Business, Legal & Accounting Glossary
The futures contract is a type of forward agreement, an agreement to buy or sell an asset at a pre-arranged future time and price. The futures contract is standardized for trade on an exchange, such as the Chicago Mercantile Exchange. Standardization of the futures contract specifies a quantity of the asset, the delivery month, the last day of trading, and other essential terms. Delivery on a futures contract is rare. Most futures contract positions are closed out before the last day of trading. The futures contract is used with several types of commodities, including raw materials and agricultural products, as well as financial assets such as interest rates and foreign exchange. The first futures contract traded on the Chicago Board of Trade in 1865.
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 specified price. The future date is called the delivery date or final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price.
A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract. Both parties of a “futures contract” must fulfil the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then the cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.
Futures contracts, or simply futures, are exchange-traded derivatives. The exchange’s clearinghouse acts as counterparty on all contracts, sets margin requirements, etc.
While futures and forward contracts are both a contract to deliver a commodity on a future date at a prearranged price, they are different in several respects:
In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearinghouse.
In some extreme cases, some exchanges tolerate ‘non-convergence’, the inability of futures contracts and the value of the physical commodities they represent to be the same value on ‘contract settlement’ day at the designated delivery points. An example of this is the CBOT (Chicago Board of Trade)Soft Red Winter wheat (SRW) futures. SRW futures have settled more than 20¢ apart on settlement day and as much as $1.00 difference between settlement days. Only a few select participants holding CBOT SRW futures contracts are qualified by the CBOT to make delivery or receive delivery of commodities to settle futures contracts. Therefore it is impossible for almost any individual producer to ‘hedge’ efficiently when they rely on the final settlement of a futures contract for SRW. The trend is the CBOT continuing to restrict those entities who can actually participate in settling contracts with commodity to only those that can ship or receive large quantities of railroad cars and multiple barges at a few select sites. The CFTC (Commodity Futures Trading Commission – a regulatory agency headed by a political appointee), which has oversight of the futures market, has made no comment as to why this trend is allowed to continue since economic theory and CBOT publications maintain that convergence of contracts with the price of the underlying commodity they represent is the basis of integrity for a futures market. It follows that the function of ‘price discovery’, the ability of the markets to discern the appropriate value of a commodity reflecting current conditions, is degraded in relation to the discrepancy in price and the inability of producers to enforce contracts with the commodities they represent.
Futures contracts ensure their liquidity by being highly standardized, usually by specifying:
To minimize credit risk to the exchange, traders must post margin or a performance bond, typically 5%-15% of the contract’s value.
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.
A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn’t want to be subject to margin calls.
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 the 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.
Settlement is the act of consummating the contract, and can be done in one of two ways, as specified per type of futures contract:
There are many different kinds of futures contracts, reflecting the many different kinds of tradable assets of which they are derivatives. For information on futures markets in specific underlying commodity markets, follow the links.
Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today’s exchange-traded futures contracts. Although contract trading began with traditional commodities such grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.
Contracts on financial instruments was introduced in the 1970s by the Chicago Mercantile Exchange(CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 75 futures and futures options exchanges worldwide trading to include:
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.
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.
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 its 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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This glossary post was last updated: 23rd April, 2020 | 0 Views.