Home and Mortgage

Buying Property in UK

admin — Sun, 31 May 2009 15:07:32 +0000

We will not go into much detail on buying property in the UK for a few reasons. Firstly, if you’ve just arrived in the country, no lender will do business with you for several years until you’ve established a credit record. Secondly very few people arriving in the UK have sufficient money to put down as a deposit. Thirdly it takes most people quite a lot of time to come to terms with their new lifestyle and surroundings before deciding where to buy a property. If you are able to put down at least 25% of the value of the property in question, then you will find more lenders willing to deal with you. Using a mortgage broker is a good idea. An useful website to help you find a suitable mortgage is:

http://www.fast-mortgage.net

About 75% of people in England own their own home. This is because of easy access to mortgages and long term repayment schemes in a highly competitive lending market. It is often cheaper to buy a home than to rent in the UK. Repayment schemes run as long as 30 years. You will need to contact several mortgage lenders to see what kind of deal they can offer you. Only once you’ve found a lender to your liking can you then consider taking action.
The first practical step to buying a property is to decide on the where you want to live. Then you investigate the properties on sale in the area you’re interested in through the local estate agents. Hopefully you can afford the area, otherwise you will have to find another area. You register with an estate agent and they make a note of your requirements. They should be able to immediately provide a number of house’s details for you to look at. Once you have selected one or more properties of interest they will arrange with the property owner for a mutually convenient time for you to view the property.
Once you have identified a property you wish to buy, you instruct the estate agent to convey your desire to buy. Remember to stipulate that your offer is subject to survey and contract. Under British law, until contracts are exchanged, either party can amend or withdraw from the sale. It normally takes 6 weeks from submitting the offer until the contracts are exchanged. The time from ‘exchange of contract’ to possession of the property can vary as it depends on either party’s wishes. This plays out up and down the line of property owners and is called a daisy chain.
When buying a property you will need a solicitor or conveyor to do the legal work, which includes the title search and deed registration. It is also advisable to hire a surveyor to check out the property structurally for you. If you are taking out a loan, most lending institutions will ask for a surveyor’s report.
Be warned though, that in England during boom periods, “gazumping” is a common occurrence. “Gazumping” is the practice of a seller agreeing to an offer from a buyer, but then accepts a higher offer from another buyer later. Gazumping does not happen in Scotland as once each party has agreed to the sale, neither party can withdraw. It is imperative therefore that you have a survey done before making an offer on a house in Scotland.

Taxing Joint Tenancy Property

admin — Sat, 23 May 2009 08:54:35 +0000

Generally, the value of all joint tenancy property is included in the estate of the first joint tenant to die, except for the proportion the executor can prove was contributed to its acquisition by the surviving joint tenant and/or as a gift by a third party to the credit of the surviving joint tenant. If the surviving spouse and the decedent were the only joint tenants, only one-half of the value of the joint tenancy property will be included in the estate.
As result of the marital deduction, property held jointly by spouses with rights of survivorship does not trigger any estate tax in the estate of the first spouse to die. Technically, only one-half of the jointly held property would be included in the estate, and that one-half would be excluded by the marital deduction. The act similarly applies to tenancies by the entirety.

Federal Gross Estate

admin — Sun, 17 May 2009 08:54:24 +0000

The federal estate tax is a tax on all property of a deceased person. The reader should be aware that these provisions are subject to change. The Economic Recovery Act of 1981 made major changes in the estate and gift tax laws. Additional changes were made more recently. The Economic Growth and Tax Relief Reconciliation Act of 2001 imposed complex changes that will be phased in between 2002 and 2009 with outright repeal of Federal estate taxes in 2010. However, the new law specifically provides that it will have no effect on estates of decedents dying after December 31, 2010, and the exemption will be $1,000,000.
The gross estate includes all real and personal property, whether tangible or intangible. These properties include the following:
• For decedents dying after 12/31/1981, the estate of the first spouse to die will include one-half the value of joint tenancy property, regardless of which spouse furnished the consideration for the property. This rule applies only where the spouses are the only joint tenants.
• All death benefits under life insurance policies on life of decedent owned or controlled by him or payable to his estate and cash values of all life insurance policies owned by him on lives of others.
• Lifetime gifts are no longer included in the gross estate, although the taxable portion will be included in the tax base for estate tax computations.
• Property over which the decedent held a general power of appointment.
• Property given away during life in which the decedent retained some control or a life estate. Revocable trust assets are included because the deceased retained control until death.
The property must be appraised at its fair market value, or if the executor elects, certain qualified property may be appraised at its current use value. Current use values for qualified property and the current market value will be discussed later in this material. Fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to sell or buy.

