Contract Design of Futures Contracts
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Contract Design of Futures Contracts | 45
educational series XVII
Contract Design of Futures Contracts
Madhoo Pavaskar
Importance of Contract Design futures trading, and serve the real interests of genuine
As commodity futures contracts are essentially standardized market functionaries requiring price risk management
contracts, designing a futures contract for any commodity facilities for their physical market forward transactions
assumes considerable importance in the development for sale or purchase in either the domestic or overseas
of a derivative or futures market in that commodity. For market, or acquisition of stocks. The principle to be borne
one thing, the contract for trading in futures for any in mind in framing the terms of futures contract is that
commodity needs to attract adequate liquidity or trading such a contract should be balanced and unbiased, favouring
volumes through trades of both commercial interests neither one or the other class of traders engaged in either
(market functionaries trading in the physical market for long (purchase), or short (sale), side of the physical market.
ready or forward delivery for that commodity) as well as To put it differently, it should be equally beneficial for
non-commercial interests (such as speculators of diverse hedging or price risk management to both long and short
hues, including day traders, position traders, arbitrageurs, hedgers in the futures market for any commodity chosen
investors, swap dealers, and others). The viability, and more for futures trading.
importantly, the economic utility of a commodity futures
contract, or its derivatives, for effective price discovery The economic utility of a commodity futures contract also
and efficient price risk management depends on wider requires that the contract should be sufficiently broad,
participation of not only the physical trade and industry or wide, enough to cover most, if not all, the available
in the commodity concerned, but also the speculative and marketable supplies from all sources and locations across
investor class. the country or region to be served by the contract. In other
words, the contract should allow deliveries of at least of all
It follows that the futures contract terms for any major varieties of the commodity at all major assembling,
commodity selected for futures trading must broadly distribution, consuming, and export locations, other than
conform to the terms of contracts for that commodity the “basis” variety (i.e. the key standard variety deliverable
as actually prevailing in the physical spot and forward against the futures contract without payment of any “off ” or
markets for that commodity to ensure the efficiency of “on” allowance at a specific location, for which prices will be
price risk management in that commodity. After all, the quoted for the contract) to enable sellers to sell freely and
price risk management or hedging efficiency of a futures without fear of supplies of the commodity being cornered
market for any commodity presupposes a close correlation by some unscrupulous traders
between the prices of physical market contracts in that
commodity and those of futures contract in it. Without All the same, the contract should also not be too broad to
such correlation, the futures market will necessarily remain permit deliveries of many diverse varieties, far different
unattractive to the physical-market players. The absence in their quality specifications and end-uses from those
of physical-market traders, in turn, will ipso facto render of the basis variety, as to render the contract awfully
the commodity futures market concerned ineffective for uncertain for the buyers in that they may end up receiving
proper price discovery. A commodity futures market is deliveries of unwanted varieties of little use to them. In
basically a hedging market. A market deserted by hedgers the process, buyers will necessarily shun away from such
is unlikely to survive for long, as it will surely be neglected market, affecting adversely its liquidity, too. This is not
by speculators, too. For, speculators and investors, who seek all. Commodity futures market may find it even more
to profit from anticipated price changes in a commodity, difficult to make prices of such a contract of heterogeneous
also need a market that discovers prices effectively. varieties, with unrelated end-uses, of a commodity. Price
At the same time, it is absolutely necessary that the contract discovery will be a fatal casualty for such a contract. Broad
terms are framed in such a manner that they provide in- homogeneity in deliverable varieties is therefore a proper
built checks to the possible malpractices and abuses of prerequisite for a good contract design.46 | Financial Vision, Volume 1/Issue 2/March 2013
Terms of Contract the basis may therefore rather be “mode”, in that the bulk
The main terms of the contract relate to the “basis variety” of the production of that commodity actually partake of
of the contract; the varieties deliverable against it, and the quality characteristic of that variety. The selection of
premiums and discounts for deliverable varieties vis-a-vis any other variety may affect adversely the efficiency of price
the price of the basis variety; the delivery locations at which discovery of the futures contract.
