Futures contracts differ from forward contracts in that they are:

1. Standardized: Futures contracts have standardized terms and conditions, such as quantity, payment mode, delivery date, and price.

2. Guaranteed: Futures contracts are guaranteed by a clearinghouse, which acts as an intermediary between the buyer and seller. This ensures that both parties fulfill their obligations.

3. Traded on an exchange: Futures contracts are traded on a centralized exchange, such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE).

4. Marked-to-market: Futures contracts are marked-to-market, meaning that gains and losses are settled daily.

5. Regulated: Futures contracts are regulated by government agencies, such as the Commodity Futures Trading Commission (CFTC) in the US.

Here's an example using the mango pulp scenario to illustrate the difference between forwards and futures:

Forwards:

• The mango farm owner and the pulp company agree on a forward contract for 10,000 tons of mangoes at Rs. 30,000/ton.

• The contract is customized and not traded on an exchange.

• The pulp company backs out of the contract, leaving the farm owner with a surplus of mangoes and no buyer.

• The farm owner is left with a high counterparty risk and no guarantee of payment.

Futures:

• The mango farm owner and the pulp company agree on a futures contract for 10,000 tons of mangoes at Rs. 30,000/ton on a regulated exchange.

• The contract is standardized and guaranteed by the exchange's clearinghouse.

• If the pulp company defaults, the clearinghouse steps in to ensure the farm owner receives payment.

• The farm owner has a low counterparty risk and a guaranteed sale.

In this example, the forwards contract exposes the farm owner to high counterparty risk, while the futures contract provides a secure and guaranteed sale.

We have seen the differences between forward and futures contracts using the mango pulp example.

To summarize:

Forwards:

• Customized contracts

• No regulation or guarantee

• High counterparty risk

• No centralized exchange

Futures:

• Standardized contracts

• Regulated and guaranteed

• Low counterparty risk

• Traded on a centralized exchange

In summary, forwards are personalized contracts with high risk and no regulation, while futures are standardized, regulated, and guaranteed contracts with lower risk, traded on an exchange. The key advantage of futures contracts is that they are well-regulated, ensuring a higher level of security and reliability for both parties involved.

How does the clearinghouse ensure this? 

In futures trading, both buyers and sellers must deposit an initial margin, a percentage of the contract value, with the clearinghouse. The contract is continuously adjusted to reflect market fluctuations, a process known as marking-to-market. Both parties must maintain a minimum balance with the clearinghouse. The clearinghouse ensures default risk is eliminated by collecting payments and settling trades. Each trade consists of two separate obligations, one for the buyer and one for the seller, both guaranteed by the clearinghouse. If one party defaults, the clearinghouse takes an opposing position to ensure the contract is fulfilled, providing a secure and reliable trading environment. 

To summarize:

• The clearinghouse requires both parties to deposit an initial margin, a percentage of the contract value.

• The contract is marked-to-market, meaning its value is adjusted in real-time to reflect market fluctuations.

• Both parties must maintain a minimum balance with the clearinghouse.

• The clearinghouse acts as a guarantor, ensuring the contract is fulfilled even if one party defaults.

• The clearinghouse takes an opposing position to ensure the contract is settled (e.g., if one party has a "right to buy", the clearinghouse takes a "sell" position).

• Futures contracts are standardized, with specified quantities, shares, and delivery dates.

• The clearinghouse handles back-office operations, guaranteeing performance and eliminating default risk.

By playing this crucial role, the clearinghouse makes futures contracts a reliable and tradable asset, like shares. Great job explaining this complex process!

MARGIN MONEY  

To enter into a futures contract, you don't need to pay the full amount. Instead, you need to maintain a margin with the broker, which is a small percentage of the contract value. The exchange determines the margin amount, which fluctuates based on daily price changes.

For example, if you buy a futures contract for 100 Infosys shares at Rs. 1000 per share with a 20% margin requirement, you'll pay Rs. 20,000 as margin. If the price drops to Rs. 900, you'll lose Rs. 10,000, reducing your margin to Rs. 10,000. To keep the contract active, you'll need to deposit an additional Rs. 8,000 to maintain the required margin of Rs. 18,000.

However, futures contracts can be actively traded. If the price rises to Rs. 1100, you can sell the contract for a profit of Rs. 10,000 (Rs. 100 per share). The exchange will return your margin and collect a new margin from the buyer.

 Forwards vs Futures: Key Differences

1. Contract Size:

   • Forwards: Customized size decided by parties involved

   • Futures: Standardized lot size fixed by the exchange

2. Price:

   • Forwards: Fixed price decided by parties until contract end

   • Futures: Price fluctuates daily, marked-to-market

3. Margin Money:

   • Forwards: Optional, decided by parties

   • Futures: Mandatory, percentage of contract value, decided by exchange

4. Number of Contracts:

   • Forwards: Unlimited

   • Futures: Limited, decided by exchange

5. Settlement:

   • Forwards: Over-the-counter (OTC)

   • Futures: Through the exchange

6. Delivery:

   • Forwards: Can be delivery or cash settlement

   • Futures: Usually cash-settled

These points highlight the main distinctions between forward and futures contracts, making it easier to understand their differences.