Money with an Intrinsic Value

admin — Wed, 29 Apr 2009 21:43:35 +0000

For most of human histor y societies have functioned without money. The development of tokens to represent value is a relatively modern development and for thousands of years those tokens were deemed to have an intrinsic value. It is only in the last 500 years or so that money has been represented by tokens with a legal status but no intrinsic value. At ﬁrst such notes were issued backed by real physical assets (gold) but today that linkage has been completely broken. The most commonly used mediums for money in historic times were gold and silver. Other more exotic currencies, to our way of thinking at least, have included salt and cowr y seashells. Gold in par ticular has always had a fascination because of its unique physical qualities. Gold does not tarnish as silver does or rust as iron does. It can be beaten into extremely thin leaf.
It has attractive, decorative qualities and is used widely in jewelr y. It is of a uniform standard – gold from Egypt cannot be distinguished from gold extracted from the New World. This is not the case with organic products such as coffee or saffron. At the time of writing the price of saffron was around $400 an ounce, in line with that of gold, but prices var y depending on quality and source. Gold also has a scarcity value. It is not a common element and is difﬁcult to extract from the ground. It is a ver y dense element and requires little storage space.
When gold is used as a medium of exchange it provides a way in which different products and ser vices can be given equivalent values in terms of a given weight of gold. To illustrate this point we use a highly stylized example taken from Dreamworld.
Dreamworld is a wonderful place where cream and chocolate are not fattening and air planes leave on time. When necessar y in Dreamworld we can assume no transaction costs, no taxes, no bid–offer spread, we can borrow or lend what we choose at the risk-free rate whenever we want, companies pay dividends only when required, there is no counter par ty risk and we don’t need to worr y about capital allocation issues! Dreamworld has a ver y convenient location and is populated largely by ﬁnance academics. One group can use the power of its simplifying assumptions to formulate fundamental theories. The second group woks on how to modify these theories to take the chosen assumptions into account.
In this example we will ignore the costs of capital investments, taxes and transaction costs, the impact of skill levels on labor costs and so on. We will take only human labor into account. Suppose it takes 10 days of human labor to produce one ounce of gold, ﬁve days to make a table, 20 days to build a car t and one day to clean a house. For the markets to be in equilibrium the table should be sold at half an ounce of gold, the car t for two ounces and the cleaner should get one-tenth of an ounce for his daily efforts.
In periods of high inﬂation or uncer tainty over the future value of paper money many people turn to gold as a way to preser ve value. A paper currency may lose all of its value in the event of a regime change or a militar y defeat. Gold hidden in a hole in the garden provides a way to preser ve value. It is a generally accepted axiom (although not always borne out by facts) that the price of gold rises in terms of political and economic uncer tainty. There are, however, signiﬁcant problems with using tokens that have an intrinsic value as money:
Transaction costs. Gold is completely negotiable and there is no foolproof way to establish ownership. Gold ornaments or coins can be melted down and recast as standard bars. Its density makes it difﬁcult to move large amounts easily and this also makes it vulnerable to loss. The physical deliver y of gold involves risks arising from natural disasters such as a ship sinking in a storm or human inter vention in the form of theft. Gold has to be kept in a secure location and shipments require tight security. Transport has been both slow and difﬁcult for most of human histor y. All of these factors push up transaction costs.
Costs to the economy. Gold’s intrinsic value comes from demand for its use in jewelry, in specialist applications such as the decoration of churches and temples and, in modern times, in the electronic and space industries. Gold extraction requires signiﬁcant capital investment and labor and is the source of damaging environmental pollution. Using gold as a medium for money ties up capital and human resources that could be used in a more productive manner. King Midas learnt the hard way that gold cannot satisfy human hungers.
The world’s central banks all have vaults where they store their gold reser ves. Between them they hold thousands of tons of gold. The US gold reserve is held at Fort Knox, one of the world’s most secure facilities, where it is jealously guarded. At least squirrels use their hoards to help them sur vive the winter. There is something delightfully ironic about a system where one group of people expend huge effor t to extract a metal from one hole in the ground which is then sold to another group of people who, at huge expense, put it in their own hole in the ground.
Supply and demand. Our simple example showing the equivalence of values in gold based on labor inputs looked only at the supply side. Suppose that demand for car ts exceeded that which could be produced. In this situation car t builders might be able to sell each cart they made at 21/2 ounces of gold. This would attract people making tables or digging for gold to switch to making car ts and would result in a reduction in the supply of gold and tables, pushing up the price of tables relative to car ts and lowering the price of car ts in terms of gold. This would continue until equilibrium between the markets was re-established.
When the Spanish discovered huge quantities of gold in the New World, much of it already extracted and reﬁned, they thought they had made their for tunes – and many of the early conquistadors did. But the huge inﬂux of gold had a much wider impact. With the supply of gold (money) expanding rapidly the price of real goods and ser vices in terms of gold rose. In modern times this would be seen as a period of high inﬂation. There was no change in the real output of the Spanish economy but a transfer of wealth took place from those who had held gold as a store of value and those on ﬁxed incomes to people who had invested in real assets.
Debasement. A gold or silver coinage can be debased in one of three ways. Ver y pure gold is ver y soft and is usually mixed with a base metal, such as silver, to make a harder alloy. A carat, or karat, is a measure of the propor tion of precious metal in an alloy. Twenty-four-carat gold is pure gold while 18-carat gold is 18/24 or three-quar ter gold. The authority to mint coins in medieval times usually rested with the monarchy.
A king could make his gold go fur ther by increasing the level of silver contained in newly minted coins. In some instances the coinage in circulation would be recalled, melted down and reissued in a debased form. For obvious reasons people preferred to hold onto older coins with the same nominal face value but a higher gold content. People tried to pay for goods and ser vices with coins that had the lower gold content. This is the basis for what is known as Gresham’s law, “Bad money drives out good money”, after Sir Thomas Gresham the master of the royal mint in the reign of Elizabeth I. In modern times the US dollar has become the preferred currency in many developing and transitional economies. This reﬂects greater conﬁdence in the US dollar retaining its value and being conver tible than in the local currency.
A second method was to shave metal off the edges of the coins. To tr y to prevent such practices coins were produced with serrated edges. Most countries continue to produce coins milled in this manner but the serrated edges are now only useful in slot and vending machines. The last method was to take a lower value base metal, such as lead, and to produce counterfeit gold-plated coins.

