While forward contracts are settled on the maturity date, futures contracts are ‘marked market’ on a periodic basis.
This means that the profits and losses on futures contracts are settled on a periodic basis.
The marking-to-market feature of a futures contract may be illustrated with an example.
Suppose on Monday morning David takes a long position in a futures contract that matures on Friday afternoon but is marked to market on a daily basis.
The agreed-upon price is, say, ₹100. At the close of trading on Monday, the futures price rises to ₹105. Now the marking-to-market feature means that three things would occur.
First, he will receive a cash profit of ₹5. Second, the existing futures contract with a price of ₹100 would be canceled.
Third, he will receive a new futures contract at ₹105. In essence, the making-to-market feature implies that the value of the futures contract is set to zero at the end of each trading day.
The settlement margins are always collected in cash. Funds for settlement are automatically debited and credited to the respective accounts of the clearing members.
Each clearing member must open an account with one of the clearing banks, and sufficient funds must be available for the process of settlements and margins – at the risk of default proceedings.
The basic purpose of the mark-to-marking is that the futures contracts should be daily marked or settled and not at the end of their life.
Every day, the trader’s gain (loss) is added or (subtracted), the margin, on the case, maybe. This brings the value of the contract back to zero. In other words, a futures contract is closed out and rewritten at a new price every day.
Example 3: Suppose that you enter into a short futures contract to sell August gold for ₹520 per gram on the XYZ Exchange. The size of the contract is 10kg.
The initial margin is ₹5,00,000, and the maintenance margin is ₹3,00,000. What change in the future price will lead to a margin call? What happens if you do not meet the margin call?
Solution: There will be a margin call when ₹2,00,000 has been lost from the margin account. This will occur when the price of gold increases by ₹2,00,000/10kg = ₹20,000.
The price of gold must, therefore, rise to ₹540 per gram for there to be a margin call. If the margin call is not met, your broker closes out your position.
Example 4: An investor predicts a price increase in the silver futures market from current futures price of ₹8000 per kg. The market lot is 10kg.
He buys one lot of futures silver of ₹(8000×10) = ₹80,000. Assume that margin is 20%. What is the amount of margin money? Suppose, if the price of silver increases by 20%, what will be profit/loss to the investor?
Solution: Margin money = 20% of the contract value ₹80,000 x 20% = ₹ 16,000
If price of silver increased by 20%, then
Price of Silver Futures Contract = ₹80,000 + (₹80,000 x 20%) =₹80,0001 f16,0001 ₹96,000
Thus, Profit to Investor = ₹96,000 – ₹80,000 = 116,000.