Futures contract

What Is 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. This type of agreement falls under the broad category of derivatives, financial contracts whose value is derived from an underlying asset. Unlike customized agreements, futures contracts are highly standardized in terms of quantity, quality, and delivery specifications, making them suitable for trading on organized exchanges. The primary purpose of a futures contract is to allow market participants to manage price risk or speculate on the future direction of an asset's price.

History and Origin

The concept of agreeing to a future price for goods has ancient roots, with early forms of forward agreements appearing in Mesopotamia and the Dojima Rice Exchange in Japan in the late 17th century, where rice futures were traded¹². The modern futures contract as we know it began to formalize in the mid-19th century in the United States. Farmers in the Midwest, needing to manage price uncertainty for their crops, entered into "to-arrive" contracts, which were agreements to deliver grain at a future date for a set price. Chicago, a central hub for agricultural trade due to its burgeoning railroad infrastructure, became the epicenter for this evolution¹¹.

On April 3, 1848, the Chicago Board of Trade (CBOT) was founded, initially as a cash market for grain. Soon after its establishment, the CBOT began facilitating forward contracts. By 1864, the CBOT introduced the first standardized, exchange-traded forward contracts, which were formally called futures contracts¹⁰. This standardization, including clear rules for margin and delivery procedures established by October 1865, was a crucial step in transforming informal agreements into regulated financial instruments⁹. This innovation provided a more efficient mechanism for price discovery and risk management in agricultural markets, laying the groundwork for the diverse futures markets seen today.

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 contracts are primarily used for hedging against price fluctuations, speculation on price movements, and arbitrage opportunities.
• Unlike spot markets, futures involve a future commitment, with gains and losses typically settled daily through a clearing house.
• The market's leverage component can significantly amplify both gains and losses.

Formula and Calculation

While the actual price of a futures contract is determined by supply and demand on an exchange, its theoretical price can be estimated using the "cost of carry" model. This model accounts for the costs and benefits of holding the underlying asset until the contract's expiration date.

For a non-dividend-paying asset (like a commodity that has storage costs but no income):

Where:

• (F_0) = Current futures price
• (S_0) = Current spot price of the underlying asset
• (r) = Risk-free interest rate (annualized)
• (d) = Dividend yield or convenience yield (annualized, if applicable to the asset)
• (T) = Time to expiration (in years)

For commodities with storage costs (c) and convenience yield (y):

(Note: (e) is the base of the natural logarithm).

The convenience yield represents the benefit of holding the physical asset, such as the ability to meet unexpected demand or avoid stockouts, which is not captured by simply holding a futures contract. These formulas provide a theoretical benchmark, but actual futures prices can deviate due to market sentiment, supply/demand imbalances, and other factors.

Interpreting the Futures Contract

Interpreting a futures contract involves understanding its components and what the price implies about future expectations. The futures price reflects the collective market expectation of the underlying asset's value at the delivery date. If the futures price is higher than the current spot price, it indicates a market expectation of rising prices (contango). Conversely, if the futures price is lower than the spot price, it suggests an expectation of falling prices or a shortage of the physical commodity (backwardation).

Participants use futures prices for price discovery, as they provide a forward-looking indication of where a market might be headed. For example, a farmer looking at corn futures prices for next year's harvest can make planting decisions based on the anticipated revenue. Investors also interpret futures prices in relation to their current portfolios, using them to gauge potential future market volatility or to identify opportunities for strategic positioning.

Hypothetical Example

Consider a hypothetical scenario involving ABC Airlines, which consumes a significant amount of jet fuel. The current spot price of jet fuel is $2.50 per gallon. ABC Airlines is concerned that rising oil prices will increase their operating costs in six months. To hedge this risk, ABC Airlines decides to enter into a futures contract.

Here's how it might work:

1. Agreement: ABC Airlines identifies a standardized jet fuel futures contract for delivery in six months. The contract specifies a quantity of 42,000 gallons (one typical oil futures contract size). The current futures price for that six-month contract is $2.60 per gallon.
2. Purchase: ABC Airlines buys one jet fuel futures contract at $2.60 per gallon, locking in the price for 42,000 gallons of fuel to be delivered in six months. They are required to put up an initial margin deposit with their broker.
3. Market Movement: Six months later, let's assume the spot price of jet fuel has risen to $2.80 per gallon.
4. Settlement: The futures contract is settled. Since ABC Airlines bought the contract at $2.60 and the market price is now $2.80, they theoretically "gain" $0.20 per gallon on the futures contract ($2.80 - $2.60 = $0.20). Their profit from the futures contract is (0.20 \times 42,000 = $8,400).
5. Overall Impact: While ABC Airlines pays the higher spot price of $2.80 per gallon for the physical fuel they need, the profit from their futures position effectively offsets the increased cost. This allows them to secure their fuel at a net cost close to their initial hedged price of $2.60 per gallon, demonstrating the effectiveness of the futures contract in mitigating price risk.

