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What Are Futures Contracts?

A futures contract is a standardized legal agreement to buy or sell a specific commodity or financial instrument at a predetermined price on a future date. This type of agreement belongs to the broader category of derivatives, financial instruments whose value is derived from an underlying asset. Futures contracts obligate both the buyer and the seller to complete the transaction, unlike other derivatives such as options contracts. They are primarily traded on regulated exchanges and are widely used for hedging price risk and for speculation in various markets.

History and Origin

The concept of agreeing to future transactions at a present price has ancient roots, with records of "to-arrive" contracts existing for centuries in agrarian societies to ensure the efficient transfer of goods. Some scholars point to the Dōjima Rice Exchange in Osaka, Japan, established in 1697, as an early example of a futures market, where samurai, who were paid in rice, needed a stable way to convert their income to currency.
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The modern history of futures contracts, however, largely begins in the United States. In 1848, the Chicago Board of Trade (CBOT) was founded as a central marketplace for grain merchants in Chicago. The city's emergence as a transportation hub for agricultural products spurred the need for more formalized agreements to manage price volatility and ensure reliable supply and demand. Initially, the CBOT facilitated forward contracts, which were private agreements. It wasn't until 1864 that the CBOT listed the first standardized "exchange-traded" forward contracts, which became known as futures contracts. ²⁰These standardized agreements, with their clearing mechanisms, reduced counterparty risk and paved the way for the robust futures markets seen today.

Key Takeaways

• Futures contracts are standardized, legally binding agreements to buy or sell an asset at a set price on a future date.
• They are a type of derivative used for both hedging against price fluctuations and speculating on market movements.
• Unlike options, futures contracts carry an obligation for both parties to fulfill the agreement.
• Trading typically occurs on centralized exchanges, and positions are often subject to daily margin requirements.
• The pricing of a futures contract incorporates the spot price of the underlying asset, interest rates, and any associated costs or benefits of holding the asset over time.

Formula and Calculation

The theoretical price of a futures contract is often determined by the "cost of carry" model, which accounts for the current spot price of the underlying asset, the time to maturity, the risk-free interest rate, and any costs (like storage or financing) or benefits (like dividends or convenience yield) associated with holding the asset.
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For a non-dividend-paying stock index or a commodity without storage costs (e.g., a financial asset that doesn't physically exist, or where storage is negligible), the formula can be simplified:

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

Where:

• (F) = Futures price
• (S) = 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 delivery of the contract (as a fraction of a year)

For physical commodities with storage costs ((s)) and a convenience yield ((c)) (the benefit of holding the physical asset), the formula becomes:

$F = S \times e^{(r + s - c) \times t}$

This formula helps participants understand how various factors influence the futures price relative to the current spot price.
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Interpreting Futures Contracts

Interpreting futures contracts involves understanding the relationship between the futures price and the current spot price of the underlying asset. When the futures price is higher than the spot price, the market is said to be in "contango." This typically occurs in commodity markets where there are costs associated with storing the physical asset, or in financial markets where interest rates outweigh any yield from the underlying asset. Conversely, when the futures price is lower than the spot price, the market is in "backwardation," which can indicate a high immediate demand for the underlying asset.

Investors and analysts use the futures price as a market's expectation of the future spot price, although it's not a perfect forecast. The difference between the futures price and the spot price is known as the basis risk. A positive basis occurs when the futures price is above the spot price, and a negative basis occurs when it is below. The interpretation of futures prices is crucial for risk management and for forming trading strategies.

Hypothetical Example

Consider an airline, "SkyHigh Airlines," that is concerned about rising jet fuel prices. It needs 100,000 gallons of jet fuel in three months. The current spot price for jet fuel is $2.50 per gallon.

To hedge against a price increase, SkyHigh Airlines decides to purchase a jet fuel futures contract. Assume a futures contract for jet fuel is standardized for 42,000 gallons (1,000 barrels) and expires in three months. The futures price is currently $2.60 per gallon.

SkyHigh Airlines purchases approximately 2.38 futures contracts (100,000 gallons / 42,000 gallons per contract). For simplicity, let's assume they buy 2 contracts and cover the remaining amount on the spot market.

• Scenario 1: Jet fuel prices rise. In three months, the spot price of jet fuel rises to $3.00 per gallon.

  • SkyHigh purchases the 2 futures contracts at the agreed-upon price of $2.60 per gallon, effectively locking in the price for 84,000 gallons. Their cost for this portion is (84,000 \text{ gallons} \times $2.60/\text{gallon} = $218,400).
  • They buy the remaining 16,000 gallons on the spot market at $3.00 per gallon, costing (16,000 \text{ gallons} \times $3.00/\text{gallon} = $48,000).
  • Total cost: ( $218,400 + $48,000 = $266,400 ).
  • Without the futures contract, their entire 100,000 gallons would have cost (100,000 \text{ gallons} \times $3.00/\text{gallon} = $300,000). The futures contracts saved them ( $300,000 - $266,400 = $33,600 ).

• Scenario 2: Jet fuel prices fall. In three months, the spot price of jet fuel falls to $2.20 per gallon.

