Futures Terminology

i) Futures: A forward contract traded on an exchange
ii) Long: A party is said to be long on an instrument when he or she owns the instrument. An investor who purchases stock with his own capital is said to be long stock. A long position indicates a net over bought position.
iii) Short: A party is said to be short if he or she has sold the contracts. An investor who sells a stock that he does not currently own is short stock. Short positions indicate an over sold position.
iv) Spot price: The price at which an asset trades in the spot market.
v) Futures price: The price at which the futures contract trades in the futures market.
vi) Expiry date: The last day on which the contract will be traded, at the end of which it will cease to exist. The expiry day is the last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday.
vii) Contract size: The amount of asset that has to be delivered under one contract. For instance, the contract size on NSE’s futures market is 200 Nifties.
viii) Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one (near) month, two (next) months and three (far) months expiry cycles which expire on the last Thursday of the month. On the Friday following the last Thursday, a new contract having a three month expiry would be introduced for trading.
ix) Marking to market: The practice of periodically adjusting a margin account by adding or subtracting funds based on changes in market value to reflect the investors’ gain or loss. This is to ensure there are no defaults.
x) Margin: An amount of money deposited by both buyers and sellers of futures contracts to ensure performance of the terms of the contact. The aim of margin money is to minimize the risk of default by either counter party. The payment of margin ensures that the risk is limited to the previous day’s price movement on each outstanding position. However this risk is offset by the initial margin holdings. There are different types of margins such as initial margin, variation margin, maintenance margin and additional margin.
xi) Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into. The purpose of initial margin is to cover the largest potential loss in one day. Both buyer and seller have to deposit margins. The technique of value–at-risk (VaR) is used for calculating this margin. This margin is calculated on the basis of variance observed in daily price of the underlying over a specified historical period. The margin is kept in a way that it covers price movements more than 99 percent of the time. Usually three sigma (standard deviation) is used for this measurement.
xii) Maintenance margin: The amount that is set aside to ensure that the balance in the margin account never becomes negative is called maintenance margin. It is usually lower than the initial margin. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call.
xiii) Variation or mark-to-market margin: The amount that is deposited as further collateral to meet daily losses. This margin is required by the close of business, the following day. Any profits on the contract are credited to the client’s variation margin account.
xiv) Additional margin: The amount that may be called for by the exchange in case of sudden higher than expected volatility. This is a preemptive move by the exchange to prevent breakdown.
xv) Hedge ratio: The number of futures contracts required to buy or sell to offset risk. If the instruments to be hedged show high volatility, then a larger number of future contracts are required than in the case of a more stable instrument. This depends on the value of a futures contract, value of the portfolio to be hedged, and sensitivity of the movement of the portfolio price to that of the index called beta. The hedge ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and the underlying (index) from which futures is derived. When a stock index futures contract is used to hedge a position in a portfolio of stocks or a position in an individual stock, the optimal number of futures contracts is equal to the beta of the position times the ratio of the value of the portfolio to the futures contract price.–

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