Futures contracts`

What Are Futures Contracts?

A futures contract is a standardized legal agreement to buy or sell a specific commodity, currency, or financial instrument at a predetermined price at a specified time in the future. These financial instruments belong to the broader category of derivatives, meaning their value is derived from an underlying asset. Futures contracts are traded on organized exchanges, providing liquidity and transparency, and are commonly used for hedging against price fluctuations or for speculation on future price movements. Parties entering a futures contract are obligated to fulfill the terms of the agreement on the expiration date, either by physical delivery of the underlying asset or, more commonly, by a cash settlement.

History and Origin

The concept of agreeing to a price for a future delivery dates back to ancient times, particularly in agricultural markets to manage crop price risks. However, the formalization of these agreements into standardized, exchange-traded contracts began in the mid-19th century in the United States. Farmers and merchants in Chicago sought a more efficient way to manage the volatile prices of agricultural commodities like wheat and corn. The Chicago Board of Trade (CBOT), established in 1848, initially served as a cash market for grain before introducing standardized "to-arrive" or forward contracts. By 1865, the CBOT formally introduced the first standardized futures contracts, which included rules for margin account requirements and delivery procedures, marking a significant step in the evolution of modern futures trading.¹¹ The development of these contracts provided a central marketplace for price discovery and risk management, evolving into the sophisticated exchange systems seen today, exemplified by institutions like CME Group.¹⁰

Key Takeaways

• Futures contracts are binding agreements to buy or sell an asset at a predetermined price on a future date.
• They are standardized and traded on regulated exchanges, ensuring transparency and market integrity.
• Market participants primarily use futures contracts for hedging against adverse price movements or for speculative trading.
• Unlike options, futures contracts carry an obligation to transact at the expiration date, unless the position is closed out beforehand.
• A clearing house guarantees the performance of futures contracts, significantly reducing counterparty risk.

Formula and Calculation

The profit or loss from a futures contract is determined by the difference between the contract price and the market price of the underlying asset at the time the position is closed or at expiration.

For a long position (buying a futures contract):

For a short position (selling a futures contract):

Where:

• (\text{Spot Price at Exit}) is the price of the underlying asset in the cash market when the futures position is closed out or at expiration.
• (\text{Futures Contract Price}) is the agreed-upon price in the futures contract.
• (\text{Contract Size}) is the standardized amount of the underlying asset per contract (e.g., barrels of oil, bushels of wheat).

These calculations are subject to daily mark-to-market adjustments, where profits and losses are settled daily based on closing prices.

Interpreting Futures Contracts

Futures contracts are interpreted primarily through their price, which reflects the market's expectation of the spot price of the underlying asset at the future delivery date. If the futures price is higher than the current spot price, it indicates a market expectation of rising prices (contango), potentially due to carrying costs like storage or interest rates. Conversely, if the futures price is lower than the current spot price (backwardation), it might signal an expected decrease in future supply or strong current demand. Traders and analysts constantly evaluate these price relationships to inform their strategies, whether taking a short position or long position, and manage their exposure to market volatility. The interpretation also heavily depends on the currencies involved if the contract is currency-denominated or involves cross-currency exposure.

Hypothetical Example

Consider an airline company, AeroFly, that anticipates needing 1 million gallons of jet fuel in three months. The current spot price for jet fuel is $3.00 per gallon. Fearing a rise in prices, AeroFly decides to hedge its exposure using jet fuel futures contracts. Each contract represents 42,000 gallons.

1. AeroFly's Action: AeroFly sells 24 futures contracts (1,000,000 gallons / 42,000 gallons/contract ≈ 23.8, rounded to 24 contracts) at a futures price of $3.05 per gallon. This creates a long hedge.
2. Three Months Later (Expiration):
   • Scenario A: Jet Fuel Price Rises. The spot price for jet fuel rises to $3.20 per gallon.
     • AeroFly buys 1 million gallons of fuel at $3.20 per gallon, costing an extra $0.15 per gallon.
     • However, on its futures contracts, AeroFly realizes a profit: ($3.20 - $3.05) * 42,000 gallons/contract * 24 contracts = $151,200. This profit largely offsets the increased cost of buying the physical fuel, effectively locking in a price close to the original futures price.
   • Scenario B: Jet Fuel Price Falls. The spot price for jet fuel falls to $2.90 per gallon.
     • AeroFly buys 1 million gallons of fuel at $2.90 per gallon, saving $0.10 per gallon.
     • However, on its futures contracts, AeroFly incurs a loss: ($3.05 - $2.90) * 42,000 gallons/contract * 24 contracts = -$151,200. The loss on the futures largely offsets the savings on the physical fuel, again demonstrating how the futures contract stabilized the effective purchase price.