Practical Applications

Futures contracts have widespread practical applications across various financial sectors and industries.

• Risk Management (Hedging): Businesses use futures to protect themselves from adverse price movements in commodities or currencies. For instance, an airline might buy jet fuel futures to lock in fuel costs, or a wheat farmer might sell wheat futures to guarantee a price for their harvest⁸. This stability in pricing helps businesses plan budgets and manage profitability.
• Speculation: Traders and investors who believe they can predict future price movements use futures contracts to profit from anticipated changes. The inherent leverage in futures allows for significant exposure to an underlying asset with a relatively small capital outlay, amplifying potential returns (and losses)⁷.
• Price Discovery: Futures markets serve as a transparent mechanism for establishing the future price of an asset based on collective market expectations. This forward-looking price information is valuable for producers, consumers, and policymakers in making informed decisions.
• Arbitrage: Sophisticated traders engage in arbitrage by simultaneously buying and selling futures contracts or the underlying assets in different markets to profit from small price discrepancies.
• Portfolio Diversification: Financial institutions and fund managers can use futures contracts on various financial instruments, such as stock indices or interest rates, to adjust their portfolio's overall exposure or to gain exposure to different asset classes without directly owning the underlying securities.
• Regulation: In the United States, the Commodity Futures Trading Commission (CFTC) oversees the U.S. derivatives markets, including futures, to promote market integrity, prevent manipulation, and protect market participants. The CFTC operates under the statutory framework of the Commodity Exchange Act (CEA)⁶.

Limitations and Criticisms

Despite their utility, futures contracts come with notable limitations and criticisms. One of the most significant risks is the potential for amplified losses due to leverage. While leverage can magnify gains, it equally magnifies losses, often requiring traders to deposit additional capital through margin calls to maintain their positions⁴, ⁵. If a trader cannot meet a margin call, their position may be liquidated, leading to substantial financial strain³.

Futures contract trading also carries substantial market risk. Prices can fluctuate rapidly and unpredictably, driven by economic data, geopolitical events, and shifts in supply and demand, making precise predictions difficult². This inherent market volatility means that even experienced traders can incur significant losses quickly.

Critics also point to the complexity of futures markets, which can be challenging for inexperienced participants to navigate. Understanding contract specifications, settlement procedures, and the various factors influencing futures prices requires a steep learning curve¹. Furthermore, the concentration of speculative activity in futures markets can sometimes lead to price distortions that do not always reflect underlying fundamental values. Concerns about regulatory oversight and potential market manipulation, while addressed by bodies like the CFTC, remain a focus for ongoing scrutiny and reform.

Futures Contract vs. Forward Contract

While a futures contract and a forward contract are both agreements to buy or sell an asset at a predetermined price on a future date, they differ significantly in their structure and market environment.

The standardization and exchange-trading of futures contracts make them more accessible and liquid for a broader range of participants, while forward contracts are tailored to specific needs and common in over-the-counter markets. Confusion often arises because both serve similar hedging or speculative purposes, but their structural differences impact risk, liquidity, and accessibility.

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 profit from anticipated price movements (speculation) of an underlying asset without needing to own the asset itself.

How are futures contracts regulated?

In the United States, futures contracts are regulated by the Commodity Futures Trading Commission (CFTC) under the Commodity Exchange Act. This regulation aims to ensure market integrity, prevent manipulation, and protect traders.

Can I lose more than my initial investment in a futures contract?

Yes, due to leverage, it is possible to lose more than your initial margin deposit when trading futures contracts. If market movements are unfavorable, you may receive margin calls requiring additional funds, and failure to meet these can lead to forced liquidation of your position.

What types of assets can have futures contracts?

Futures contracts exist for a wide range of assets, including physical commodities (like crude oil, gold, agricultural products), financial instruments (such as stock indices, interest rates, and foreign currencies), and even cryptocurrencies.

What is a clearing house's role in futures trading?

A clearing house acts as a central counterparty to every trade in the futures market, guaranteeing the performance of the contract for both the buyer and the seller. This significantly reduces counterparty risk and facilitates the daily marking-to-market process where profits and losses are settled.