Functions and Roles of Money

admin — Wed, 29 Apr 2009 16:41:32 +0000

Money is a commodity that we tend to take for granted. Most of us think of money as cash, but cash is just a small por tion of broad money. Most ﬁnancial transactions are conducted using checks, electronic transfer of funds or credit cards. Economists have a number of different deﬁnitions of money. We do not need to deﬁne these here par ticularly as deﬁnitions vary from country to countr y and this is ver y much moving into the realm of macroeconomics. It is, however, worth reviewing the three fundamental functions that money performs.
Accounting basis. Money provides a means of accounting for the value of real goods. It allows, for example, one to compare the cost of a cup of coffee with the price of a telephone call.
Store of value. Money represents a form of savings, whether it is in the form of a bank deposit or cash. It provides a means of making purchases of real goods and ser vices in the future. It is not a good store of value in an inﬂationary environment, however.
Means of exchange. Money provides a means of exchange for real goods and ser vices. In the absence of money transactions between two par ties would have to be done on a barter basis. Bar ter is a ver y inefﬁcient means of effecting transactions. Money reduces transaction costs and makes the real economy more efﬁcient.
The ﬁrst subjects to examine are how money is created and the role of banks in that process. In most countries the central bank controls how much money is created. The creation of money has always reminded me of a magician’s sleight of hand. While your intellect tells you one thing no matter how many times you see the trick it is still impossible to work out how it is done. The ancient street hustle of the “three cup” trick is a good example. In the case of money the con is contained in the word conﬁdence.

