How is risk eliminated in the futures market?
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The default risk involved with forward contracts is eliminated by the futures exchange, thereby making them accessible to retail and small entities.
The task of risk elimination lies with organizations called clearinghouses. The clearinghouse creates standards according to which contracts have to be created. This includes specifying what the underlying can be, the quantity, quality, place of delivery and the alike.
The risk of default is eliminated by ensuring that all losses and gains made by the parties are settled at the end of each day. This is also known as daily settlement or mark to market. As the profits and loss made by each party gets credited or debited from their accounts every day, it does not build up over time. The party which is incurring the losses has to arrange for funds to keep the contract or they are forfeited. As all futures contracts are similar, it is not very difficult for the exchange to find new buyers for contracts that have been forfeited from a party due to lack of funds. In forward contracts the losses continue to add up till expiry and this is usually the primary reason for default.
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