Limitations of Futures – Mark-to-Market & Margin Requirements

Futures are safe, but they are strict. They have "Rigid Rules".

1. Key Limitations

A. Lack of Flexibility (Standardization Disadvantage)

• You cannot hedge odd amounts.
• Example: If Lot Size is 50 and you have 75 shares to hedge, you must hedge 50 or 100. You are either under-hedged or over-hedged.

B. Margin Calls (Cash Flow Risk)

• Daily MTM: If the market goes against you, you must pay cash immediately (by next morning).
• Risk: A company might have a valid hedge, but if it runs out of cash to pay daily margins, the broker will square off the position.

C. Basis Risk

• The Futures price might not move exactly perfectly with the Spot price. This imperfect correlation is Basis Risk.

2. Diagram: The Margin Trap

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3. Exam Notes: Writing the Answer

Question: "Discuss the limitations of Futures Contracts." (5 Marks)

Answering Strategy:

1. Standardization: Explain "Lot Size problem" (Imperfect hedge).
2. Cash Flow: Explain "Margin Calls". Even if you are right in long term, temporary loss can bankrupt you.
3. Basis Risk: Mention "futures price vs spot price gap".

Summary

• Forwards wins here: For corporate who hate daily cash adjustments, Forwards are better because settlement is only at the end.

Quiz Time! 🎯

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