Low Price-to-Earnings Ratio

admin — Tue, 28 Apr 2009 21:35:53 +0000

It sounds very clichéd, but low P/E stocks in the micro cap world will ultimately be recognized. Many academic and investment studies point to low-P/E stocks as a powerful indicator of future stock performance. It is important to note that the low P/E in the micro cap world is the trailing or historic P/E. Because there is a general lack of analyst coverage of micro cap stocks, the ability to get a consensus forward earnings estimate is nearly impossible. Without direct guidance from the company, it is possible to estimate future earnings only by building a company financial model to estimate those earnings. This is not something the individual investor will typically undertake. However, finding companies that are trading at a low multiple of past earnings is a simple screen that can be used on most Internet stock screening sites. Again, because there are very few analysts that cover the micro cap world, these companies often post a strong change in earnings trend and trade at a low P/E multiple for some period of time before a broader cross section of investors realizes the valuation level and begins to examine the company. There are times that companies with good growth prospects and excellent business performance trade at low P/E multiples. This can be a window of opportunity to make excellent investments at reasonable prices.

FUNDAMENTAL VALUATION TECHNIQUES FOR MICRO CAP STOCKS

admin — Tue, 28 Apr 2009 16:26:27 +0000

When analyzing fundamental valuation ratios for micro cap stocks, it is important not to let any single factor summarily eliminate a stock from consideration. Because of the relatively dynamic financial nature of micro cap companies, there are reasons, at times, to discount some factors while putting more weight on other factors when reviewing the financial ratios of a company. For example, there are many rapidly growing small companies that generate very little free cash flow. Conversely, there are small companies that generate very modest earnings growth but generate significant levels of free cash flow from operations. Simple screening techniques could eliminate either of the companies from consideration; however, a little more effort within the analysis can yield potentially great stocks.
As is the case with financial ratios, certain measures will be more or less applicable, depending on the sector within which a company operates. It is often the best strategy to use ratios that reflect a company’s valuation relative to its peers rather than relative to the market. In addition, it is important to study the accounting practices of the company and its peers to determine whether any adjustments are necessary for different accounting policies and procedures. For example, manufacturing companies tend to lend themselves better to cash flow and EBITDA (earnings before interest, taxes, depreciation, and amortization) analysis, whereas fast-growing service companies tend to better lend themselves to price-to-sales ratio analysis or earnings-per-share growth analysis.

