What Is a Futures Contract?
A futures contract is a standardized legal agreement to buy or sell a specific commodity or financial instrument at a predetermined price on a specified future date. It is a type of derivative because its value is derived from an underlying asset. Participants use futures contracts for various purposes, including price discovery, risk management, and speculation. These contracts are traded on organized exchanges and are highly standardized, specifying the quantity, quality, delivery location, and delivery month of the underlying asset.
History and Origin
The concept of agreeing to a future price for a good has ancient roots, with references dating back to Mesopotamia and Aristotle's writings on Thales of Miletus. However, the first organized exchange for what we now recognize as futures contracts is often attributed to the Dojima Rice Exchange in Osaka, Japan, established in 1697. This market allowed participants to trade futures on rice, addressing the needs of samurai paid in rice who required a stable conversion to currency.9
In the United States, the modern development of futures trading began in Chicago in the 1840s, primarily driven by the agricultural sector. Farmers and merchants sought ways to manage price volatility for commodities like grain. The Chicago Board of Trade (CBOT) was formed in 1848, initially as a spot market, but soon began standardizing "to-arrive" contracts. These standardized agreements, which included public bids and offers, evolved into the first modern futures contracts. Financial futures, covering instruments like currencies and interest rates, were introduced much later in 1972, significantly broadening the scope of the futures market.
Key Takeaways
- A futures contract is a legally binding agreement to buy or sell an asset at a set price on a future date.
- They are standardized and traded on regulated exchanges, ensuring transparency and liquidity.
- Futures are used for hedging against price risk, speculating on future price movements, and price discovery.
- All futures contracts are guaranteed by a clearinghouse, which mitigates counterparty risk.
- Participants are required to post initial margin and manage maintenance margin to cover potential losses due to price fluctuations.
Formula and Calculation
The pricing of a futures contract is influenced by several factors, including the spot price of the underlying asset, the time to expiration, the risk-free interest rate, and any carrying costs (like storage or insurance) or convenience yields. The theoretical fair value of a futures contract (F) can be approximated by the following formula for non-dividend-paying assets or commodities with carrying costs:
Where:
- (F) = Futures price
- (S) = Current spot price of the underlying asset
- (e) = The base of the natural logarithm (approximately 2.71828)
- (r) = Risk-free interest rate (e.g., U.S. Treasury bill rate)
- (c) = Carrying costs (e.g., storage, insurance) as a percentage of the asset value
- (y) = Convenience yield (benefit of holding the physical asset, relevant for commodities)
- (T) = Time to settlement (in years)
For financial assets like stock indexes, dividends or interest payments would be subtracted from the exponent similar to convenience yield.
Interpreting the Futures Contract
Interpreting a futures contract involves understanding its relationship to the underlying asset's current price and market expectations. When the futures price is higher than the spot price, it's known as "contango," often seen in commodity markets where carrying costs contribute to the higher future price. Conversely, when the futures price is lower than the spot price, it's called "backwardation," which can occur when there's high immediate demand for the underlying asset.
Market participants analyze these price relationships to gauge sentiment regarding future supply and demand. For example, a sharp contango in oil futures might suggest ample current supply but expectations of tighter supply or higher demand in the future. Futures prices also reflect prevailing interest rate risk and market participants' expectations for those rates, particularly for financial futures.
Hypothetical Example
Consider a farmer expecting to harvest 5,000 bushels of corn in three months. The current spot price of corn is $4.00 per bushel. The farmer is concerned that the price might fall before harvest. To lock in a price and mitigate this risk, the farmer sells one corn futures contract (standardized at 5,000 bushels) for delivery in three months at a price of $4.10 per bushel.
Three months later, at the contract's expiration, there are two possible scenarios:
- Corn price falls: The spot price of corn is now $3.80 per bushel. The farmer's harvest is worth $3.80 per bushel in the cash market. However, their futures contract obliges them to sell at $4.10 per bushel. The gain on the futures contract ($4.10 - $3.80 = $0.30 per bushel) offsets the lower cash market price. The farmer effectively sells their corn at $4.10 per bushel, having successfully used the futures contract for hedging.
- Corn price rises: The spot price of corn is now $4.30 per bushel. The farmer's harvest is worth $4.30 per bushel in the cash market. However, their futures contract obliges them to sell at $4.10 per bushel. The loss on the futures contract ($4.30 - $4.10 = $0.20 per bushel) means they miss out on the higher cash market price. While they sold for less than the peak cash price, they achieved their goal of locking in a predictable selling price of $4.10 per bushel, demonstrating risk management rather than maximizing profit.
Practical Applications
Futures contracts have a wide range of practical applications across various financial and industrial sectors:
- Risk Management (Hedging): Businesses use futures to protect against adverse price movements in raw materials, currencies, or interest rates. For instance, an airline might use crude oil futures to lock in fuel costs.
