Margining and marking to market are mechanisms that are designed to prevent defaults in futures contracts
By Sunil Parameswaran
In the case of futures contracts, the profit or loss from a position is computed and settled at the close of trading on a day. Thus, profits and losses cannot accumulate over time. The price that is used for computing the gain or loss is called the settlement price.
Some exchanges state that the closing price will be taken as the settlement price. Others, like exchanges in India, hold the view that since there is heavy trading at the close, it is difficult to pinpoint one price as the closing price. Consequently, they take a volume weighted average of prices in the last half hour of trading. Since futures contracts are zero sum games, one party’s account will be credited, while that of the other will be debited with an equivalent amount.
As the futures price fluctuates, an active contract acquires value. If the price were to increase, a long position would see an increase in value, whereas if the price declines, a short position would see a rise in value. Marking to market at the end of the day is a settlement of built-up value. Thus, each time the contract is marked to market the value of an existing futures position reverts back to zero. Hence, the only time a futures contract acquires a value is between two successive markings to market calculations.
If a party trades on a day the position will be marked to market at the end of that day. Thereafter the position will be marked to market at the end of every following day, unless the contract expires or is offset. Offsetting means taking a counter-position. That is, if a party has gone long initially it goes short subsequently and vice versa. Once a trader offsets a position, the exchange has no further interest in him or her.
Forward a position
In practice, a trader will trade on multiple occasions during a day. Typically, he will bring forward a position from one day to the next. On the next day, he will trade multiple times. So, how is the cash flow determined when the contract is marked to market on the following day?
For contracts brought forward from the previous day, take the previous day’s settlement price and subtract it from the current day’s settlement price. If it is positive, the long will have a positive cash flow while the short will have a negative cash flow. The situation will be reversed if the difference is negative.
Next, we consider each trade on the second day. If the trader has gone long, we subtract the trade price from the settlement price. Else, if the trader has gone short, we subtract the settlement price from the trade price. Positive differences lead to credits to the margin account, whereas negative differences lead to debits to the margin account.
A contract will have a contract size or multiplier. Thus, the profit or loss for a trade is the product of the number of contracts, the contract multiplier, and the difference in the prices. Margining and marking to market are mechanisms that are designed to prevent defaults. Since futures contracts are commitment contracts, a priori there is a possibility that the long may default, as well as a possibility that the short may default. Consequently, the clearinghouses will collect margins from both parties.
The writer is CEO, Tarheel Consultancy Services