deliveries against the maturing contract are permitted; the
delivery or maturity months of the contract spread over a Thus, in the 1950s and the 1960s, when a single all-India
year; the unit of pricing, trading, and delivery; and the time cotton futures contract was traded at the East India Cotton
of commencement of trading in different delivery months Association (the precursor to the present day Cotton
that determine the duration of trading for different delivery Association of India) in the then Bombay (renamed presently
months. as Mumbai), M. G. Moglai Jarilla 25/32” staple variety was
prescribed as the basis, while all other cotton varieties grown
Basis Variety across the country were allowed to be delivered against the
The selection of “basis variety” presents no problem contract, with stipulated premiums and discounts. Moglai
for commodities that are absolutely homogenous. Not Jarilla 25/32”, however, was a relatively inferior variety of
many commodities partake of such character, however. cotton, grown in some parts of Central India (mostly the
True, during the 1950s and 1960s, futures contracts for Vidharbha region of Maharashtra), and accounted for less
coconut oil traded at Alleppey and Cochin (present day than 5% of the all-India cotton production in those days.
Kochi) provided for delivery of coconut oil without any As a result of the choice of this inferior variety of cotton as
specific variety being described. This took place largely the basis, the Indian Cotton Contract, as it was then known,
because of the lack of knowledge among local traders in traded at Bombay became bearish, upsetting its utility for
those days on the chemical properties of most edible oils. either effective price discovery or risk management for most
Such conditions rarely arise these days with far-reaching of the cotton production in the country. In fact, because
advances in chemical technology. The quality characteristics of its bearishness, the market was almost, not altogether,
of most commodities entering trade are now quite precisely though, devoid of short hedging mostly, and turned purely
assessable, and even quantifiable. speculative, with not much volumes in it most of the time.
The need for defining the “basis” variety arises because in In contrast, the castor seed futures contract traded during
most of the commodities, there are usually several varieties the 1950s and the 1960s at the then Bombay Oilseeds and
traded in the same market at different prices, depending on Oils Exchange (now renamed as Commodity Exchange
their physical and chemical characteristics, source of origin, of India) had its basis, Bombay Small, which basically
end-uses, and so on. Futures contracts cannot be developed represented Gujarat Small and Madras Small varieties
in all such varieties of a commodity; as such, different of castor seed, both being deliverable at par against the
varietal contracts in the same commodity, if were traded contract. With these two varieties accounting for most
on an exchange simultaneously, are unlikely to attract of the castor supplies in the country, the contract then
adequate trading volumes, or liquidity, without which no attracted massive trading volumes, which was several times
market for a futures contract can ever survive. Hence, even the castor production in the country. Unsurprisingly, the
in a commodity with a large number of diverse varieties, castor contract was then extensively used for hedging
not many varietal futures contracts can be developed by castor merchants, crushers, and exporters, with the
successfully for a commodity exchange. After all, though castorseed futures price actually serving as the benchmark
quality specifications of different varieties are different, price not only domestically, but also globally, because India,
many of the varieties of a commodity are substitutable to along with Brazil, had virtual monopoly in the export trade
a large extent over a wide spectrum of end-uses. A more of castor oil in those days. The castorseed futures market in
representative variety from among these can therefore well Mumbai was then the price setter for castor seed the world
serve as the basis variety for the futures contract in that over because unlike India, Brazil had no futures market in
commodity, and such contract can effectively be used for castor seed at that time.
price discovery and risk management in all other varieties,
too. For, it is only when the prices of a futures contract can In fact, Bombay Oilseeds and Oils Exchange (BOOE)
reflect the general trend of prices of different varieties of a successfully ran during the first two decades of the last
commodity that it can provide adequate hedging protection century futures contracts in several oilseeds and their
to the various trade and industry interests dealing in products like groundnut, cottonseed, linseed, groundnut
different varieties of that commodity. That underscores oil, and groundnut expeller cake. Owing to the choice
the need for selecting a fairly representative variety as the of the most representative and widely traded varieties in
basis variety. these different commodities as the basis varieties, BOOE
allowed deliveries of other varieties at proper premia and
A representative variety is necessarily the one that accounts discounts, depending on their qualitative differences from
for the major or significant proportion of the production the stipulated specifications of the respective basis varieties
or supply of that commodity. It follows that the basis in such commodities. To be sure, groundnut being then
variety need neither be the “mean” nor “median” variety the kingpin amongst all oilseeds grown in the country, the
among the different varieties of a commodity in their prices of futures contracts in groundnut and groundnut oil
measurable quality specifications. The preferable variety for at BOOE served at that time as yardsticks for determiningContract Design of Futures Contracts | 47
the physical-market prices of even other oilseeds like
sesamum seed, safflower seed, niger seed, and also rapeseed/ In contracts for all base metals, the purity of the highest
mustard seed; these different oilseeds were not traded in order has been sanctioned as deliverable for the basis.