This example illustrates how futures contracts can be used to manage price risk, providing predictable costs for businesses.

Practical Applications

Futures contracts have widespread applications across various financial sectors and industries. Their primary uses include:

• Risk Management (Hedging): Businesses use futures to lock in prices for future purchases or sales of raw materials, energy, or financial assets, thus mitigating price volatility. For example, an agricultural producer might sell wheat futures to guarantee a price for their upcoming harvest, while a food manufacturer might buy wheat futures to secure their input costs. Airlines, for instance, frequently utilize futures to manage the cost of jet fuel. S⁹uch strategies allow companies to protect against unfavorable price movements in commodity markets.
  *⁸ Price Discovery: The active trading of futures contracts on exchanges helps establish current and future expected prices for a wide range of assets, providing valuable information for economic planning and investment decisions.
• Speculation: Traders and institutional investors buy or sell futures contracts with the expectation of profiting from anticipated price movements. They aim to capitalize on differences between the futures price and the eventual spot price.
• Arbitrage: Discrepancies between the prices of the same underlying asset in different markets (e.g., spot market vs. futures market) can create arbitrage opportunities, where traders profit by simultaneously buying and selling to exploit these inefficiencies.
• Portfolio Diversification: Financial futures on stock indexes, bonds, or currencies allow investors to gain exposure to different asset classes or markets without directly buying the underlying securities, contributing to broader portfolio strategies.

The Commodity Futures Trading Commission (CFTC) plays a crucial role in regulating U.S. futures and derivatives markets to ensure their integrity and protect market participants.

⁶, ⁷## Limitations and Criticisms

While futures contracts offer significant benefits for risk management and price discovery, they also come with limitations and criticisms:

• Leverage and Risk: Futures contracts are highly leveraged instruments, meaning a small initial margin deposit controls a large notional value of the underlying asset. This leverage can magnify both profits and losses. A slight adverse price movement can lead to substantial losses, potentially exceeding the initial investment.
• Complexity and Misuse: The complexity of derivatives, including futures, means they can be misunderstood or misused, leading to significant financial losses for unprepared participants. Instances of mismanagement or speculative over-extension have historically resulted in notable financial distress for firms.
  *⁴, ⁵ Basis Risk: Hedging with futures is not always perfect due to "basis risk," which is the risk that the price of the futures contract and the price of the underlying physical asset do not move in perfect correlation. This can occur due to differences in quality, location, or timing.
• Liquidity Risk: While major futures markets are highly liquid, some thinly traded contracts may experience reduced liquidity, making it difficult to enter or exit positions without impacting prices.
• Regulatory Scrutiny: Due to their inherent risks and the potential for systemic impact, futures markets are subject to strict regulation, primarily by bodies like the CFTC. T³hese regulations, while necessary, can add layers of complexity and cost for market participants. Academic research sometimes highlights how past losses in derivatives can even influence future hedging behavior by companies, suggesting a behavioral aspect to their use.

¹, ²## Futures Contracts vs. Forward Contracts

Futures contracts and forward contracts are both agreements to buy or sell an asset at a predetermined price on a future date, but they differ significantly in their structure and trading environment:

Confusion often arises because both serve similar functions of price locking and risk management. However, the standardization, exchange trading, and clearing house guarantee of futures contracts make them more transparent and liquid, while forward contracts offer flexibility for specific, unique needs between parties.

FAQs

What is the primary purpose of a futures contract?

The primary purpose of a futures contract is to allow parties to manage price risk (hedging) or to speculate on future price movements of an underlying asset. It provides a way to lock in a price for a future transaction.

Are futures contracts risky?

Yes, futures contracts can be very risky due to the high leverage involved. While they offer the potential for significant gains, they also expose traders to substantial losses that can exceed their initial investment if market prices move unfavorably. Proper risk management and understanding of margin account requirements are essential.

How are futures contracts settled?

Futures contracts can be settled in two main ways: physical delivery or cash settlement. Physical delivery involves the actual exchange of the underlying asset, which is common for commodities. Cash settlement, more prevalent for financial futures like stock indexes or interest rates, involves a cash payment based on the difference between the contract price and the final settlement price. Most positions are closed out before expiration.

Who regulates futures markets?

In the United States, futures markets are primarily regulated by the Commodity Futures Trading Commission (CFTC). The CFTC oversees the trading of futures and options to prevent manipulation, abusive practices, and fraud, ensuring fair and transparent markets.

Can individuals trade futures contracts?

Yes, individuals can trade futures contracts through brokerage firms that offer access to futures exchanges. However, due to the inherent risks and complexities, it is generally recommended for experienced investors who understand the mechanics of futures trading, including daily mark-to-market requirements and the potential for substantial losses.