Future contract

What Is a Future Contract?

A future contract is a standardized legal agreement to buy or sell a specific commodity, currency, financial instrument, or other asset at a predetermined price and at a specified date in the future. These contracts are a fundamental component of the broader financial category known as derivatives, deriving their value from an underlying asset or benchmark. Unlike traditional spot transactions where assets are exchanged immediately at the current spot price, a future contract obligates both the buyer and the seller to fulfill the transaction on the expiration date, regardless of the market price at that time.

Participants use future contracts primarily for hedging against potential price fluctuations in the underlying asset or for speculation, aiming to profit from anticipated price movements. They are traded on organized exchanges, which provide a regulated environment, standardized terms, and the assurance of a clearinghouse to mitigate counterparty risk.

History and Origin

The origins of future contracts can be traced back to agricultural markets in the 19th century United States. Farmers and merchants faced significant uncertainty due to volatile crop prices, leading to the need for agreements that would lock in prices for future delivery. This informal system of "forward contracts" eventually evolved into the more standardized future contracts. A pivotal moment in this evolution occurred in 1865 when the Chicago Board of Trade (CBOT) formalized grain trading with the development of standardized agreements called "futures contracts."⁸ This standardization brought greater transparency and efficiency to the trading process, paving the way for the robust derivatives markets seen today. The Chicago Mercantile Exchange (CME), which later merged with CBOT to form CME Group, also played a significant role, introducing its first futures contracts on frozen pork bellies in 1961.

Key Takeaways

• A future contract is a binding agreement to buy or sell an asset at a predetermined price on a future date.
• They are standardized and traded on regulated exchanges, unlike customized forward contracts.
• Market participants use future contracts for both hedging against price risk and speculating on future price movements.
• The use of leverage is common in futures trading, which can amplify both gains and losses.
• The Commodity Futures Trading Commission (CFTC) regulates the futures markets in the United States.

Formula and Calculation

While a future contract itself does not have a "formula" in the traditional sense like an option's pricing model, its theoretical price is influenced by several factors, including the spot price of the underlying asset, the time to expiration, the risk-free interest rate, and any costs of carry (such as storage costs for commodities or dividend yields for equities).

The theoretical no-arbitrage price for a future contract (F) on a non-dividend-paying asset can be expressed as:

Where:

• (F) = Future 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)
• (T) = Time to expiration (in years)

For assets with a cost of carry (c), such as storage costs for physical commodities, the formula adjusts to:

If the underlying asset provides a yield (y), such as dividends or convenience yield, the formula becomes:

In practice, market future prices may deviate slightly from these theoretical values due to factors like supply and demand dynamics, market sentiment, and transaction costs. The actual profit or loss on a future contract is determined by the difference between the contract's entry price and its exit or settlement price.

Interpreting the Future Contract

Interpreting a future contract involves understanding its key specifications and how they reflect market expectations. A higher future price compared to the current spot price typically indicates a market expectation of rising prices for the underlying asset, often driven by storage costs and interest rates, a concept known as contango. Conversely, a lower future price than the spot price, known as backwardation, may suggest expectations of future supply increases or immediate demand, common in certain commodity markets.

The terms of a future contract, such as the underlying asset, contract size, expiration date, and minimum price fluctuation (tick size), are standardized by the exchanges where they are traded. This standardization promotes liquidity and facilitates efficient price discovery. Traders and analysts interpret future prices as a forward-looking indicator for the supply and demand dynamics of the underlying asset. For example, a sharp increase in oil futures prices might signal concerns about future supply disruptions.

Hypothetical Example

Consider a hypothetical scenario involving a farmer and a food manufacturer. It is currently June, and the farmer expects to harvest 5,000 bushels of corn in September. The current spot price for corn is $4.00 per bushel, but the farmer is concerned that prices might fall by September. A food manufacturer needs 5,000 bushels of corn in September and is concerned that prices might rise.

To manage this price risk, both parties can use a future contract. Let's assume a September corn future contract is trading at $4.10 per bushel.

1. Farmer (Seller): The farmer enters into a future contract to sell 5,000 bushels of corn at $4.10 per bushel for September delivery. This acts as a hedging strategy, locking in a price for their harvest.
2. Food Manufacturer (Buyer): The food manufacturer enters into a future contract to buy 5,000 bushels of corn at $4.10 per bushel for September delivery. This also acts as a hedge, securing the cost of their raw material.

Come September, there are two possible outcomes:

• Scenario A: Corn spot price drops to $3.80.
  • The farmer sells their physical corn on the spot market for $3.80, taking a loss compared to the $4.10 futures price. However, the short future contract gains. The future contract is either closed out for a profit (selling at $4.10, buying back at $3.80) or delivered. If closed out, the profit from the futures offsets the loss on the physical sale, effectively realizing the initial hedged price.
  • The food manufacturer buys physical corn on the spot market for $3.80. The long future contract loses value (buying at $4.10, selling back at $3.80). The loss on the futures contract is offset by the lower price paid for the physical corn.
• Scenario B: Corn spot price rises to $4.50.
  • The farmer sells their physical corn for $4.50, but the short future contract loses value. The loss on the futures offsets the gain on the physical sale, effectively realizing the initial hedged price.
  • The food manufacturer buys physical corn for $4.50, but the long future contract gains value. The profit from the futures offsets the higher price paid for the physical corn.

