchange then chooses a party with a long position to accept delivery.

123.Futures: history of futures.

The basic concept of the futures market is that the fluctuations in the price of a commodity are prevented by agreeing to pay a certain fixed price for the commodity when it will be delivered in the future. This practice dates back to Greek and Roman marketplaces. Whether it was the supply of grains from North Africa and Egypt to fulfill the ever growing needs of ancient Rome or other goods brought from different corners of the Roman Empire.

The first formalized futures exchange market is generally accepted to be Dojima Rice Exchange in Japan formed in the 1730s. Early the forward contracts would be signed between individual traders. However the basic problem was about trust within the entire system. If the price increased substantially the seller would have a great incentive to sell the commodity in open market rather than to the person with whom the contract is signed at a lower fixed price. There was no third party which could ensure that the terms of the contracts are fulfilled by both the parties.

Chicago emerged as one of the major centers for grain farmers in the 1840s. However during good harvest season the price would drop substantially and during bad harvest season the price would become astronomically high. For this purpose Chicago Board of Trade (CBOT) was formed where the first forward contract was written on 13^th March 1851. By 1865 the CBOT introduced futures contract for a range of commodities including Wheat, Corn and Oats. These contracts would specify the quantity and quality of commodities to be delivered and let the price to be decided by the market.

By 1898 other goods were included for which futures were traded such as eggs, butter, potatoes, onion and hides (Chicago Butter and Egg Board). It changed its name to Chicago Mercantile Exchange (CME) in 1919. Slowly more products were added and by 1970s financial and currency futures were added, interest rate products added in 1981 and options and equity index futures in 1980s. One of the major reasons for the popularity in these products during the last quarter of the twentieth century is the breakdown of Bretton Woods exchange rate mechanism and development of a free market mechanism to discover exchange rate values.

In 1850s the first forward contract was traded in New York. By 1870 there were standardized futures contract on the New York Cotton Exchange. By 1882 the New Orleans Cotton Exchange started formalizing futures contract. Similar developments were seen elsewhere in London, Amsterdam, Brussels, and more. With the advent of internet and better technologies electronic trading has become much more common. CME launched the CME Globex electronic trading platform. The EUREX exchange was formed in 1998 when the German derivatives exchange Deutsche Terminborse (DTB) and the Swiss Options and Financial Futures Exchange (SOFFEX) merged. It was also the first exchange which offered only electronic trading and removed pit trading completely.

The futures contract may have got its start with agricultural products however now more than 80% of the contracts traded are financial contracts.