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A futures contract is a form
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
- The last trading date.
- Other details such as tick size, the minium permissible price
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
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 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
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
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.
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.
Metal Exchange - metals, mainly copper,
- International Petroleum Exchange - energy including crude
oil, heating oil, natural
gas and unleaded gas.
- Chicago Board of Trade (CBOT) -- financials (bonds), traditional
soybean meal, soybean oil, wheat,
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,
- New York Board of Trade - Softs : cocoa,
- New York Mercantile Exchange - Energy and metals: crude
heating oil, natural
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
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.
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.