Future contracts

Future contracts are a cornerstone of modern financial markets, providing essential tools for price discovery, risk management, and speculation within the broader category of derivatives. These legally binding agreements obligate parties to buy or sell an asset at a predetermined price on a specified future date. Unlike options, which grant the holder a right but not an obligation, future contracts carry a firm commitment for both the buyer (long position) and the seller (short position). They are highly standardized and traded on regulated exchanges, ensuring transparency and liquidity.

History and Origin

The origins of future contracts can be traced back to agricultural markets, where farmers sought to lock in prices for their crops before harvest, and buyers wished to secure future supply at predictable costs. Early forms of these agreements, known as "forward contracts," emerged as merchants sought to mitigate the uncertainty of fluctuating commodity prices. However, these were largely private, customizable agreements.¹¹

The formalization and standardization of these arrangements began in the United States in the mid-19th century. In 1848, the Chicago Board of Trade (CBOT) was established to bring order to the chaotic grain trading system. By 1865, the CBOT introduced the world's first standardized future contracts, along with the first futures clearing operation, which required performance bonds, or margin, to be posted by buyers and sellers.⁹, ¹⁰ This innovation laid the groundwork for modern futures exchanges. Over the 20th century, exchanges like the Chicago Mercantile Exchange (CME) expanded futures trading beyond commodities to include financial products such as currencies in 1972 and interest rates in 1975.⁷, ⁸ The merger of the CBOT and CME in 2007 created the CME Group, solidifying its position as a global leader in derivatives trading.⁶

Key Takeaways

• Future contracts are standardized, legally binding agreements to buy or sell an underlying asset at a predetermined price on a specific expiration date.
• They are traded on organized exchanges and cleared through a clearing house, which acts as the counterparty to both sides of the trade.
• Future contracts are primarily used for hedging against price risk or for speculation on future price movements.
• Due to the use of leverage inherent in futures trading, potential gains and losses can be amplified.
• Positions are typically "mark-to-market" daily, meaning profits and losses are settled each day, affecting the margin account balance.

Formula and Calculation

While there isn't a single formula to "price" a future contract, as their value is determined by supply and demand on the exchange, the profit or loss from a future contract can be calculated directly. The value of a future contract fluctuates with the market price of the underlying asset.

The profit or loss (P&L) for a future contract can be calculated as follows:

Where:

• Exit Price: The price at which the contract is sold (for a long position) or bought back (for a short position).
• Entry Price: The price at which the contract was initially bought (for a long position) or sold (for a short position).
• Contract Size: The specified quantity of the underlying asset per contract (e.g., 5,000 bushels of corn, 100 barrels of oil).
• Multiplier: A factor used to convert the price movement into currency value.

For example, if an investor buys a future contract for crude oil at $70 per barrel with a contract size of 1,000 barrels and a multiplier of $1, and then sells it at $72 per barrel, the profit would be:

Conversely, if the price dropped to $68, the loss would be $2,000. Positions are subject to daily mark-to-market adjustments, meaning profits and losses are credited or debited to the trader's margin account each day.

Interpreting Future contracts

Interpreting future contracts involves understanding market expectations and the sentiment surrounding the underlying asset. The price of a future contract reflects what market participants collectively believe the asset will be worth at the contract's expiration date. A higher futures price compared to the current spot price (contango) suggests that traders expect the price to rise, possibly due to carrying costs like storage and insurance. Conversely, a lower futures price (backwardation) might indicate expectations of future supply surpluses or strong current demand, as seen in commodity markets during periods of scarcity.

Furthermore, the volume and open interest in future contracts provide insights into market activity and liquidity. High volume indicates active trading, while high open interest suggests significant outstanding positions, which can be a measure of market depth and the commitment of traders. The standardization of future contracts allows for easy comparison and interpretation across different maturities and exchanges.

Hypothetical Example

Consider a hypothetical scenario involving corn future contracts. A large cereal producer anticipates needing 50,000 bushels of corn in three months. The current spot price of corn is $5.00 per bushel, but the producer is concerned that prices might rise significantly by then, impacting their production costs.

To manage this risk management, the producer decides to hedge by buying 10 corn future contracts, each representing 5,000 bushels. The three-month future contract is currently trading at $5.10 per bushel.

1. Action: The cereal producer goes "long" 10 corn future contracts at $5.10 per bushel.
2. Scenario 1: Corn prices rise. In three months, the spot price of corn has risen to $5.50 per bushel. The producer's future contracts also appreciate in value.
3. Outcome: The producer takes physical delivery of corn at the market price of $5.50 per bushel. However, the profit from their long futures position ($5.50 - $5.10 = $0.40 profit per bushel) offsets the higher cost. The profit on the futures contracts would be $0.40/bushel * 50,000 bushels = $20,000. This gain effectively locks in the initial cost of $5.10 per bushel for their corn needs.