THE CLEARINGHOUSE, MARGINS, AND PRICE LIMITS

admin — Mon, 27 Apr 2009 21:23:11 +0000

As briefly noted in the previous posts, when a trader takes a long or short position in a futures, he must first deposit sufficient funds in a margin account. This amount of money is traditionally called the margin, a term derived from the stock market practice in which an investor borrows a portion of the money required to purchase a certain amount of stock. Margin in the stock market is quite different from margin in the futures market. In the stock market, “margin” means that a loan is made. The loan enables the investor to reduce the amount of his own money required to purchase the securities, thereby generating leverage or gearing, as it is sometimes known. If the stock goes up, the percentage gain to the investor is amplified. If the stock goes down, however, the percentage loss is also amplified. The borrowed money must eventually be repaid with interest. The margin percentage equals the market value of the stock minus the market value of the debt divided by the market value of the stock-in other words, the investor’s own equity as a percentage of the value of the stock. For example, in the United States, regulations permit an investor to borrow up to 50 percent of the initial value of the stock. This percentage is called the initial margin requirement. On any day thereafter, the equity or percentage ownership in the account, measured as the market value of the securities minus the amount borrowed, can be less than 50 percent but must be at least a percentage known as the maintenance margin requirement. A typical maintenance margin requirement is 25 to 30 percent. In the futures market, by contrast, the word margin is commonly used to describe the amount of money that must be put into an account by a party opening up a futures position, but the term is misleading. When a transaction is initiated, a futures trader puts up a certain amount of money to meet the initial margin requirement; however, the remaining money is not borrowed. The amount of money deposited is more like a down payment for the commitment to purchase the underlying at a later date. Alternatively, one can view this deposit as a form of good faith money, collateral, or a performance bond: The money helps ensure that the party fulfills his or her obligation.’ Moreover, both the buyer and the seller of a futures contract must deposit margin.
In securities markets, margin requirements are normally set by federal regulators. In the United States, maintenance margin requirements are set by the securities exchanges and the NASD. In futures markets, margin requirements are set by the clearinghouses. In further contrast to margin practices in securities markets, futures margins are traditionally expressed in dollar terms and not as a percentage of the futures price. For ease of comparison, however, we often speak of the futures margin in terms of its relationship to the futures price. In futures markets, the initial margin requirement is typically much lower than the initial margin requirement in the stock market. In fact, futures margins are usually less than 10 percent of the futures price.’ Futures clearinghouses set their margin requirements by studying historical price movements. They then establish minimum margin levels by taking into account normal price movements and the fact that accounts are marked to market daily. The clearinghouses thus collect and disburse margin money every day. Moreover, they are permitted to do so more often than daily, and on some occasions they have used that privilege. By carefully setting margin requirements and collecting margin money every day, clearinghouses are able to control the risk of default.
In spite of the differences in margin practices for futures and securities markets, the effect of leverage is similar for both. By putting up a small amount of money, the trader’s gains and losses are magnified. Given the tremendously low margin requirements of futures markets, however, the magnitude of the leverage effect is much greater in futures markets. We shall see how this works as we examine the process of the daily settlement. As previously noted, each day the clearinghouse conducts an activity known as the daily settlement, also called marking to market. This practice results in the conversion of gains and losses on paper into actual gains and losses. As margin account balances change, holders of futures positions must maintain balances above a level called the maintenance margin requirement. The maintenance margin requirement is lower than the initial margin requirement. On any day in which the amount of money in the margin account at the end of the day falls below the maintenance margin requirement, the trader must deposit sufficient funds to bring the balance back up to the initial margin requirement. Alternatively, the trader can simply close out the position but is responsible for any further losses incurred if the price changes before a closing transaction can be made.
To provide a fair mark-to-market process, the clearinghouse must designate the official price for determining daily gains and losses. This price is called the settlement price and represents an average of the final few trades of the day. It would appear that the closing price of the day would serve as the settlement price, but the closing price is a single value that can potentially be biased high or low or perhaps even manipulated by an unscrupulous trader. Hence, the clearinghouse takes an average of all trades during the closing period (as defined by each exchange).
Exhibit 3-1 provides an example of the marking-to-market process that occurs over a period of six trading days. We start with the assumption that the futures price is $100 when the transaction opens, the initial margin requirement is $5, and the maintenance margin requirement is $3. In Panel A, the trader takes a long position of 10 contracts on Day 0, depositing $50 ($5 times 10 contracts) as indicated in Column 3. At the end of the day, his ending balance is $50.~
Although the trader can withdraw any funds in excess of the initial margin requirement, we shall assume that he does not do so.”
The ending balance on Day 0 is then carried forward to the beginning balance on Day 1. On Day 1, the futures price moves down to 99.20, as indicated in Column 4 of Panel A. The futures price change, Column 5, is -0.80 (99.20 – 100). This amount is then multiplied by the number of contracts to obtain the number in Column 6 of -0.80 X 10 = -$8. The ending balance, Column 7, is the beginning balance plus the gain or loss. The ending balance on Day 1 of $42 is above the maintenance margin requirement of $30, so no funds need to be deposited on Day 2.
