Futures contracts, daily settlement and margin calls

How do futures differ from forwards?

A futures contract is a forward with standardized size, dates and underlying that trades on a futures exchange. The agreed price is the futures price , f₀(T). The exchange sets the contract terms based on what buyers and sellers want, so every contract is the same. That uniformity, together with an organized market and a central clearinghouse , gives futures more liquidity and much better protection against default than a forward, which trades over the counter (OTC).

	Forward	Futures
Where	OTC	exchange
Terms	customized	standardized
Gains and losses settled	at expiration	daily (mark to market)
Counterparty risk	bilateral	clearinghouse guarantee, margin
Closing early	offsetting contract with the dealer	trade the same contract on the exchange
Regulation and transparency	lighter	heavier; prices public

At expiration a futures contract settles on the same difference as a forward: S_T − f₀(T) for the long. If the two have the same terms, the final payoff profile is the same. The difference is when the cash moves, and that is the whole point of the next section.

$$f_T(T) - f_0(T) = S_T - f_0(T)$$

Futures protectionsnone of these exist in a plain forward

• Daily settlement Memorize losses cannot build up
• Margin Memorize collateral posted by both sides
• Clearinghouse guarantee Memorize backed by its insurance fund
• Price limits and circuit breakers Use it cap how far a price can jump in a day

How does daily settlement work?

At the end of every trading day the clearinghouse takes an average of the final prices of the day and calls it the settlement price . All contracts are then valued at that price. This process is called daily settlement , or mark to market (MTM) . Each day the long gains if the settlement price rose and loses if it fell, and the short has the opposite result.

$$\text{MTM} = [f_t(T) - f_{t-1}(T)] \times \text{units} \times \text{contracts}$$

The money moves through each party’s margin account, held at the exchange. The clearinghouse credits the account of the side with the gain and debits the side with the loss, so a loss is paid for immediately, not at expiration. That is why the clearinghouse’s guarantee is cheap to provide: losses never get large before they are collected.

How does the margin account work?

No cash changes hands for the price when a futures position is opened, as with a forward. Instead each side must deposit a minimum amount with the exchange.

• The initial margin is the deposit required to open the position.
• The maintenance margin is the minimum balance that must be held from then until settlement. It is set below the initial margin.
• The variation margin is the deposit that restores the balance after it has fallen below maintenance.

Futures margin accountheld at the exchange for each position

• Initial margin Memorize deposit to open the position
• Maintenance margin Memorize the floor, set below initial; falling under it triggers a call
• Variation margin Memorize the deposit that restores the balance to initial

If the balance falls below the maintenance margin, the exchange issues a margin call : a request to deposit funds at once. The amount must bring the account back to the initial margin, not to the maintenance level.

$$V = M_{\text{initial}} - B \quad \text{when } B < M_{\text{maintenance}}$$

If a margin call is not met, the position must be closed out as soon as possible and the holder covers any further losses. If the holder cannot pay, the clearinghouse covers the loss from its insurance fund. That is the guarantee.

Exam tip Two checks catch most margin errors: compare the balance with maintenance (total, not per contract), and if there is a call, bring it to initial.

What are price limits and circuit breakers?

Exchanges can protect themselves further. They may raise margins or call for margin intraday when a position is large or volatility jumps. Some contracts also have price limits : a band around the previous day’s settlement price outside which no trade may occur. If someone wants to trade beyond the band, trading stops until two parties agree on a price inside it. A circuit breaker is a short pause in intraday trading when a limit is hit.

At expiration the number of contracts still outstanding is the open interest . These are settled by cash or by physical delivery. Most traders close out earlier instead, by taking the opposite position in the same contract; the clearinghouse marks it to the latest price and removes it.

Go deeper Same payoff, different timing

A forward pays all of the gain or loss at expiration. A futures contract pays it in daily instalments. The total over the life is the same, S_T − f₀(T), but money received sooner can be invested sooner, so the two are not strictly equal in value. The difference is small for short maturities and low interest rates, and it is the reason forward and futures prices can differ slightly. The futures pricing module explains the effect.

Go deeper Physical delivery and convergence

A futures contract states whether it settles by physical delivery or in cash. With physical delivery the seller must deliver a specified type, amount and quality of the underlying to a set location, and the buyer must accept and pay. That obligation forces the futures price to converge to the spot price at expiration.

Go deeper Why margin calls create liquidity risk

A holder with a hedge on a futures position may be right on the economics but still need cash within hours when the market moves against the futures leg. Raising that cash in a hurry can force the sale of other assets. The risks of derivatives module returns to this point.