What Are Futures?
A futures contract is a standardized legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price on a specified future date. As a type of derivative, the value of a futures contract is derived from an underlying asset, rather than having intrinsic value itself. These contracts are traded on organized exchanges and are characterized by their standardization in terms of quantity, quality, and expiration date, making them highly liquid. Futures play a crucial role in modern finance, enabling participants to manage price risk or engage in speculation regarding future price movements.
History and Origin
The concept of agreeing on a price for future delivery dates back to ancient times, with records suggesting similar arrangements in Mesopotamian civilizations around 1750 BC. However, the first organized futures exchange emerged in Osaka, Japan, with the Dojima Rice Exchange in the late 17th century. This market allowed farmers and merchants to lock in future rice prices, providing a degree of certainty against unpredictable harvests.4
In the United States, formalized futures trading began in the mid-19th century. The Chicago Board of Trade (CBOT), founded in 1848, initially facilitated trading in forward contracts for agricultural products like corn and wheat. As transportation and communication networks improved, these forward contracts evolved into the standardized futures contracts recognized today.3 The development of modern futures markets expanded beyond agricultural goods to include financial products in the 1970s, significantly broadening their scope and influence within the global economy.
Key Takeaways
- Futures contracts are standardized agreements to buy or sell an asset at a future date for a predetermined price.
- They serve as critical tools for both hedging against price risk and engaging in speculative trading.
- Futures trading typically involves significant leverage, meaning a small initial capital outlay controls a large contract value.
- All futures transactions are guaranteed by a clearing house, which mitigates counterparty risk.
- Futures prices are influenced by the spot price of the underlying asset and the "cost of carry."
Formula and Calculation
The theoretical price of a futures contract, particularly for storable assets, is often determined by the "cost of carry" model. This model suggests that the futures price should reflect the spot price plus the costs associated with holding the asset until the expiration date, minus any benefits received from holding the asset.
For a non-dividend-paying asset, the theoretical futures price ( F ) can be expressed as:
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 (cost of financing)
- ( y ) = Convenience yield (benefit of holding the physical asset, often zero for financial assets)
- ( T ) = Time until expiration of the futures contract (in years)
For financial futures (like stock index futures) where physical storage costs are negligible and a convenience yield is generally not applicable, and considering dividends (D) as a negative carry:
Where:
- PV(D) = Present Value of any dividends or income expected from the underlying asset until expiration.
Interpreting Futures Contracts
Interpreting a futures contract involves understanding its underlying asset, contract specifications, and the market's collective expectation for the asset's future price. A futures price higher than the current spot price indicates a market in "contango," suggesting that carrying costs (like interest and storage) are priced in, or that future supply is expected to be tighter. Conversely, a futures price lower than the spot price indicates "backwardation," often seen in commodity markets when there's an immediate high demand or a perceived shortage, or when there's a significant convenience yield for holding the physical asset.
Traders and businesses use futures prices as a bellwether for future supply and demand dynamics, guiding production decisions, purchasing strategies, and overall risk management.
Hypothetical Example
Consider a hypothetical scenario for a farmer expecting to harvest 5,000 bushels of corn in three months. The current spot price for corn is $4.00 per bushel. The farmer is concerned that the price of corn might fall by harvest time. To mitigate this price risk, the farmer decides to sell a futures contract for 5,000 bushels of corn with a three-month expiration date at a futures price of $4.10 per bushel.
In this instance, the farmer is taking a short position in the futures market. Regardless of the spot price of corn in three months, the farmer has locked in a selling price of $4.10 per bushel for their crop through the futures contract. If the spot price of corn falls to $3.80 per bushel at harvest, the farmer can sell their physical corn at $3.80 per bushel in the local market and simultaneously close out their futures position by buying an offsetting contract. The profit from the futures contract (selling at $4.10, buying back at $3.80) offsets the lower physical selling price, effectively ensuring they receive approximately $4.10 per bushel for their harvest. This is a classic example of using futures for hedging.
Practical Applications
Futures contracts are widely applied across various sectors of the financial market and real economy:
- Risk Management: Companies and producers use futures to hedge against adverse price movements in raw materials (e.g., oil, agricultural goods) or currencies, allowing them to stabilize costs and revenues. An airline, for example, might buy crude oil futures to lock in fuel prices.
- Price Discovery: Futures markets reflect a collective consensus on future prices based on available information, providing valuable benchmarks for producers, consumers, and policymakers.
- Speculation: Traders and investors use futures to profit from anticipated price changes without needing to own the underlying asset directly, leveraging small initial margin accounts.
- Arbitrage: Differences between futures prices and underlying spot prices, or between different futures contracts, can create opportunities for arbitrageurs to profit from temporary mispricings.
- Portfolio Diversification: Adding futures contracts for different asset classes can contribute to portfolio diversification and enhanced risk-adjusted returns.
- Regulation: Regulatory bodies like the U.S. Commodity Futures Trading Commission (CFTC) oversee futures markets to ensure fair and orderly trading, protect market participants, and prevent manipulation.2 The CFTC’s mission is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets.
1## Limitations and Criticisms
While futures contracts offer significant benefits, they also come with notable limitations and criticisms. One primary concern is the inherent leverage involved. While leverage can amplify gains, it can equally magnify losses, potentially exceeding the initial margin deposited. This can lead to rapid and substantial financial losses for traders if the market moves unfavorably.
Another criticism revolves around market volatility. Futures markets can be highly susceptible to rapid price swings due to factors like economic data releases, geopolitical events, and shifts in supply and demand. This liquidity and volatility can make futures trading challenging, especially for inexperienced participants. Furthermore, concerns have been raised historically about the potential for excessive speculation to distort prices in certain commodity markets, particularly agricultural ones, impacting real-world costs. However, regulators continuously monitor and implement measures, such as position limits, to mitigate such risks.
Futures vs. Options
Both futures and Options are types of derivative contracts, yet they differ significantly in their obligations and risk profiles. A futures contract obligates both the buyer and the seller to complete the transaction at the agreed-upon price on the expiration date, regardless of the market price at that time. This means that both parties have unlimited profit and loss potential.
In contrast, an option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (the strike price) on or before a certain date. The seller of the option, however, has an obligation to fulfill the contract if the buyer chooses to exercise it. This fundamental difference means that the maximum loss for an option buyer is limited to the premium paid for the option, while the potential for profit is theoretically unlimited for a call option buyer and limited for a put option buyer. For the option seller, the potential losses can be unlimited (for a naked call) or substantial (for a naked put), while their profit is limited to the premium received. Futures involve a higher degree of mandatory commitment and therefore typically carry more symmetrical risk and reward profiles than options.
FAQs
What is the minimum investment required for futures trading?
The minimum investment for futures trading is typically the initial margin account requirement set by the exchange and your broker. This is a percentage of the total contract value, usually much smaller than the full value of the underlying asset, making futures highly leveraged instruments.
Can you lose more than your initial investment in futures?
Yes, due to leverage, it is possible to lose more than your initial margin deposit in futures trading. If the market moves significantly against your position, your broker may issue a margin call, requiring additional funds, or automatically liquidate your position, potentially resulting in losses exceeding your initial capital.
Are futures contracts suitable for beginners?
Futures contracts are generally considered complex and high-risk financial instruments, often better suited for experienced traders or institutions. The high leverage and potential for rapid losses require a deep understanding of market dynamics, risk management strategies, and diligent monitoring.