On Day 2 the settlement price goes down to $96. Based on a price decrease of $3.20 per contract and 10 contracts, the loss is $32, lowering the ending balance to $10. This amount is $20 below the maintenance margin requirement. Thus, the trader will get a margin call the following morning and must deposit $40 to bring the balance up to the initial margin level of $50. This deposit is shown in Column 3 on Day 3.
Here, we must emphasize two important points. First, additional margin that must be deposited is the amount sufficient to bring the ending balance up to the initial margin requirement, not the maintenance margin requirement.” This additional margin is called the variation margin. In addition, the amount that must be deposited the following day is determined regardless of the price change the following day, which might bring the ending balance well above the initial margin requirement, as it does here, or even well below the maintenance margin requirement. Thus, another margin call could occur. Also note that when the trader closes the position, the account is marked to market to the final price at which the transaction occurs, not the settlement price that day.
Over the six-day period, the trader in this example deposited $90. The account balance at the end of the sixth day is $130–nearly a 50 percent return over six days; not bad. But look at Panel B, which shows the position of a holder of 10 short contracts over that same period. Note that the short gains when prices decrease and loses when prices increase. Here the ending balance falls below the maintenance margin requirement on Day 4, and the short must deposit $35 on Day 5. At the end of Day 6, the short has deposited $85 and the balance is $45, a loss of $40 or nearly 50 percent, which is the same $40 the long made. Both cases illustrate the leverage effect that magnifies gains and losses. When establishing a futures position, it is important to know the price level that would trigger a margin call. In this case, it does not matter how many contracts one has. The price change would need to fall for a long position (or rise for a short position) by the difference between the initial and maintenance margin requirements. In this example, the difference between the initial and maintenance margin requirements is $5 – $3 = $2. Thus, the price would need to fall from $100 to $98 for a long position (or rise from $100 to $102 for a short position) to trigger a margin call.
As described here, when a trader receives a margin call, he is required to deposit funds sufficient to bring the account balance back up to the initial margin level. Alternatively, the trader can choose to simply close out the position as soon as possible. For example, consider the position of the long at the end of the second day when the margin balance is $10. This amount is $20 below the maintenance level, and he is required to deposit $40 to bring the balance up to the initial margin level. If he would prefer not to deposit the additional funds, he can close out the position as soon as possible the following day. Suppose, however, that the price is moving quickly at the opening on Day 3. If the price falls from $96 to $95, he has lost $10 more, wiping out the margin account balance. In fact, if it fell any further, he would have a negative margin account balance. He is still responsible for these losses. Thus, the trader could lose more than the amount of money he has placed in the margin account. The total amount of money he could lose is limited to the price per contract at which he bought, $100, times the number of contracts, 10, or $1,000. Such a loss would occur if the price fell to zero, although this is not likely. This potential loss may not seem like a lot, but it is certainly large relative to the initial margin requirement of $50. For the holder of the short position, there is no upper limit on the price and the potential loss is theoretically infinite.
Some futures contracts impose limits on the price change that can occur from one day to the next. Appropriately, these are called price limits. These limits are usually set as an absolute change over the previous day. Using the example above, suppose the price limit was $4. This would mean that each day, no transaction could take place higher than the previous settlement price plus $4 or lower than the previous settlement price minus $4. So the next day’s settlement price cannot go beyond the price limit and thus no transaction can take place beyond the limits.
If the price at which a transaction would be made exceeds the limits, then price essentially freezes at one of the limits, which is called a limit move. If the price is stuck at the upper limit, it is called limit up; if stuck at the lower limit, it is called limit down. If a transaction cannot take place because the price would be beyond the limits, this situation is called locked limit. By the end of the day, unless the price has moved back within the limits, the settlement price will then be at one of the limits. The following day, the new range of acceptable prices is based on the settlement price plus or minus limits. The exchanges have different rules that provide for expansion or contraction of price limits under some circumstances. In addition, not all contracts have price limits.
Finally, we note that the exchanges have the power to mark contracts to market whenever they deem it necessary. Thus, they can do so during the trading day rather than wait until the end of the day. They sometimes do so when abnormally large market moves occur. The daily settlement procedure is designed to collect losses and distribute gains in such a manner that losses are paid before becoming large enough to impose a serious risk of default. Recall that the clearinghouse guarantees to each party that it need not worry about collecting from the counterparty. The clearinghouse essentially positions itself in the middle of each contract, becoming the short counterparty to the long and the long counterparty to the short. The clearinghouse collects funds from the parties incurring losses in this daily settlement procedure and distributes them to the parties incurring gains. By doing so each day, the clearinghouse ensures that losses cannot build up. Of course, this process offers no guarantee that counterparties will not default. Some defaults do occur, but the counterparty is defaulting to the clearinghouse, which has never failed to pay off the opposite party. In the unlikely event that the clearinghouse were unable to pay, it would turn to a reserve fund or to the exchange, or it would levy a tax on exchange members to cover losses.