- Price Discovery: The active trading of futures contracts on exchanges like the CME Group helps establish future prices for commodities and financial assets, providing valuable forward-looking information to the market. Daily trading volume and open interest reports from major exchanges illustrate their role in price discovery.8
- Speculation: Traders use futures to profit from anticipated price changes without owning the underlying asset. The high leverage offered by futures contracts can amplify returns, but also losses.
- Arbitrage: Sophisticated traders exploit temporary price discrepancies between the spot market and futures market, or between different futures contracts, to make risk-free profits.
- Portfolio Management: Institutional investors use financial futures, such as equity index futures, to quickly adjust their portfolio's exposure to the broader market or to gain exposure to an asset class without buying individual securities.
- Regulation: The trading of futures contracts is overseen by regulatory bodies like the Commodity Futures Trading Commission (CFTC) in the United States, which establishes rules and monitors market activity to ensure fair and orderly markets and protect market participants.7
Limitations and Criticisms
While futures contracts offer significant benefits for risk management and price discovery, they come with inherent limitations and criticisms:
- Leverage and Risk: Futures contracts are highly leveraged instruments, meaning a small initial capital outlay (margin) can control a large value of the underlying asset. This amplification of exposure means that while profits can be substantial, losses can also exceed the initial margin deposit. Participants are subject to daily mark-to-market requirements, potentially requiring additional funds to maintain their margin account.
- Volatility: Futures markets can be highly volatile, especially for commodities influenced by unpredictable events like weather, geopolitical developments, or sudden shifts in supply and demand. This volatility can lead to rapid and significant price swings.
- Liquidity Risk: While major futures contracts are highly liquid, some less actively traded contracts or those with distant expiration dates may experience lower liquidity, making it difficult to enter or exit positions at desired prices.
- Complexity: Understanding the nuances of futures pricing, margin calls, and various trading strategies can be complex, making them less suitable for inexperienced investors.
- Settlement Risk: Although clearinghouses mitigate counterparty default, there can still be operational risks associated with the settlement process, particularly for physically delivered contracts. Academic research highlights various financial and non-financial risks, including liquidity, credit, and market risks, that need careful management in futures markets.6
Futures Contract vs. Forward Contract
Futures contracts and forward contracts are both agreements to buy or sell an asset at a predetermined price on a future date, placing them both under the umbrella of derivatives. However, key differences exist, primarily concerning standardization, trading venue, and regulation:
| Feature | Futures Contract | Forward Contract |
|---|---|---|
| Standardization | Highly standardized (quantity, quality, date) | Customized between two parties |
| Trading Venue | Traded on organized exchanges (e.g., CME Group) | Traded over-the-counter (OTC) |
| Regulation | Regulated (e.g., by CFTC in the U.S.) | Largely unregulated (bilateral agreements) |
| Clearing | Guaranteed by a clearinghouse | Direct counterparty risk between parties |
| Settlement | Marked-to-market daily; cash or physical delivery | Typically settled at expiration; often physical delivery |
| Liquidity | High liquidity | Lower liquidity; difficult to offset |
The standardization and exchange trading of futures contracts allow for greater transparency and liquidity compared to the customized nature of forward contracts, which are private agreements.
FAQs
What is the primary purpose of a futures contract?
The primary purpose of a futures contract is to allow market participants to manage price risk (hedging) or to speculate on the future price movements of an underlying asset. It provides a mechanism for buyers and sellers to lock in a price today for a transaction that will occur at a specified date in the future.
Can individuals trade futures contracts?
Yes, individuals can trade futures contracts through brokerage firms that offer access to futures markets. However, due to the high leverage and potential for significant losses, it is generally recommended for experienced investors with a thorough understanding of the risks involved.
What is "margin" in futures trading?
Margin in futures trading is a good-faith deposit required to open and maintain a futures position. It is not a down payment, but rather a performance bond to ensure that market participants can meet their obligations. There's an initial margin to open a position and a maintenance margin, which is the minimum amount that must be kept in the margin account to avoid a margin call.
How do futures contracts settle?
Futures contracts can settle in two main ways: physical delivery or cash settlement. Physical delivery involves the actual exchange of the underlying commodity or financial instrument. Cash settlement involves a cash payment based on the difference between the contract price and the prevailing market price at expiration, without physical exchange. Many financial futures, such as stock index futures, are cash-settled.
What is the difference between a futures contract and an options contract?
While both are derivatives, a futures contract is an obligation to buy or sell the underlying asset, whereas an options contract gives the buyer the right, but not the obligation, to buy or sell the underlying asset. The seller of an option has the obligation if the buyer chooses to exercise the option.12345