Page 253 - A Canuck's Guide to Financial Literacy 2020

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Futures Contract

A futures contract is very much similar to a forward contract where two parties agree to buy
or sell an underlying asset at a specific price sometimes in the future. However, there are
distinctions that we'll discuss below. First, a futures contract is a legally binding agreement
that allows two parties to buy or sell a standardized asset at a specific point in time.
Second, the transaction is facilitated and settled through a futures exchange.

Futures Exchange

A futures exchange is where investors can buy or sell standardized futures contracts that
are defined by the exchange. The most common type of contracts are in reference to
commodity or financial instruments. Future exchanges are valued by investors as they
make the transaction and the settlement process straight forward. Benefits of the exchange
include but not limited to;

• Act as physical or electronic trading venue - Futures contract act as a place
where parties can negotiate and agree to various types of contracts. They may do
the negotiations strictly on the trading floor or through high speed, online, electronic
trading.
• Standardize each contract - An exchange would standardize each futures contract
by specifying the quantity, quality, physical delivery and location for the asset in
question. All specifications would be identical for all parties transacting on a
particular contract.
• Provide market and price data- Futures can be bought and sold on a daily basis.
The exchanges would provide liquidity and enable investors to complete their buy or
sell transactions.
• Provide settlement & delivery procedures - As each futures contract is
standardized, the settlement and delivery location would be known ahead of time.
• Act as clearinghouses - Upon expiration or maturity of the contract, the exchange
would act as a intermediary to help settle the contract by either taking delivery of the
underlying asset or proceeding with a cash settlement.
• Assist in margin mechanism - Depending on the type of contract and underlying
asset, it's important to note that exchanges can issue margin calls as a way to
manage credit and default risk.

The Chicago Board of Trade is one of the first and largest commodities exchanges in the
world. They've developed a standardized agreement to a futures contract.

Futures Margin

As you recall, a futures contract is a standardized agreement between two parties agreeing
to buy or sell an underlying asset at set price on or before the expiration date. When you