Overview

In finance, a futures contract (often just called a future) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.

Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.

Futures contracts are traded at futures exchanges, which act as a marketplace between buyers and sellers. The party who agrees to buy the underlying asset at the agreed futures price on the delivery date is said to be the long position holder, while the party who agrees to sell (deliver) the underlying asset at the agreed futures price on the delivery date is said to be the short position holder.

As both parties risk their counter-party reneging if the price goes against them, the contract may involve both parties lodging a margin of the value of the contract with a mutually trusted third party for security. For example, in gold futures trading, the margin varies between 2% and 20% depending on the volatility of the spot market.

A stock future is a cash-settled futures contract on the value of a particular stock market index. Stock futures are one of the high risk trading instruments in the market. Stock market index futures are also used as indicators to determine market sentiment.

Origin

The first historically known creation and use of futures may have been Thales of Miletus with his purchase of olive presses before an expected bumper crop of olives.

The Dōjima Rice Exchange, first established in 1697 in Osaka, is considered by some to be the first futures exchange market, to meet the needs of samurai who—being paid in rice—needed a stable conversion to coin after a series of bad harvests.

The Chicago Board of Trade (CBOT) listed the first-ever standardized 'exchange traded' forward contracts in 1864, which were called futures contracts. This contract was based on grain trading, and started a trend that saw contracts created on a number of different standardized futures contracts based on commodities, as well as a number of futures exchanges set up in countries around the world. By 1875 cotton futures were being traded in Bombay in India and within a few years this had expanded to futures on edible oilseeds complex, raw jute and jute goods and bullion.

In the 1930s two thirds of all futures was in wheat.

Risk mitigation

Although futures contracts are oriented towards a future time point, their main purpose is to mitigate the risk of default by either party in the intervening period. In this vein, the futures exchange requires both parties to put up initial cash, or a performance bond, known as the margin. Margins, sometimes set as a percentage of the value of the futures contract, must be maintained throughout the life of the contract to guarantee the agreement, as over this time the price of the contract can vary as a function of supply and demand, causing one side of the exchange to lose money at the expense of the other.

To mitigate the risk of default, the product is marked to market on a daily basis where the difference between the initial agreed-upon price and the actual daily futures price is re-evaluated daily. This is sometimes known as the variation margin, where the futures exchange will draw money out of the losing party's margin account and put it into that of the other party, ensuring the correct loss or profit is reflected daily. If the margin account goes below a certain value set by the exchange, then a margin call is made and the account owner must replenish the margin account.

On the delivery date, the amount exchanged is not the specified price on the contract but the spot value, since any gain or loss has already been previously settled by marking to market.

Margin

To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty.

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.

Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.

Expiry

Expiry (or "expiration" in the U.S.) is the time and the day that a particular delivery month of a futures contract stops trading, as well as the final settlement price for that contract. For many equity index futures and interest rate futures as well as for most equity (index) options, this happens on the third Friday of certain trading months. On this day the back month futures contract becomes the front-month futures contract, and the front-month futures contract becomes the back month futures contract.

For example, for most CME and CBOT contracts, at the expiration of the December contract, the March futures become the nearest contract. During a short period (perhaps 30 minutes) the underlying cash price and the futures prices sometimes struggle to converge. At this moment the futures and the underlying assets are extremely liquid and any disparity between an index and an underlying asset is quickly traded by arbitrageurs.

At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions.

On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets every approximate half hour. Exchanges implement strict limits on how much exposure an entity may have closer to expiration as an effort to avoid any volatility around final settlement.