Futures contract

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date.

A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. If it is an American-style option, it can be exercised on or before the expiration date; a European option can only be exercised at expiration. Thus, a Futures contract is more like an European option. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

Futures contracts, or simply futures, are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.

Futures vs. Forwards

While futures and forward contracts are both a contract to deliver a commodity on a future date, key differences include:

• Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties.
• Futures are highly standardized, whereas each forward is unique
• The price at which the contract is finally settled is different:
  • Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end)
  • Forwards are settled by the delivery of the commodity at the specified contract price.
• The credit risk of futures is much lower than that of forwards:
  • Traders are not subject to credit risk because the clearinghouse always takes the other side of the trade. The day's profit or loss on a futures position is marked-to-market in the trader's account. If the mark to market results in a balance that is less than the margin requirement, then the trader is issued a margin call.
  • The risk of a forward contract is that the supplier will be unable to deliver the grade and quantity of the commodity, or the buyer may be unable to pay for it on the delivery day.
• In case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty on a futures contract is chosen randomly by the exchange.
• In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and a daily mark to market of the traders' accounts.

Standardization

Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

• The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate.
• The type of settlement, either cash settlement or physical settlement.
• The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
• The currency in which the futures contract is quoted.
• The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API specific gravity, as well as the location where delivery must be made.
• The delivery month.
• The last trading date.
• Other details such as the commodity tick, the minimum permissible price fluctuation.

Margin

To minimize credit risk to the exchange, traders must post margin or a performance bond, typically 5%-15% of the contract's value.

Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading.

A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.

Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls.

Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)^{(year/trade_duration)}-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

Settlement

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

• 'Physical delivery' - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long). The Nymex crude futures contract uses this method of settlement upon expiration.
• Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index. A futures contract might also opt to settle against an index based on trade in a related spot market. Ice Brent futures use this method.
• Expiry is the time when the final prices of the future is determined. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t forward contract. For example, for most CME and CBOT contracts, at the expiry on December, the March futures become the nearest contract. This is an exciting time for arbitrage desks, as they will try to make rapid gains during the short period (normally 30 minutes) where the final prices are averaged from. At this moment the futures and the underlying assets are extremely liquid and any mispricing between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.

Pricing

When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a future is determined via arbitrage arguments. The forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see rational pricing of futures.

Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r.

$F(t)=S(t)\times (1+r)^{(T-t)}$

or, with continuous compounding

$F(t)=S(t)e^{r(T-t)}\,$

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.

In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.

The above relationship, therefore, is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. on corn after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist, for example on wheat before the harvest or on Eurodollar Futures or Federal Funds Rate futures (in which the supposed underlying instrument is to created upon the delivery date), the futures price cannot be fixed by arbitrage. In this scenario there is only one forces setting the price which is simple supply and demand for the future asset as expressed by supply and demand for the futures contract.

In a deep and liquid market, this supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship

$F(t)=E_{t}\left\{S(T)\right\}$.

With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.

In a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as a corner), the market clearing price for the future may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.

See:

• Pricing Futures and Forwards by Arbitrage Argument, Quantnotes

Futures contracts and exchanges

There are many different kinds of futures contract, reflecting the many different kinds of tradable assets of which they are derivatives. For information on futures markets in specific underlying commodity markets, follow the links.

• Foreign exchange market
• Money market
• Bond market
• Equity index market
• Soft Commodities market

Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.

Contracts on financial instruments was introduced in the 1970s by the Chicago Mercantile Exchange(CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 75 futures and futures options exchanges worldwide trading to include:

• Chicago Board of Trade (CBOT) -- Interest Rate derivatives (US Bonds); Agricultural (Corn, Soybeans, Soy Products, Wheat); Index (Dow Jones Industrial Average); Metals (Gold, Silver)
• Chicago Mercantile Exchange -- Currencies, Agricultural (Pork, Cattle, Butter, Milk); Index (NASDAQ, S&P, etc); Various Interest Rate Products
• ICE Futures - the International Petroleum Exchange trades energy including crude oil, heating oil, natural gas and unleaded gas and merged with IntercontinentalExchange(ICE)to form ICE Futures.
• Euronext.liffe
• London Commodity Exchange - softs: grains and meats. Inactive market in Baltic Exchange shipping.
• Tokyo Commodity Exchange TOCOM
• London Metal Exchange - metals: copper, aluminium, lead, zinc, nickel and tin.
• New York Board of Trade - softs: cocoa, coffee, cotton, orange juice, sugar
• New York Mercantile Exchange - energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium
• Futures exchange

Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.

Hedgers typically include producers and consumers of a commodity.

For example, in traditional commodities markets farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example.

Options on futures

In many cases, options are traded on futures. A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. See the Black model, which is the most popular method for pricing these option contracts.

Futures Contract Regulations

All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the United States Government. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rule. Although by law the commission regulates all transactions, each exchange can have their own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out.

The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment, which has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as 'Commitments-Of-Traders'-Report, COT-Report or simply COTR.

See also

• List of finance topics
• Agriculture
• Freight derivatives
• Seasonal spread trading
• Prediction market
• 1256 Contract

References

• An Introduction To Global Financial Markets, Steven Valdez, Macmillan Press Ltd. (ISBN 0-333-76447-1)
• Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate Swaps, and Mortgage Securities, Fred D. Arditti, Harvard Business School Press (ISBN 0-87584-560-6)

Futures Exchanges & Regulators

• Chicago Board of Trade Glossary
• Chicago Mercantile Exchange Glossary
• Commodity Futures Trading Commission Glossary
• Eurex Glossary
• Futures Industry Association
• Institute for Financial Markets, a nonprofit education foundation
• National Futures Association

External Links

• Futures and Options on Futures - an illustrated tutorial.
• Commodity Futures Trading Commission - the main federal agency that regulates futures and the exchanges in the United States.
• The Numa Directory of Futures and Options Exchanges - includes exchanges from around the world, grouped by country.