futures at Bombay, though. This happened because the There are no other deliverable specifications. To put it
futures contracts traded at BOOE were all-India contracts differently, there are no deliverable varieties for all the
serving the trade and industry interests of the entire oilseeds different contracts in base metals. The active energy futures
economy across the country. at MCX are two, namely, crude oil, and natural gas. Here
too, there are no deliverable varieties. Only the precise basis
Unlike the Indian Cotton Contract, the local commodity specifications are prescribed for delivery.
contracts traded at various regional commodity exchanges
in the country also fared quite well in those times. For these Among agro-commodities and their products, only the
regional contracts, the varieties chosen as the basis were basis variety is deliverable against the rubber futures
the local varieties grown in the area commanded by the contract. In oilseeds and their products, futures contracts
exchange market. Thus, the basis of the futures contract exist at MCX in cottonseed cake, crude palm oils, soya bean,
traded those days in the futures market at Ahmedabad, and refined soya oil. All these contracts have deliverable
which then to the requirements of the local cotton interests, varieties against their respective basis varieties, but the
was ‘Kalyan’ cotton grown mostly in Gujarat. Similarly, the contracts are still narrow in that deliveries are restricted to
basis of the cottonseed futures contract at Akola exchange a few centres only. As a result, these contracts have failed to
was then ‘Jarilla’ cottonseed, whereas at Amritsar futures attract adequate trade interest.
market it was ‘320F’ cottonseed, both being local varieties
grown in the command areas of the respective exchanges. Cotton futures contract was added by MCX in its portfolio
Same was the case with other regional exchanges trading of traded contracts in 2011. The basis variety for this
in such commodities as raw jute and jute goods, rapeseed/ contract is standardized grade of Indian cotton as per HVI
mustard seed, pepper, and gur. Middling 31-3 American grade of 29 mm (+/- 2 mm) staple,
with 2.5% span length, micronaire varying from 3.6 to
With the emergence of national exchanges from the New 4.8, tensile strength of 28 GPT, trash content of 3.5%, and
Millennium, the situation changed, however. Major farm moisture up to 8.5%. However, cotton varieties of staples
commodities and their products like cotton and cotton ranging from 27mm to 31 mm of the same span length were
seed, oilseeds and oils, and raw jute and jute products, by allowed to be delivered at such premiums and discounts as
and large, lost their importance in the futures market arena; were calculated by the exchange in the stipulated manner
a few other agricultural commodities, such as mentha oil, before the commencement of trading for each delivery
soya oil, and rubber, disclose some volumes, though. Metals, month. Premiums were payable by the buyers on receiving
both precious and non-precious, and energy products, deliveries of cotton of staples exceeding 29 mm, while sellers
presently preponderate on the Indian commodity futures were required to accept discounts on cotton of staples short
scene. of 29 mm delivered by them. Similarly, some variations
were permitted in Middling grade, micronaire, and trash
The basis varieties for the different contracts in precious content, subject again to premiums and discounts drawn in
metals are essentially based on the purity of bars of the the stipulated manner before launching contract for trading
respective metals as are sold in their physical markets. Thus, in each delivery month. These provisions rendered the
in the case of gold futures contract for one kilogram, the cotton futures contract traded at MCX sufficiently broad-
basis has been stipulated at 995 purity (fineness) gold bar, based, with deliverable cotton accounting for almost 80% of
but if the purity of the delivered bar were 999, then the cotton produced in the country. Small wonder, the cotton
seller is entitled to receive a premium calculated at 999/995 futures contract traded at MCX has evoked considerable
of the delivery rate, while if the purity of the bar were less hedging and speculative interest from both commercial as
than 995, the delivery will be rejected by the exchange itself. well as non-commercial trade interests.
