Futures contracts

What Is Futures Contracts?

A futures contract is a standardized legal agreement to buy or sell a specific underlying asset at a predetermined price on a specified date in the future. These contracts are a type of derivatives, a broader category of financial instruments whose value is derived from an underlying asset, such as commodities, currencies, interest rates, or stock indexes. Futures contracts are traded on organized exchanges, ensuring standardization in terms of quantity, quality, and delivery dates. This standardization facilitates liquidity and allows participants to easily enter and exit positions.

History and Origin

The origins of futures contracts can be traced back to the mid-19th century in the United States, primarily in response to the volatile nature of agricultural prices. Farmers and merchants sought a way to manage the risks associated with price fluctuations for crops like corn and wheat. The Chicago Board of Trade (CBOT), established in 1848, initially served as a centralized meeting point for buyers and sellers to negotiate "to-arrive" contracts, which were early forms of forward contracts¹⁴, ¹⁵.

In 1865, the CBOT formalized these agreements into what became known as futures contracts, making them standardized and exchange-traded¹³. This innovation helped to reduce counterparty risk and increased market efficiency. The CBOT also introduced the concept of a clearinghouse in 1865, requiring performance bonds (known as margin) to be posted by traders, which further guaranteed the integrity of the trades¹². Over time, the scope of futures markets expanded beyond agricultural commodities to include financial products, interest rates, and foreign currencies, reflecting the evolution of global financial markets¹⁰, ¹¹. The CBOT later merged with the Chicago Mercantile Exchange (CME) in 2007, forming CME Group, which became the largest derivatives market.

Key Takeaways

• Futures contracts are standardized agreements to buy or sell an asset at a future date for a predetermined price.
• They are exchange-traded derivatives, offering transparency and liquidity.
• Market participants use futures contracts for both hedging against price risk and for speculation on future price movements.
• A clearinghouse acts as a counterparty to every trade, reducing counterparty risk.
• Trading futures involves the use of margin, which provides significant leverage.

Formula and Calculation

The pricing of a futures contract is fundamentally linked to the spot price of the underlying asset, the time to expiration, and the prevailing risk-free interest rate, minus any income generated by the asset (like dividends or storage costs). The theoretical fair value of a futures contract (F) can be calculated using the following formula for an asset that does not provide any income:

$F = S \times e^{(r \times T)}$

Where:

• $F$ = Futures price
• $S$ = Current spot price of the underlying asset
• $e$ = The base of the natural logarithm (approximately 2.71828)
• $r$ = Risk-free interest rate (continuously compounded)
• $T$ = Time to expiration of the contract (in years)

For assets that incur storage costs or provide income, the formula is adjusted to account for these factors. The relationship between the spot price and the futures price is known as the "cost of carry."

Interpreting Futures Contracts

Futures contracts reflect the market's expectation of an asset's market price at a future date. If the futures price is higher than the spot price, it's known as "contango," often indicating expectations of rising prices or a positive cost of carry. Conversely, if the futures price is lower than the spot price, it's called "backwardation," which can suggest expectations of falling prices or a negative cost of carry, often seen in commodity markets due to supply shortages.

Participants interpret these prices to inform their hedging strategies or speculation decisions. For instance, a producer might lock in a selling price for a future harvest by entering a short futures position if they anticipate prices will fall, while a consumer might buy a futures contract to secure a purchase price if they expect prices to rise. The prices also incorporate factors such as storage costs for physical commodities and the opportunity cost of capital.

Hypothetical Example

Consider a hypothetical scenario involving corn futures contracts. A farmer anticipates harvesting 5,000 bushels of corn in December. The current spot price of corn is $4.00 per bushel, but the farmer is concerned that the price might fall by December. To mitigate this price risk, the farmer decides to sell one December corn futures contract.

Assume one corn futures contract represents 5,000 bushels. The farmer sells one December corn futures contract at a price of $4.10 per bushel.

Come December:

Scenario 1: Corn prices fall
The spot price of corn in December is $3.80 per bushel.
The farmer sells their physical corn in the cash market for $3.80 per bushel, realizing $3.80 * 5,000 = $19,000.
The futures contract the farmer sold at $4.10 is now worth $3.80. To close their position, they buy back a December corn futures contract at $3.80.
Their profit from the futures contract is ($4.10 - $3.80) * 5,000 = $0.30 * 5,000 = $1,500.
The effective price the farmer received for their corn is ($19,000 + $1,500) / 5,000 = $4.10 per bushel, effectively locking in their desired price.

