Futures

What Is Futures?

A futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future. These contracts are a core component of derivatives markets, representing a type of financial agreement whose value is derived from an underlying asset. This underlying asset can be a physical commodity like oil or agricultural products, a financial instrument such as currency or stocks, or even an interest rates index. Futures are primarily used for hedging against price risk or for speculation on future price movements. Unlike other financial contracts, futures are typically exchange-traded and subject to rigorous regulation.

History and Origin

The origins of futures contracts can be traced back to agricultural markets in the mid-19th century in the United States, particularly Chicago. Farmers and merchants sought ways to manage the price volatility of agricultural commodities between harvest seasons. This led to the formation of the Chicago Board of Trade (CBOT) in 1848, initially as a voluntary association for grain merchants to formalize "to-arrive" contracts.¹⁷, ¹⁸ These early contracts were precursors to modern futures, allowing buyers and sellers to agree on a price for a commodity to be delivered at a future date, thereby reducing uncertainty. The CBOT played a pivotal role in standardizing these agreements, and in 1865, formalized the first "futures contracts."¹⁵, ¹⁶

Over time, these agreements evolved from simple forward contracts into highly standardized, exchange-traded instruments. The practice of requiring performance bonds, known as margin, by 1865, further solidified their structure.¹⁴ The industry saw significant expansion beyond agriculture, with the launch of financial futures in the 1970s, including interest rate and currency futures.¹², ¹³ In 2007, the CBOT merged with the Chicago Mercantile Exchange (CME) to form CME Group, creating one of the world's largest and most diverse derivatives marketplaces.¹¹ Today, the CME Group facilitates trading across a wide range of asset classes.¹⁰

Key Takeaways

• Futures contracts are standardized agreements to buy or sell an asset at a predetermined price on a future date.
• They are primarily used for hedging price risk or for speculation on market movements.
• Futures are traded on regulated exchanges and are cleared through a clearinghouse.
• Participants are required to post initial and maintenance margin to cover potential losses.
• The price of a futures contract reflects market expectations of the underlying asset's price at expiration.

Formula and Calculation

The theoretical price of a futures contract, often referred to as the fair value, can be calculated using the cost-of-carry model. This model considers the current spot price of the underlying asset, the cost of financing (interest rates), and any carrying costs or benefits (such as storage costs for commodities or dividends for stocks).

For an asset that does not pay dividends or have storage costs (like a stock index future):

$F = S_0 e^{(r)(T)}$

Where:

• ( F ) = 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, continuously compounded)
• ( T ) = Time to expiration (in years)

For a commodity that has carrying costs and benefits (like a dividend yield or convenience yield):

$F = S_0 e^{(r+c-y)(T)}$

Where:

• ( c ) = Annualized carrying cost rate (e.g., storage costs)
• ( y ) = Annualized convenience yield or dividend yield (benefit of holding the physical asset)

These formulas help market participants determine whether a futures contract is trading at a premium or discount to its theoretical fair value.

Interpreting the Futures

Interpreting futures prices involves understanding what they reflect about market expectations. A futures price represents the market's collective forecast for the price of the underlying asset at the contract's expiration date. When the futures price is higher than the current spot price, the market is said to be in "contango," suggesting that market participants expect the underlying asset's price to increase over time, or it reflects the cost of carrying the asset until the future delivery date. Conversely, when the futures price is lower than the spot price, it's known as "backwardation," indicating an expectation of falling prices or a high immediate demand for the underlying asset.

Futures markets are crucial for price discovery, as they provide transparent, real-time pricing information for future delivery dates. Traders analyze the relationship between current spot prices and various futures contract prices to gauge market sentiment, supply and demand dynamics, and anticipated economic conditions.

Hypothetical Example

Consider an airline company that needs a significant amount of jet fuel (a type of petroleum commodities) in six months. The current spot price of jet fuel is $2.50 per gallon. The airline is concerned that fuel prices might rise, significantly increasing its operating costs.

To mitigate this risk, the airline's financial manager decides to enter into futures contracts. They purchase futures contracts for jet fuel expiring in six months at a price of $2.60 per gallon. Each contract represents 42,000 gallons. The airline buys 10 contracts, locking in the price for 420,000 gallons.

Scenario 1: Jet fuel prices rise
In six months, the spot price of jet fuel rises to $2.80 per gallon.

• The airline needs to buy jet fuel at the current market price of $2.80 per gallon for its operations, incurring a higher direct cost.
• However, the futures contracts they bought also appreciate in value. They can sell their futures contracts at the new market price of $2.80 per gallon.
• Profit from futures: (( $2.80 - $2.60 ) \times 42,000 \text{ gallons/contract} \times 10 \text{ contracts} = $84,000)
• This profit from the futures contracts offsets the higher cost of purchasing fuel in the spot market, effectively allowing the airline to pay close to the $2.60 price they initially locked in.

Scenario 2: Jet fuel prices fall
In six months, the spot price of jet fuel falls to $2.40 per gallon.

• The airline needs to buy jet fuel at the current market price of $2.40 per gallon, which is cheaper than expected.
• However, the futures contracts they bought also decline in value. If they sell their futures contracts at $2.40 per gallon, they incur a loss.
• Loss from futures: (( $2.40 - $2.60 ) \times 42,000 \text{ gallons/contract} \times 10 \text{ contracts} = -$84,000)
• While the airline pays less for fuel in the spot market, the loss on the futures contracts means their effective price is still around the $2.60 they locked in.

This example illustrates how futures can be used to stabilize future costs, regardless of market price fluctuations.