Alternatively, if the contract was settled via cash settlement, the futures position would be closed out, and the profit would be received, which would then offset the higher cost of buying corn in the physical market.

Practical Applications

Future contracts are widely applied across various sectors of the financial world for distinct purposes:

• Hedging: Businesses and producers use futures to mitigate adverse price movements in underlying assets they buy or sell. For instance, an airline might purchase crude oil futures to lock in fuel costs, while a farmer might sell grain futures to guarantee a price for their harvest. This helps in stabilizing revenues and managing expenses.
• Speculation: Traders and investors utilize futures to profit from anticipated price changes. By taking a long position if they expect prices to rise or a short position if they expect prices to fall, they can gain significant exposure with a relatively small initial capital outlay due to the leverage offered.
• Price Discovery: The active trading of future contracts on exchanges like the CME Group helps in the efficient formation of prices for various assets, reflecting global supply and demand dynamics and future expectations. This transparent pricing mechanism benefits producers, consumers, and other market participants by providing clear benchmarks.⁵ The Commodity Futures Trading Commission (CFTC) oversees these markets to ensure competitiveness, efficiency, and integrity.
• Portfolio Diversification: Adding future contracts on diverse asset classes like commodities or currencies can help diversify an investment portfolio, potentially reducing overall portfolio risk when combined with traditional equity and bond holdings. Many major asset classes, including agricultural products, energy, metals, interest rates, and equity indexes, are traded via futures contracts.⁴

Limitations and Criticisms

While highly versatile, future contracts come with inherent limitations and criticisms:

• High Leverage and Risk: The significant leverage offered in futures trading means that relatively small price movements can lead to substantial gains or losses, potentially exceeding the initial margin deposit. This amplification of risk makes futures unsuitable for all investors.
• Volatility: Futures markets, particularly for commodities and certain financial instruments, can experience high volatility, leading to rapid and unpredictable price swings. This volatility can challenge even experienced traders and increase the risk of margin calls.
• Complexity: Understanding the nuances of contract specifications, margin requirements, and mark-to-market processes requires a degree of financial sophistication. Misunderstanding these aspects can lead to costly errors.
• Basis Risk: For hedgers, basis risk exists when the price of the future contract does not move in perfect correlation with the price of the physical underlying asset being hedged. This imperfect correlation can lead to unexpected losses in the hedge.
• Contribution to Systemic Risk: In extreme scenarios, the interconnectedness of derivatives markets, including futures, has been highlighted as a potential contributor to systemic financial instability. Regulators, such as the Federal Reserve Bank of San Francisco, monitor these markets due to their critical role in the broader financial system.², ³ The misuse or excessive speculation in derivatives can amplify market shocks.

Future contracts vs. Forward contracts

While both future contracts and forward contracts are agreements to buy or sell an asset at a predetermined price on a future date, key differences distinguish them. Future contracts are standardized, exchange-traded, and guaranteed by a clearing house, which mitigates counterparty risk. They involve daily mark-to-market settlement and require margin payments.

In contrast, forward contracts are customized, over-the-counter (OTC) agreements negotiated directly between two parties. They are not typically guaranteed by a clearing house, meaning they carry higher counterparty risk. Forward contracts usually involve a single settlement at the expiration date, rather than daily adjustments. Their bespoke nature makes them less liquid than futures, but more flexible for specific hedging needs.

FAQs

What is a future contract used for?

Future contracts are primarily used for hedging to protect against price fluctuations, and for speculation to profit from anticipated price movements of an underlying asset.

Are future contracts risky?

Yes, future contracts can be highly risky due to the significant leverage involved. Small price changes in the underlying asset can lead to large profits or losses, often exceeding the initial investment. Understanding and managing margin account requirements is crucial.

How are future contracts regulated?

In the United States, future contracts are primarily regulated by the Commodity Futures Trading Commission (CFTC). The CFTC's role is to ensure the integrity, competitiveness, and financial soundness of the U.S. derivatives markets, protecting market participants from fraud and manipulation.¹

Can I take physical delivery of an asset with a future contract?

For some future contracts, particularly those based on physical commodities like crude oil or agricultural products, physical delivery of the underlying asset is an option at expiration. However, many financial future contracts (e.g., stock index futures, interest rate futures) are settled via cash settlement, meaning money changes hands based on the contract's value rather than physical exchange.