In both scenarios, the future contract allowed both the farmer and the manufacturer to mitigate price uncertainty and effectively secure a price for their respective transactions.

Practical Applications

Future contracts are widely used across various sectors of the financial market for diverse purposes. Their applications include:

• Risk Management and Hedging: Businesses exposed to commodity price volatility (e.g., airlines hedging fuel costs, farmers hedging crop prices) use future contracts to lock in prices and reduce exposure to adverse price movements. Financial institutions also use them to hedge against interest rate or currency fluctuations.
• Speculation: Traders and investors who anticipate price movements in specific assets can use future contracts to take a leveraged position. For instance, a speculator who believes oil prices will rise might buy crude oil futures.⁷ Major exchanges like CME Group offer a vast array of future contracts on various asset classes, including energy, metals, agriculture, interest rates, and equity indexes.⁶,⁵
• Price Discovery: The active trading of future contracts contributes to the efficient discovery of future prices for underlying assets, providing valuable forward-looking information to market participants. This contributes to overall market efficiency.
• Arbitrage: Traders may engage in arbitrage strategies, exploiting temporary price discrepancies between the spot market and the futures market, or between different future contracts on the same asset, to generate risk-free profits.
• Portfolio Diversification: For some investors, including commodities or other assets via futures contracts can offer diversification benefits, as these assets may not move in perfect correlation with traditional stocks and bonds.

The Commodity Futures Trading Commission (CFTC) oversees the U.S. futures markets to ensure market integrity and protect participants.⁴ This regulatory oversight is crucial for maintaining confidence in the integrity of these markets.

Limitations and Criticisms

While future contracts offer significant advantages, they also come with inherent limitations and risks. One of the primary concerns is the high degree of leverage involved. Traders typically only need to deposit a small percentage of the contract's total value as margin to control a much larger underlying asset value. While this can amplify potential gains, it also means that losses can quickly exceed the initial margin deposit. The possibility exists that losses can be substantial and, in some cases, unlimited, exceeding the amount initially deposited with a broker.³,²

Other limitations and criticisms include:

• Volatility: Prices of underlying assets can be highly volatile, leading to rapid and significant swings in the value of future contracts. This volatility can make it challenging for inexperienced traders to manage positions effectively.
• Liquidity Risk: While major future contracts are highly liquid, some less actively traded contracts may suffer from limited liquidity, making it difficult to enter or exit positions at desired prices.
• Margin Calls: Due to daily mark-to-market adjustments, if a contract moves unfavorably, traders may face margin calls, requiring them to deposit additional funds to maintain their position. Failure to meet a margin call can lead to the forced liquidation of the position, potentially incurring substantial losses.¹
• Complexity: Understanding the nuances of different future contracts, expiration cycles, and settlement procedures requires a significant level of financial knowledge. For retail investors, direct involvement in futures trading may not be suitable.
• Regulatory Scrutiny: Despite robust regulation by bodies like the CFTC, the complexity and leverage of future contracts can still lead to instances of fraud or manipulation, although regulatory bodies actively work to prevent such occurrences.

Future Contract vs. Forward Contract

The terms future contract and forward contract are often used interchangeably or cause confusion due to their similar function of obligating a buyer and seller to a transaction at a future date. However, key distinctions exist primarily in their standardization, trading venue, and associated risks.

While both serve the purpose of fixing a price for a future transaction, the standardization and exchange-traded nature of a future contract provide greater transparency, liquidity, and reduced counterparty risk compared to a customized forward contract.

FAQs

What is the primary purpose of a future contract?

The primary purpose of a future contract is to allow parties to lock in a price today for an asset that will be delivered or settled at a specific date in the future. This enables participants to either hedge against potential price changes or speculate on future price movements.

Can I lose more than my initial investment with a future contract?

Yes, it is possible to lose more than your initial margin deposit when trading a future contract. This is due to the inherent leverage in futures trading and the daily mark-to-market process, which can lead to margin calls. If the market moves significantly against your position, your losses can exceed the funds in your account.

Are future contracts regulated?

In the United States, future contracts and the markets on which they trade are extensively regulated by the Commodity Futures Trading Commission (CFTC). This oversight aims to ensure fair and transparent trading practices, maintain market integrity, and protect market participants.

How do future contracts differ from options?

A future contract is an obligation: the buyer is obligated to buy and the seller is obligated to sell the underlying asset at the agreed-upon price on the expiration date. An option, on the other hand, grants the buyer the right, but not the obligation, to buy or sell an asset at a specific price before or on a certain date. The seller of an option is obligated to fulfill the transaction if the buyer chooses to exercise their right.