Future

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 at a specified time in the future. These contracts are a fundamental component of the broader derivatives market, allowing participants to manage risk or speculate on price movements without immediately exchanging the underlying asset. Futures contracts specify the quantity, quality, price, and delivery date of the asset, and they are traded on organized exchanges. Unlike a spot price transaction where goods are exchanged immediately, a futures contract obligates both the buyer and seller to fulfill the agreement on the expiration date.

History and Origin

The concept of agreeing to future delivery of goods dates back centuries, but the formal, standardized futures contract originated in the United States. The Chicago Board of Trade (CBOT), established in 1848, played a pivotal role in this evolution. Initially, the CBOT was formed to provide a centralized marketplace where buyers and sellers could meet to formalize forward contracts for agricultural products, particularly grain. The inherent risks associated with price fluctuations and the uncertainty of future supply and demand led to the need for more structured agreements.

In 1864, the CBOT listed the first standardized "exchange-traded" forward contracts, which became known as futures contracts,¹⁸. These innovations helped farmers and merchants manage price risk for their accumulating grain inventories¹⁷. The standardization, coupled with formal trading rules instituted in 1865, including those concerning margin and delivery procedures, marked key steps in developing modern futures contracts¹⁶. The growth of futures markets was also driven by the need for price discovery and a mechanism for hedging against adverse price movements in agricultural commodities.

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 exchanges, contrasting with over-the-counter forward contracts.
• Futures are used primarily for hedging against price risk and for speculation.
• A clearinghouse guarantees the performance of futures contracts, mitigating counterparty risk.
• Participants are required to maintain a margin account to cover potential losses.

Formula and Calculation

The pricing of a futures contract often reflects the expected future spot price of the underlying asset, accounting for factors such as storage costs, interest rates, and any income generated by the asset (like dividends for a stock index future). While there isn't a single universal formula for the "value" of a futures contract in the same way there is for, say, options, its theoretical price can be expressed, particularly for non-dividend-paying assets, as:

Where:

• (F_0) = Current futures price
• (S_0) = Current spot price of the underlying asset
• (e) = The base of the natural logarithm (approximately 2.71828)
• (r) = Risk-free interest rate (annualized, continuous compounding)
• (q) = Annualized storage cost or convenience yield (for commodities), or dividend yield (for equities)
• (T) = Time to expiration (in years)

This formula provides a theoretical no-arbitrage price for a futures contract. In practice, market forces and supply and demand dynamics also influence the futures price.

Interpreting the Futures Contract

Interpreting a futures contract involves understanding its various components and how they relate to the underlying commodity or financial instrument. For instance, the listed price of a crude oil futures contract represents the price at which a buyer agrees to purchase, and a seller agrees to deliver, 1,000 barrels of West Texas Intermediate (WTI) crude oil on a specified future date¹⁵. Traders and analysts closely watch these prices as indicators of future market expectations for the underlying asset.

A futures contract can indicate market sentiment. A futures price significantly higher than the current spot price, known as contango, suggests that market participants expect the underlying asset's price to increase. Conversely, backwardation, where the futures price is lower than the spot price, might suggest expectations of a price decrease or strong immediate demand. Understanding these price relationships is crucial for effective risk management and for making informed decisions regarding hedging or speculation.

Hypothetical Example

Consider a farmer, Sarah, who expects to harvest 10,000 bushels of corn in three months. The current spot price for corn is $5.00 per bushel. Sarah is concerned that the price of corn might fall before she can sell her harvest. To hedge this price risk, she decides to sell corn futures contracts.

A single corn futures contract on the exchange might represent 5,000 bushels. So, Sarah sells two corn futures contracts with a delivery date three months from now at a futures price of $4.95 per bushel.

Scenario 1: Corn prices fall.
In three months, the spot price of corn has fallen to $4.70 per bushel. Sarah sells her physical corn in the cash market for $4.70 per bushel, realizing $47,000 (10,000 bushels * $4.70). However, her futures position gained value. She can now buy back (offset) her futures contracts at the lower market price of $4.70. Her profit on the futures contracts is $0.25 per bushel ($4.95 - $4.70), totaling $2,500 ($0.25 * 10,000 bushels). Her net revenue is $47,000 (cash market) + $2,500 (futures profit) = $49,500, effectively locking in a price close to her original futures sale price.

Scenario 2: Corn prices rise.
In three months, the spot price of corn has risen to $5.20 per bushel. Sarah sells her physical corn in the cash market for $5.20 per bushel, realizing $52,000. Her futures position, however, incurred a loss. She has to buy back her futures contracts at $5.20 per bushel. Her loss on the futures contracts is $0.25 per bushel ($5.20 - $4.95), totaling $2,500 ($0.25 * 10,000 bushels). Her net revenue is $52,000 (cash market) - $2,500 (futures loss) = $49,500.

In both scenarios, the futures contract helped Sarah stabilize her revenue, illustrating its utility as a hedging tool.