FUTURES TRADING

admin — Sun, 26 Apr 2009 21:20:19 +0000

In this article, we look more closely at how futures contracts are traded. As noted above, futures contracts trade on a futures exchange either in a pit or on a screen or electronic terminal. Pit trading is a very physical activity. Traders stand in the pit and shout out their orders in the form of prices they are willing to pay or accept. They also use hand signals to indicate their bids and offer^.^ They engage in transactions with other traders in the pits by simply agreeing on a price and number of contracts to trade. The activity is fast, furious, exciting, and stressful. The average pit trader is quite young, owing to the physical demands of the job and the toll it takes on body and mind. In recent years, more trading has come off of the exchange floor to electronic screens or terminals. In electronic or screen-based trading, exchange members enter their bids and offers into a computer system, which then displays this information and allows a trader to consummate a trade electronically. In the United States, pit trading is dominant, owing to its long history and tradition. Exchange members who trade on the floor enjoy pit trading and have resisted heavily the advent of electronic trading. Nonetheless, the exchanges have had to respond to market demands to offer electronic trading. In the United States, both pit trading and electronic trading are used, but in other countries, electronic trading is beginning to drive pit trading out of busines. A person who enters into a futures contract establishes either a long position or a short position. Similar to forward contracts, long positions are agreements to buy the underlying at the expiration at a price agreed on at the start. Short positions are agreements to sell the underlying at a future date at a price agreed on at the start. When the position is established, each party deposits a small amount of money, typically called the margin, with the clearinghouse. Then, the contract is marked to market, whereby the gains are distributed to and the losses collected from each party.
A party that has opened a long position collects profits or incurs losses on a daily basis. At some point in the life of the contract prior to expiration, that party may wish to re-enter the market and close out the position. This process, called offsetting, is the same as selling a previously purchased stock or buying back a stock to close a short position.
The holder of a long futures position simply goes back into the market and offers the identical contract for sale. The holder of a short position goes back into the market and offers to buy the identical contract. It should be noted that when a party offsets a position, it does not necessary do so with the same counterparty to the original contract. In fact, rarely would a contract be offset with the same counterparty. Because of the ability to offset, futures contracts are said to be fungible, which means that any futures contract with any counterparty can be offset by an equivalent futures contract with another counterparty. Fungibility is assured by the fact that the clearinghouse inserts itself in the middle of each contract and, therefore, becomes the counterparty to each party.
For example, suppose in early January a futures trader purchases an S&P 500 stock index futures contract expiring in March. Through 15 February, the trader has incurred some gains and losses from the daily settlement and decides that she wants to close the position out. She then goes back into the market and offers for sale the March S&P 500 futures. Once she finds a buyer to take the position, she has a long and short position in the same contract. The clearinghouse considers that she no longer has a position in that contract and has no remaining exposure, nor any obligation to make or take delivery at expiration. Had she initially gone short the March futures, she might re-enter the market in February offering to buy it. Once she finds a seller to take the opposite position, she becomes long and short the same contract and is considered to have offset the contract and therefore have no net position.

THE CLEARINGHOUSE, DAILY SETTLEMENT, AND PERFORMANCE GUARANTEE

admin — Sun, 26 Apr 2009 16:19:05 +0000

Another important distinction between futures and forwards is that the futures exchange guarantees to each party the performance of the other party, through a mechanism known as the clearinghouse. This guarantee means that if one party makes money on the transaction, it does not have to worry about whether it will collect the money from the other party because the clearinghouse ensures it will be paid. In contrast, each party to a forward contract assumes the risk that the other party will default.
An important and distinguishing feature of futures contracts is that the gains and losses on each party’s position are credited and charged on a daily basis. This procedure, called daily settlement or marking to market, essentially results in paper gains and losses being converted to cash gains and losses each day. It is also equivalent to terminating a contract at the end of each day and reopening it the next day at that settlement price. In some sense, a futures contract is like a strategy of opening up a forward contract, closing it one day later, opening up a new contract, closing it one day later, and continuing in that manner until expiration.