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Futures contract

 

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A futures contract is a form of forward contract that has been standardised for a wide range of uses. It is traded on a futures exchange. Futures may also differ from forwards in terms of margin and delivery requirements.

The standardisation usually involves specifying:

  • The amount and units of the underlying asset to be traded. This can be a fixed number of: barrels of oil; lengths of random lumber; units of weight (bushels of wheat, ounces of bullion &c); units of foreign currency; interest rate points; Equity index points; Notional bonds
  • the unit of currency in which the asset is quoted. Because U.S. futures exchanges have dominated the market, this is very often the US dollar (USD), even when the corresponding OTC market quotes differently (for example the Interbank market quotes in Yen per USD, whereas currency futures are quoted in USD per Yen).
  • The grade of the deliverable. 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 minium permissible price fluctuation.

Because they vary in price as a direct function of these variables only, a futures contract is an example of a parametric contract, and is easily combined or traded as part of more complex financial derivatives deals.

Table of contents

Margin
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. To minimise this risk, the exchange demands that contract owners post a form of collateral, known as margin. The amount of margin changes each day, involving movements of cash handled by the exchange's clearing house.

Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or offsetting contracts for its purchase or sale.

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 margin, is called 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 marign. The probability of losing their entire capital at some point would be high. By contrast, if margin-equity so low as to make the trader's capital equal to the value of the futures contract itself, not profit from the inherent leverage implicit in futures trading. A conservative trader might margin-equity at 15%, a more aggressive trader at 40%.

Delivery
Delivery is the act of actually delivering (for sales) or accepting delivery (for purchases) of the underlying contract after trading has ceased. There are two main methods of delivery:

  • Cash delivery, settling against an agreed reference rate such as the closing value of a stock index, or of an interest index such as LIBOR.
  • Physical delivery . where the amount specified of the underlying asset of the contract is delivered by a seller of the contract to the exchange, and by the exchange to buyers of the contract. Physical delivery is more common with commodities, though is also used for financial instruments such as bonds.

Delivery normally occurs only on a minority of contracts. Others 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 cover an earlier purchase (covering a long).

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; any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away. 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)*(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.

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

  • Foreign exchange market
  • Money market
  • Bond market
  • Equity index market
  • Base metals market
  • Precious metals market
  • Energy market
  • Soft Commodities market

Originally, futures were traded only on commodities, in a market dominated by Chicago. However, after their introduction in the 1970's, 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 LIFFE, EUREX and TIFFE.

  • London International Financial Futures Exchange (LIFFE)
  • London Commodity Exchange - 'softs', grains and meats. Inactive market in Baltic Exchange shipping.
  • London Metal Exchange - metals, mainly copper, aluminium, lead, zinc, nickel and tin.
  • International Petroleum Exchange - energy including crude oil, heating oil, natural gas and unleaded gas.
  • Chicago Board of Trade (CBOT) -- financials (bonds), traditional commodities: maize, oats, rough rice, soybeans, soybean meal, soybean oil, wheat,
  • Chicago Mercantile Exchange -- financial futures, traditional commodities: lumber, live cattle, feeder cattle, boneless beef, boneless beef trimmings, lean hogs, frozen pork bellies, fresh pork bellies, Basic Formula Price milk, butter,
  • New York Board of Trade - Softs : cocoa, coffee, cotton, orange juice, sugar
  • New York Mercantile Exchange - Energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium

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 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 between traders with different risk preferences, from a hedger to a speculator for example.

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 used for the pricing of these option contracts.
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