Practical Applications

Futures contracts have widespread practical applications across various sectors of the economy:

• Risk Management: Businesses use futures to hedge against adverse price movements in raw materials (e.g., airlines hedging jet fuel costs with crude oil futures) or currencies (e.g., importers hedging against unfavorable exchange rate fluctuations). Agricultural producers commonly use futures to lock in prices for their crops or livestock.
• Speculation: Individual traders and institutional investors use futures to speculate on the future direction of prices for profit. This activity provides liquidity to the futures markets.
• Price Discovery: The continuous trading of futures contracts on exchanges like the CME Group provides transparent and real-time price discovery for various assets, from agricultural products to interest rates and stock indexes¹⁴,¹³.
• Arbitrage: Sophisticated traders engage in arbitrage by exploiting small price discrepancies between the futures market and the underlying cash market to earn risk-free profits.
• Portfolio Diversification: Investors may use futures contracts to gain exposure to different asset classes (e.g., commodities) to enhance portfolio diversification or for tactical asset allocation.
• Financial Market Regulation: The Commodity Futures Trading Commission (CFTC) regulates the U.S. futures and options markets to ensure fair trading practices and protect market participants from fraud and manipulation,¹²,¹¹. The CFTC was established in 1974 to oversee these markets, replacing the Commodity Exchange Authority¹⁰,.
• Capital Efficiency: Futures contracts often require a relatively small initial margin deposit compared to the total value of the contract, allowing for significant leverage. This capital efficiency can be attractive for certain trading strategies.

Limitations and Criticisms

While futures contracts offer significant benefits, they also come with inherent limitations and criticisms:

• Leverage and Risk: The high degree of leverage available in futures trading amplifies both potential gains and losses. A small adverse price movement can result in substantial losses that exceed the initial margin deposit, requiring additional funds through a margin call. This makes futures highly risky for inexperienced traders⁹.
• Standardization and Flexibility: Futures contracts are highly standardized, which facilitates trading on exchanges but limits flexibility. Participants needing highly specific quantities, qualities, or delivery dates might find them unsuitable and may prefer bespoke forward contracts instead⁸.
• Basis Risk: Even when used for hedging, futures contracts are subject to basis risk, which is the risk that the relationship between the spot price of the underlying asset and the futures price will change unexpectedly. This can lead to the hedge not perfectly offsetting the price exposure.
• Expiration and Rollover Costs: Futures contracts have finite expiration dates. To maintain exposure to an underlying asset, traders must "roll over" their positions by closing out the expiring contract and opening a new one with a later expiration, which incurs transaction costs⁷.
• Market Manipulation: Historically, futures markets have been susceptible to manipulation, such as "corners" and "squeezes," where a single entity gains control of enough of a commodity's supply to dictate its price⁶,⁵. While regulators like the CFTC actively police such activities and new forms of manipulation like "spoofing" have emerged with electronic trading, the risk persists⁴,³,²,¹.
• Liquidity: Not all futures contracts are equally liquid. Contracts for less actively traded underlying assets might have wide bid-ask spreads or difficulty in execution at desired prices.

Futures Contract vs. Options Contract

Futures contracts and options contracts are both popular financial instruments in the derivatives market, primarily used for hedging and speculation, but they differ significantly in their obligations and risk profiles.

A futures contract is a binding agreement where both the buyer (long position) and seller (short position) are obligated to fulfill the terms of the contract on the expiration date. The buyer is obligated to purchase the underlying asset, and the seller is obligated to deliver it, at the agreed-upon price. This obligation means that both parties face unlimited potential losses if the market moves significantly against their position, though daily settlement through the clearinghouse helps manage this risk.

In contrast, an options contract grants the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price (the strike price) on or before a certain date. The seller (writer) of the option, however, has the obligation to fulfill the contract if the buyer chooses to exercise their right. For the option buyer, the maximum loss is limited to the premium paid for the option, whereas for the option seller, potential losses can be substantial, depending on the type of option and whether it's covered or uncovered. Futures contracts do not involve a premium payment like options do; instead, they require margin deposits.

FAQs

What is the primary purpose of a futures contract?

The primary purpose of a futures contract is to provide a mechanism for hedging against price risk, allowing businesses and individuals to lock in a future price for a commodity or financial instrument. They also serve as a tool for speculation on future price movements.

How do futures contracts reduce risk for businesses?

Futures contracts reduce risk for businesses by allowing them to secure a future price for a product they will buy or sell. For example, a bakery can buy wheat futures to lock in the price of flour for future production, protecting against unexpected price increases. This practice is a form of hedging.

Are futures contracts only for commodities?

No, while futures contracts originated with agricultural commodities, they now exist for a wide range of underlying assets. These include financial instruments like stock indexes, interest rates, currencies, and energy products such as crude oil and natural gas.

What happens if I don't close a futures position before expiration?

If you hold a futures contract until its expiration, you are obligated to either deliver or take physical delivery of the underlying asset, depending on whether you hold a short or long position, respectively. However, most futures contracts are closed out (offset) before expiration through an opposite transaction, avoiding physical delivery.

Who regulates futures markets in the U.S.?

In the U.S., the Commodity Futures Trading Commission (CFTC) is the independent federal agency responsible for regulating the futures and options markets. The CFTC's mission is to promote market integrity, efficiency, and protect market participants from fraud and abusive practices.