several functions. One of these functions is to guarantee that the
two parties to the transaction will perform. To see the importance of
this function, consider potential problems in the futures trade described
earlier from the perspective of the two parties—Chuck the buyer and
Donna the seller. Each must be concerned with the other’s ability to fulfill
the obligation at the settlement date. Suppose that at the settlement
date the cash price of the stock of Company X is $70. Donna can buy
the stock of Company X for $70 and deliver it to Chuck, who in turn
must pay her $100. If Chuck does not have the capacity to pay $100 or
refuses to pay, however, Donna has lost the opportunity to realize a
profit of $30. Suppose, instead, that the cash price of the stock of Company
X is $150 at the settlement date. In this case, Chuck is ready and
willing to accept delivery of the stock of Company X and pay the
agreed-upon price (i.e., futures price) of $100. If Donna cannot deliver
or refuses to deliver the stock of Company X, Chuck has lost the opportunity
to realize a profit of $50.
The clearinghouse exists to meet this problem. When someone takes
a position in the futures market, the clearinghouse takes the opposite
position and agrees to satisfy the terms set forth in the contract. Because
of the clearinghouse, the two parties need not worry about the financial
strength and integrity of the party taking the opposite side of the trade.
After initial execution of an order, the relationship between the two parties
is severed. The clearinghouse interposes itself as the buyer for every
sale and the seller for every purchase. Thus, the two initial parties are
free to liquidate their position without involving the other party in the
original trade, and without worry that the other party may default.
Besides its guarantee function, the clearinghouse makes it simple for
parties to a futures trade to unwind their positions prior to the settlement
date. Suppose that Chuck wants to get out of his futures position.
He will not have to seek out Donna and work out an agreement with her
to terminate the original agreement. Instead, Chuck can unwind his position
by selling an identical futures contract. As far as the clearinghouse is
concerned, its records will show that Chuck has bought and sold an
identical futures contract. At the settlement date, Donna will not deliver
the stock of Company X to Chuck but will be instructed by the clearinghouse
to deliver to someone who bought and still has an open futures
position. In the same way, if Donna wants to unwind her position prior
to the settlement date, she can buy an identical futures contract.
Margin Requirements
When a position is first taken in a futures contract, the investor must deposit
a minimum dollar amount per contract as specified by the exchange. This
amount, called initial margin, is required as a deposit for the contract. Individual
brokerage firms are free to set margin requirements above the minimum
established by the exchange. The initial margin may be in the form of
an interest-bearing security such as a Treasury bill. As the price of the
futures contract fluctuates each trading day, the value of the investor’s equity
in the position changes. The equity in a futures account is the sum of all
margins posted and all daily gains less all daily losses to the account.
At the end of each trading day, the exchange determines the settlement
price for the futures contract. The settlement price is different from
the closing price, which many people know from the stock market and
which is the price of the stock in the final trade of the day (whenever that
trade occurred during the day). The settlement price by contrast is the
value the exchange considers to be representative of trading at the end of
the day. The representative price may in fact be the price in the day’s last
trade. But, if there is a flurry of trading at the end of the day, the exchange
looks at all trades in the last few minutes and identifies a median or average
price among those trades. The exchange uses the settlement price to
mark to market the investor’s position, so that any gain or loss from the
position is quickly reflected in the investor’s equity account.
Maintenance margin is the minimum level (specified by the exchange)
to which an investor’s equity position may fall as a result of an unfavorable
price movement before the investor is required to deposit additional
margin. The additional margin deposited is called variation margin, and
it is an amount necessary to bring the equity in the account back to its
initial margin level. Unlike initial margin, the variation margin must be in
cash rather than an interest-bearing instrument. Any excess margin in the
account may be withdrawn by the investor. If a party to a futures contract
who is required to deposit variation margin fails to do so within a
specified period, the exchange closes the futures position out.
Although there are initial and maintenance margin requirements for
buying stock on margin, the concept of margin differs for stock and
futures. When stocks are acquired on margin, the difference between the
stock price and the initial margin is borrowed from the broker. The
stock purchased serves as collateral for the loan, and the investor pays
interest. For futures contracts, the initial margin, in effect, serves as
good faith money, an indication that the investor will satisfy the obligation
of the contract. Normally, no money is borrowed by the investor
who takes a futures position.
Read More : The Role of the Clearinghouse
