Futures contract

From Academic Kids

A futures contract is a form of forward contract, a contract to buy or sell an asset of any kind at a pre-agreed future point in time, 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, troy ounces of bullion); units of foreign currency; interest rate points; Equity index points; National 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 minimum 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.

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 spreaders 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 exchanges perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized (ROM) is equal to (return on margin) / (calendar days of trade) x (number of days in year). For example if a trader earns 10% on margin in two months, that would be about 60% annualized.

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 / SIBOR.
  • 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—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.

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

or, with continuous compounding

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

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:

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 LIFFE, EUREX and TIFFE.

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, and increase liquidity between traders with different risk and time 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 the most popular method for pricing these option contracts.

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.

Glossary

See also

External links

Exchanges

es:futuro fr:Futures zh:期货

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