Futures contract

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In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a set price specified on the last trading date. The future date is called the delivery date or final settlement date. The set price is called the delivery price or settlement price.

A futures contract gives the holder the right and the obligation to buy or sell. Contrast this with an options contract, which gives the buyer the right, but not the obligation, and the writer (seller) the obligation, but not the right. In other words, an option buyer can choose not to exercise when it would be uneconomical for him. The holder of a futures contract and the writer of an option, do not have a choice. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing the position.

Futures contracts, or simply futures, are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

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Futures vs. Forwards

A futures contract is very similar to a forward contract, which is also a contract to trade on a future date. The main differences are, that:

  • futures are always traded on an exchange, whereas forwards always trade over-the-counter.
  • futures are highly standardized, whereas each forward is unique.
  • the price at which the contract is finally settled is different:
    • futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end)
    • forwards are settled at the forward price agreed on the trade date (i.e. at the start)
  • the credit risk of futures is much lower than that of forwards:
    • the profit or loss on a futures position is exchanged in cash every day. After this the credit exposure is again zero.
    • the profit or loss on a forward contract is only realised at the time of settlement, so the credit exposure can keep increasing.
  • in case of physical delivery, the forward contract specifies whom to make the delivery to. The counterparty on a futures contract is chosen randomly by the exchange.
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Standardisation

Futures contracts are highly standardized, to ensure that they are liquid. The standardisation usually involves specifying:

  • The underlying. This can be anything from a barrel of Sweet Crude Oil to a short term interest rate.
  • The type of settlement, either cash settlement or physical settlement.
  • The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
  • The currency in which the futures contract is quoted.
  • The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. In the case of physical commodities, this specifies not only the quality of the underlying goods but also the manner and location of delivery. For example, the NYMEX Light Sweet Crude Oil contract specifies the acceptable sulfur content and API specific gravity, as well as the location where delivery must be made.
  • The delivery month.
  • The last trading date.
  • Other details such as tick size, the minimum permissible price fluctuation.
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Margin

Main article: Margin (finance)

Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value, and creates a credit risk to the exchange, who always acts as counterparty. To minimise this risk, the exchange demands that contract owners post a form of collateral, in the US formally called performance bond, but commonly known as margin

Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.

Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading.

Because a series of adverse price changes may exhaust the initial margin, a further margin, usually called variation or maintenance margin, is required by the exchange. This is calculated by the futures contract, i.e. agreeing a price at the end of each day, called the "settlement" or mark-to-market price of the contract.

Margin-equity ratio is a term used by speculators, repesenting the amount of their trading capital that is being held as margin at any particular time. Traders would rarely (and unadvisedly) hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader's capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative trader might hold a margin-equity ratio of 15%, while a more aggressive trader might hold 40%.

Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.

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Settlement

Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:

  • Physical delivery - the amount specified of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds. In practice, it occurs only on a minority of contracts. Most are cancelled out by purchasing a covering position - that is, buying a contract to cancel out an earlier sale (covering a short), or selling a contract to liquidate an earlier purchase (covering a long).
  • Cash settlement - a cash payment is made based on the underlying reference rate, such as a short term interest rate index such as Euribor, or the closing value of a stock market index.
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Pricing

The price of a future is determined via arbitrage arguments. The forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see rational pricing of futures.

Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by discounting the present value S(t) at time t to maturity T by the rate of risk-free return r.

F(t) = S(t)\times (1+r)^{(T-t)}

or, with continuous compounding

F(t) = S(t)e^{r(T-t)} \,

This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.

In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.

See:

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Futures contracts and exchanges

There are many different kinds of futures contract, reflecting the many different kinds of tradeable assets of which they are derivatives. For information on futures markets in specific underlying commodity markets, follow the links.

Originally, futures were traded only on commodities, in a market dominated by the Chicago Mercantile Exchange (CME). However, after their introduction in the 1970s, contracts on financial instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This led to the introduction of many new futures exchanges across the world, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo International Financial Futures Exchange (now Tokyo Finance Exchange).

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Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use.

Hedgers typically include producers and consumers of a commodity.

For example, in traditional commodities markets farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example.

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Options on futures

In many cases, options are traded on futures. A put is the option to sell a futures contract, and a call is the option to buy a futures contract. For both, the option strike price is the specified futures price at which the future is traded if the option is exercised. See the Black model, which is the most popular method for pricing these option contracts.

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Future Contract Regulations

All futures transactions in the United States are regulated by the Commodity Futures Trading Commission (CFTC), an independent agency of the United States Government. The Commission has the right to hand out fines and other punishments for an individual or company who breaks any rule. Although by law the commission regulates all transactions, each exchange can have their own rule, and under contract can fine companies for different things or extend the fine that the CFTC hands out.

The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment, which has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as 'Commitments-Of-Traders'-Report, COT-Report or simply COTR.

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See also

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References

  • An Introduction To Global Financial Markets, Steven Valdez, Macmillan Press Ltd. (ISBN 0333764471)
  • Derivatives: A Comprehensive Resource for Options, Futures, Interest Rate Swaps, and Mortgage Securities, Fred D. Arditti, Havard Business School Press (ISBN 0875845606)
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External links

Retrieved from "http://en.wikipedia.org/wiki/Futures_contract"
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