Practical Applications

Futures contracts have diverse applications across various sectors of the financial markets:

• Risk Management (Hedging): Businesses and investors use futures to protect themselves from adverse price movements in the underlying assets they produce, consume, or hold. For instance, a farmer might sell corn futures to lock in a price for their harvest, safeguarding against a drop in corn prices before delivery. Similarly, an airline uses jet fuel futures to manage its exposure to volatile energy costs.⁹
• Speculation: Traders who believe they can accurately predict future price movements use futures to profit from those predictions. They buy futures if they expect prices to rise (go "long") or sell futures if they expect prices to fall (go "short"), without intending to take or make physical delivery of the underlying asset.
• Arbitrage: Discrepancies between the futures price and the spot price of an asset can create arbitrage opportunities. Sophisticated traders exploit these temporary price differences to make risk-free profits by simultaneously buying the undervalued asset and selling the overvalued asset.
• Portfolio Diversification: Adding certain futures contracts, especially commodity futures, to a portfolio can offer diversification benefits, as their price movements may not always correlate with traditional assets like stocks and bonds.
• Central Clearing: A critical practical application is the role of the clearinghouse. When a futures trade is executed, a clearinghouse steps in as the counterparty to both the buyer and the seller. This mechanism significantly reduces counterparty risk and ensures the integrity of the market. The CME Group, for example, operates CME Clearing, acting as a central counterparty clearing provider for various derivatives.⁸
• Price Discovery: Futures markets serve as a transparent venue for participants to express their views on future supply and demand, which helps in efficient price discovery for various assets globally.

Limitations and Criticisms

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

• Leverage and [Margin] Call Risk: Futures trading involves substantial leverage, meaning a small initial investment (margin) can control a large contract value. While this can amplify profits, it also magnifies losses. If the market moves against a trader, they may face a "margin call," requiring them to deposit additional funds to maintain their position or risk liquidation. Failure to meet a margin call can lead to significant losses, potentially exceeding the initial investment.⁷
• Complexity and Volatility: Futures markets can be highly complex and volatile, especially for novice traders. Understanding contract specifications, delivery dates, and the factors influencing the underlying asset's price requires considerable knowledge and experience. Unexpected events or rapid shifts in supply and demand can lead to sharp price fluctuations.
• [Liquidity] Risk: While major futures contracts are highly liquid, some smaller or less active contracts may suffer from lower liquidity. This can make it difficult to enter or exit positions at desired prices, especially during times of market stress.
• [Credit Risk] (Counterparty): Although clearinghouses largely mitigate counterparty risk in exchange-traded futures, the possibility of a clearing member or even the clearinghouse itself defaulting, though rare, remains a systemic risk. This is why strict regulatory oversight by bodies like the Commodity Futures Trading Commission (CFTC) is crucial.⁶
• Basis Risk: Hedgers face basis risk, which is the risk that the relationship between the spot price of the underlying asset and the futures price changes unexpectedly. If the basis (the difference between the spot and futures price) moves unfavorably, a hedge might not perfectly offset the price risk.
• Regulatory Scrutiny: The derivatives markets, including futures, are subject to continuous regulatory scrutiny due to their systemic importance. The CFTC, for instance, protects market participants from fraud, manipulation, and abusive trading practices.⁵ Despite extensive regulation, market manipulation and other abuses can still occur, posing risks to market integrity.⁴ Academic research also highlights the various financial and non-financial risks inherent in these markets, including operational and model risks, emphasizing the ongoing need for robust risk management strategies.², ³

Futures vs. Options

Both futures and options are types of derivatives that allow traders to take positions on the future price of an underlying asset. However, a key distinction lies in the obligation they impose:

The primary difference is the symmetric obligation in futures versus the asymmetric right (for the buyer) in options. A futures contract obligates both parties to fulfill the agreement at expiration, whether by physical delivery or cash settlement. An options contract, conversely, grants the buyer the choice to exercise their right or let the option expire worthless, while the seller is bound by the buyer's decision. This fundamental difference leads to distinct risk-reward profiles and strategic applications for each instrument.

FAQs

What is the primary purpose of a futures contract?

The primary purpose of a futures contract is to allow parties to lock in a price today for an asset to be delivered or received at a future date. This helps in managing price risk through [hedging] (https://diversification.com/term/hedging) and enables individuals or institutions to speculation on future price movements.

Can I lose more than my initial investment in futures trading?

Yes, it is possible to lose more than your initial investment (margin) in futures trading. This is because futures contracts use leverage. If the market moves significantly against your position, your losses can exceed the margin deposited, leading to margin calls and potentially larger financial liabilities.

Are futures contracts standardized?

Yes, futures contracts are highly standardized. This standardization covers the quantity and quality of the underlying asset, the expiration date, and the delivery procedures. This uniformity ensures that all contracts of a particular type are identical, which facilitates their trading on exchanges and enhances liquidity.

Who regulates futures markets in the United States?

In the United States, the Commodity Futures Trading Commission (CFTC) is the independent federal agency responsible for regulating the futures, options, and swaps markets. Its mission is to promote market integrity, resilience, and vibrancy, and to protect market participants from fraud and manipulation.¹

What happens at the expiration of a futures contract?

At expiration, a futures contract can be settled in one of two ways: physical delivery or cash settlement. Physical delivery involves the actual exchange of the underlying asset for the agreed-upon price. Cash settlement means that the difference between the contract price and the market price at expiration is exchanged in cash, with no physical asset changing hands. The vast majority of futures contracts are cash-settled or closed out before expiration.