Scenario 2: Corn prices rise
The spot price of corn in December is $4.30 per bushel.
The farmer sells their physical corn in the cash market for $4.30 per bushel, realizing $4.30 * 5,000 = $21,500.
The futures contract the farmer sold at $4.10 is now worth $4.30. To close their position, they buy back a December corn futures contract at $4.30.
Their loss from the futures contract is ($4.10 - $4.30) * 5,000 = -$0.20 * 5,000 = -$1,000.
The effective price the farmer received for their corn is ($21,500 - $1,000) / 5,000 = $4.10 per bushel.

In both scenarios, by utilizing futures contracts, the farmer effectively hedged against price fluctuations, securing a net selling price of $4.10 per bushel.

Practical Applications

Futures contracts are widely used in various sectors for risk management and investment.

• Hedging: Companies use futures to protect against adverse price movements in raw materials, currencies, or interest rates. For example, an airline might buy crude oil futures to lock in fuel costs, mitigating commodity price risk. Similarly, a multinational corporation can use currency futures to hedge against unfavorable exchange rate fluctuations, managing currency risk. Derivatives, including futures, play a crucial role in allowing investors to hedge against potential losses in underlying assets, covering various risks like interest rate risk, currency risk, and commodity price risk⁹.
• Speculation: Traders speculate on the future direction of prices, attempting to profit from correctly predicting price movements. They can take long positions (betting on price increases) or short positions (betting on price decreases) without owning the underlying asset.
• Arbitrage: Opportunities arise when there are price discrepancies between the futures market and the underlying cash market or between different futures contracts. Arbitrageurs aim to profit from these temporary inefficiencies.
• Price Discovery: Futures markets contribute to price discovery by providing transparent and public information about expected future prices, helping producers and consumers make informed decisions.
• Portfolio Diversification: While complex, some sophisticated investors might use futures for portfolio diversification or tactical asset allocation, particularly through futures on broad market indices.

The Commodity Futures Trading Commission (CFTC) is the primary federal agency responsible for regulating the U.S. derivatives markets, including futures contracts, options, and swaps, with a mission to promote market integrity and protect participants from fraud⁶, ⁷, ⁸.

Limitations and Criticisms

Despite their utility, futures contracts come with inherent limitations and criticisms. One significant concern is the potential for substantial losses due to the inherent leverage involved. A small movement in the underlying asset's price can lead to a magnified gain or loss on the futures position, potentially exceeding the initial margin deposited. Volatility in the underlying market can accelerate these gains or losses, making futures trading highly risky for inexperienced investors.

Another criticism revolves around the complexity of these instruments, especially for retail investors. The Financial Industry Regulatory Authority (FINRA) has issued warnings regarding "complex products" like certain commodity-linked exchange-traded products (ETPs) that invest in futures contracts, highlighting that retail investors may not fully understand their risks and payout structures³, ⁴, ⁵. This concern is heightened when investors access these products through self-directed platforms without professional guidance².

Furthermore, while intended for risk management, misuse or excessive speculation in futures markets can contribute to market instability. The interconnectedness of derivatives markets can amplify systemic risks, as highlighted by discussions surrounding the financial turmoil of 2008 and the role of derivatives in that crisis¹. Regulatory bodies continually monitor these markets to prevent manipulation and ensure fair practices.

Futures Contracts vs. Forward Contracts

While often confused, futures contracts and forward contracts have key distinctions.

The standardization and exchange-traded nature of futures contracts provide greater transparency and reduce default risk compared to forward contracts, which are private agreements tailored to specific needs but carry greater counterparty risk.

FAQs

What is the main purpose of futures contracts?

The main purposes are hedging against future price changes and speculation to profit from anticipating market movements. Businesses use them to manage price risk for commodities or currencies, while investors may use them to bet on market direction.

Are futures contracts risky?

Yes, futures contracts are considered high-risk financial instruments. They involve significant leverage, meaning a small price change in the underlying asset can lead to substantial gains or losses, potentially exceeding the initial investment. Understanding the risks involved, including daily margin requirements, is crucial before trading.

How are futures contracts regulated?

In the United States, futures contracts are primarily regulated by the Commodity Futures Trading Commission (CFTC). This federal agency oversees the derivatives markets to ensure fair practices, prevent fraud, and protect market participants.

Can individuals trade futures contracts?

Yes, individuals can trade futures contracts, typically through brokerage accounts that offer access to futures exchanges. However, due to their complexity and significant risk, they are generally considered more suitable for experienced investors who understand the mechanics of leverage and market volatility.