  • SkyHigh still purchases the 2 futures contracts at $2.60 per gallon, costing $218,400.
  • They buy the remaining 16,000 gallons on the spot market at $2.20 per gallon, costing (16,000 \text{ gallons} \times $2.20/\text{gallon} = $35,200).
  • Total cost: ( $218,400 + $35,200 = $253,600 ).
  • Without the futures contract, their entire 100,000 gallons would have cost (100,000 \text{ gallons} \times $2.20/\text{gallon} = $220,000). In this case, the futures contract resulted in a higher cost of ( $253,600 - $220,000 = $33,600 ), but they successfully hedged against an adverse price movement.

This example illustrates how futures contracts provide price certainty, enabling businesses to manage input costs.

Practical Applications

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

• Hedging: Producers and consumers use futures to lock in prices for commodities like oil, natural gas, agricultural products, or metals. For instance, a farmer can sell futures contracts on their crop to guarantee a selling price, protecting against a fall in market prices.
  ¹⁶* Speculation: Traders who believe the price of an asset will move in a certain direction can buy (go long) or sell (go short) futures contracts to profit from anticipated price changes. Due to the inherent leverage in futures, even small price movements can result in significant gains or losses.
• Arbitrage: Differences in pricing between the spot market and the futures market, or between different futures contracts, can create opportunities for arbitrageurs to profit without significant risk.
• Portfolio Diversification: Beyond traditional stocks and bonds, futures on various asset classes (e.g., currency futures, interest rate futures, stock index futures) offer avenues for portfolio diversification and exposure to different market segments.
• Price Discovery: The active trading of futures contracts on exchanges provides a transparent mechanism for continuous price discovery, reflecting market participants' collective expectations about future supply and demand. The CME Group, for example, offers a wide range of futures products for risk management and market data.
  ¹⁴, ¹⁵* Regulatory Oversight: Regulatory bodies like the Commodity Futures Trading Commission (CFTC) oversee futures markets in the U.S., aiming to ensure market integrity, protect participants from fraud, and mitigate systemic risk.
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Limitations and Criticisms

Despite their utility, futures contracts come with certain limitations and risks:

• Obligation to Transact: Unlike options, futures contracts carry an absolute obligation. A buyer is obligated to purchase the underlying asset (or cash settle), and a seller is obligated to deliver it (or cash settle), regardless of whether the market price moves favorably or unfavorably. This means potential losses are theoretically unlimited if the market moves against a position.
  ⁹, ¹⁰* Margin Calls: Futures positions require an initial margin deposit, and positions are marked to market daily. If the value of a position moves adversely, traders may face margin calls, requiring them to deposit additional funds to cover potential losses. Failure to meet a margin call can lead to forced liquidation of the position.
  ⁸* Leverage Risk: The high degree of leverage inherent in futures trading amplifies both gains and losses. A small movement in the underlying asset's price can lead to a substantial percentage gain or loss on the initial margin investment. This makes futures trading inherently risky, especially for less experienced investors.
• Basis Risk: While futures contracts help manage price risk, they introduce basis risk, which is the risk that the relationship between the spot price and the futures price changes unexpectedly. This can erode the effectiveness of a hedge if the basis widens or narrows unfavorably.
• Liquidity and Open Interest: While major futures contracts are highly liquid, some smaller or newer contracts may not attract sufficient trading volume or open interest, making them difficult to enter or exit at desired prices. The success of a futures contract often depends on a commercial need for hedging and attracting a sufficient pool of speculators.
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Futures Contracts vs. Options Contracts

Futures contracts and options contracts are both derivatives that allow participants to trade on the future price of an underlying asset. However, a fundamental difference lies in the obligation they impose.

A futures contract creates a legally binding obligation for both the buyer and the seller to execute the transaction at the predetermined price on the specified future date. The buyer is obligated to buy, and the seller is obligated to sell.
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In contrast, an options contract grants the buyer the right, but not the obligation, to buy (a call option) or sell (a put option) an underlying asset at a specified price (the strike price) on or before a certain date. The seller of an option, however, does have an obligation if the buyer chooses to exercise the option. For this right, the option buyer pays a non-refundable premium to the seller. This distinction means that an option buyer's maximum loss is typically limited to the premium paid, whereas a futures trader's potential losses can be significantly larger due to the mandatory nature of the contract and the use of leverage.
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FAQs

Q: What is the primary purpose of a futures contract?
A: The primary purpose of a futures contract is to allow market participants to lock in a price today for a transaction that will occur in the future. This is commonly used for hedging against adverse price movements or for speculation on future price direction.

Q: Are futures contracts risky?
A: Yes, futures contracts are considered high-risk financial instruments. They involve significant leverage, meaning a small price movement can lead to substantial gains or losses relative to the initial capital invested. The obligation to buy or sell the underlying asset, along with potential margin calls, contributes to their risk profile.

Q: How do futures contracts settle?
A: Futures contracts can settle in two main ways: by physical delivery of the underlying asset (common for commodities like oil or grain) or by cash settlement. In cash settlement, the difference between the contract price and the market price at expiration is paid in cash, with no physical exchange of the asset.

Q: What kinds of assets can be traded with futures contracts?
A: Futures contracts are traded on a wide array of underlying assets, including commodities (like crude oil, gold, corn), financial instruments (such as interest rates, foreign currencies, and stock market indices), and even novel assets like cryptocurrencies.