Nearly similar quality specifications have been mandated
for gold futures contracts of smaller trading units like “gold Deliverable Varieties
mini” of 100 gm, “gold guinea” of 8 gm, and gold petal of The need for deliverable varieties arises in futures contracts
just 1 gm. for most commodities, which have different tradable
varieties because if the delivery of only the basis variety
In silver, on the other hand, only 999 purity forms the were permitted against the futures contract, it is likely
basis for contracts of all trading units, namely, 30 kg that one or more powerful and resourceful individuals or
silver, 5 kg silver, and 1 kg silver, whereas in platinum, firms may buy in the ready market all the available stocks
only 99.95 purity bar is deliverable against the contract of of that variety, especially when such stocks are small, and
250 gm trading denomination. In other words, there are simultaneously make heavy purchases in the futures market
no deliverable varieties, besides the basis variety. All these also to squeeze the sellers. In such a situation, the sellers
contracts in precious metals are quite popular, and attract in the futures market would be unable to deliver against the
huge trading volumes, because their specifications for the futures contract for want of free stocks in the market, and
basis and deliverable are in consonance with the prevailing would therefore be compelled to settle their contracts with
specifications that are in vogue in the physical market the buyers at prices dictated by the latter.
trades for precious metals.48 | Financial Vision, Volume 1/Issue 2/March 2013
To prevent such unhealthy situations, the terms of futures about delivery locations in the buyers’ minds, it is also
contracts for most commodities need to permit delivery essential that the number of delivery centres is not so small
of several varieties other than the basis variety. Without as to exclude sizeable supplies of the commodity available
such deliverable varieties, the contract may become too at major locations. Whereas too many delivery centres
narrow, and will be susceptible to easy squeezes or corners may render the futures contract bearish as buyers seek to
by unprincipled traders. Such other varieties are known cover the delivery locational uncertainty in their minds,
as tenderable varieties and these can be delivered against too few centres may make the contract susceptible to easy
the futures contract at premium (to be paid by the buyer manipulation, besides denying the facility for hedging to
when a superior variety is delivered), or discount (to be major producing or consuming areas outside the hinterland
allowed by the seller when an inferior variety is delivered of the primary centre.
by him). Such premia and discounts for different varieties
are generally fixed according to the actual or normal spot Of course, when delivery is permitted at centres other than
price differences between such tenderable varieties and the the primary pricing centre, there is ordinarily a provision
basis variety. for the seller paying to the buyer the cost of transport from
the place of delivery to such primary pricing centre, and also
The methods of fixing tendering differences vary among an additional charge to compensate the buyer for incidental
exchanges for different commodities. As a rule, however, expenses and inconvenience that may be caused to him for
it is advisable to fix the tendering differences before the receiving delivery at such other centre. All such transport
commencement of trading in a contract for a delivery and other incidental costs need to be always prescribed
month. That removes the uncertainty in the market about before the onset of trading for any delivery month.
the magnitude of premia and discounts while trading in the
contract. On the other hand, if the tendering differences Delivery Months
were to be fixed during the delivery month based on The months of delivery are the months or the periods
actual spot prices for different varieties as prevailing then, during which delivery are required to be issued by the
not only an element of uncertainty prevails in the minds sellers against their outstanding transactions in the futures
of both buyers and sellers of the futures contract during contract. Strictly from the hedging point of view, it
the duration of that contract, but also provides scope might appear desirable to have as many delivery months
for unscrupulous traders to manipulate the spot prices in a year as possible. Thus a person (like exporter) who
during the month of delivery to their advantage for either wishes to have the actual commodity in the month of say,
issuing or receiving deliveries of the tenderable varieties. May, (for shipment) would like to effect his hedge purchase
Ideally, therefore, tendering differences need to be fixed in for delivery in the month of May rather than in any other
prescribed amounts based on the spot prices of different near or distant delivery month. This would be so because
varieties prevailing before the beginning of trading in a the futures contract for delivery in May would truly reflect
contract for a specified delivery month. the price at which such person would be able to secure his
physical goods for shipment in that month. He could also
Delivery Centres enter into his forward sale commitment (in this instance,
For fixing the price of a futures contract in any commodity, export commitment) based on the price of the futures
the contract terms prescribes a centre, where deliveries contract for that particular delivery month, and could
against the contract are primarily to be received or issued. simultaneously also make his hedge purchase in the futures
The bid and ask prices for a commodity futures contract are contract for that delivery month. That would ensure a
therefore essentially for delivery of the basis variety at that perfect hedge for him.
stipulated centre only. Nevertheless, to make the futures
contract broad and difficult to corner, it is also necessary Besides, if all the calendar months are prescribed as delivery
to allow deliveries at the option of the seller at one or months, the hedgers would avoid the costs of switching over
more of the major centres located in different producing or their hedges from contracts for the near maturity months
consuming areas. It is then practically impossible for one to those for the subsequent delivery months. Ideally,
or a group of individuals to corner all stocks of the basis therefore, contracts for delivery in as many as subsequent
and the tenderable varieties at all the delivery points, which 12 months, or even more, should be permitted for trading
are usually important up-country assembling and terminal simultaneously. Thus, the futures markets in the U.S. mostly
market centres. At the same time, to enhance the utility of provide for contracts for as many as 18 to 24 delivery
the hedge contract and reduce the uncertainty among the months, or even more for some commodities. But when
minds of genuine buyers as to where they may be required contracts for too many delivery months are traded at a time,
to receive deliveries, it is always necessary to keep the the volume of trading in each of such contracts may turn
delivery centres as restricted as possible in consonance with out to be relatively small, and, as a result, each such contract
the objective of keeping the market free from manipulative may not prove to be as liquid as is necessary for placing and
tendencies, but, all the same, also broad enough to cover lifting hedges quickly without undue fluctuations in prices.
all homogenous varieties for quality specifications of It is for this reason that most of the futures markets in
different origins. India allow trading in not more than three to four delivery
In other words, while the contract terms should not permit months at a time. Often, the prescribed delivery months in
too many delivery centres spread over much distant area a year are also few, and at least in agricultural commodities,
from the primary pricing centre so as to create uncertainty they coincide with the peak months of market arrivals. ForContract Design of Futures Contracts | 49
non-farm commodities, like metals and energy products, Quantities which can be purchased or sold in the futures
all 12 calendar months are prescribed as delivery months; market at any one time are expressed in units of trading
simultaneous trading is permitted in not more than three or or multiple thereof. For instance, in the oilseeds futures
four delivery months, though. Even in the U.S. and other market, the unit of trading is 10 tonnes. In cotton, it is
international commodity exchanges, contracts for mostly 50 bales. A higher unit of trading is generally fixed in
near delivery months are active, while trading in distant many futures markets to discourage speculation by persons
delivery months is generally sparse. of small means. At the same time, it is essential to avoid
fixation of a prohibitively high unit of trading, which may
During the prescribed delivery month, sellers can offer discourage speculation altogether and affect the liquidity of
deliveries on any one or more of the several days specified the market. In fact, of late, to encourage volumes and offer
in this behalf. These days are called ‘tender’ days. The facilities for hedging to small traders, exchanges have issued
seller has usually the option to offer delivery on any of mini contracts also.
the tender days. Of late, however, the Forward Markets
Commission (FMC) has provided for compulsory delivery Timing of Commencement of Trading
in all outstanding contracts during the delivery month for The timing of the commencement of trading for contracts
most commodities. When supplies are scarce, this provision in different delivery months is important for providing
has not infrequently adverse influence on prices, as buyers continuous hedging facilities. It is essential that trading
of futures contracts (longs) then tend to squeeze the sellers in at least one delivery of the futures contract should be
(shorts). permitted at any time, and for orderly transfer of positions
from one delivery to the next, it is desirable that trading
Pricing and Trading Units in the next delivery should commence about a month
In commodity futures contracts, units of pricing or before the maturity of the preceding delivery. At present,
quotation are generally laid down according to the trade the exchanges need the permission of the FMC before
practices. After the introduction of the metric system of they embark on trading for a contract for any delivery
weights and measures in this country, however, a quintal or month. Though the contract terms often provide for
a multiple of it has generally been the unit of quotation in specific months for commencement of trading in contracts
most of the markets. for different delivery months, the FMC has curbed the
freedom of exchanges in this regard.
madhoo.pavaskar@ftindia.comYou can also read
