Business, Legal & Accounting Glossary
Futures are a type of financial instrument where the buyer purchased the underlying commodity for a specified price at some time in the future. The specific item traded is a futures contract.
A “future” or “futures contract” (typically used interchangeably) is an agreement between two parties where one side buys a specific amount of a commodity (metals, grains, oil, etc.) at a particular price, to be delivered and paid for on a particular day in the future. For that guaranteed price, regardless of what the actual price is when the contract comes due, the buyer pays a premium.
These are a form of derivative security in that their price (the premium) is determined by the price of the underlying commodity.
The contracts are standardized and trade on an exchange, just like options do, but unlike some other derivatives such as credit default swaps.
These contracts allow people like farmers who are planting, say, corn in the spring to know exactly what price they’ll be able to sell it for after harvesting. This takes a lot of risk out of the equation for the farmer (or miner in the case of metals) and thus is valuable for hedging.
Futures are similar to options, except where the option gives the buyer a right, but no obligation, to purchase the underlying item, the buyer of a futures contract must buy the underlying if he or she holds it to maturity. Of course, the futures buyer can always close the (long) position by selling (going short) an identical contract. If that short contract has a higher premium than the long one did, then the futures trader made money.
It is this possibility of making money by going long (buying) or short (selling) future contracts as the underlying price of the commodity rises or falls that has led in recent times to the large increase in futures trading. Most contracts do not last to maturity as they are closed by taking the opposite position before then, so no actual commodity trades hands.
A future is an exchange-traded derivative which is similar to a forward. Both futures and forwards represent agreements to buy/sell some underlying asset in the future for a specified price. Both can be for physical settlement or cash settlement. Both offer a convenient tool for hedging or speculation. For little or no initial cash outlay, both instruments provide price exposure without a need to immediately pay for, hold or warehouse the underlying asset. In this sense, both instruments are leveraged. Futures and forwards trade on a variety of underliers: wheat, oil, live beef, Eurodollar deposits, gold, foreign exchange, the S&P 500 stock index, etc.
The fundamental difference between futures and forwards is the fact that futures are traded on exchanges. Forwards trade over the counter. This has three practical implications.
Futures are standardized instruments. You can only trade the specific contracts supported by the exchange. Forwards are entirely flexible. Because they are privately negotiated between parties, they can be for any conceivable underlier and for any settlement date. Parties to the contract decide on the notional amount and whether physical or cash settlement will be used. If the underlier is for a physically settled commodity or energy, parties agree on issues such as delivery point and quality.
Forwards entail both market risk and credit risk. A counterparty may fail to perform on a forward. With futures, there is only market risk. This is because exchanges employ a system whereby counterparties exchange daily payments of profits or losses on the days they occur. Through these margin payments, a futures contract’s market value is effectively reset to zero at the end of each trading day. This all but eliminates credit risk.
The daily cash flows associated with margining can skew futures prices, causing them to diverge from corresponding forward prices.
A future is transacted through a brokerage firms that hold a “seat” on the exchange that trades that particular contract. Working through their respective brokers, two parties will transact a trade. Legally, that trade is structured as two trades, both with a clearinghouse owned by or closely affiliated with the exchange. For example, suppose Party A and Party B trade five May natural gas futures at USD 3.24. Party A is long and Party B is short. This would be legally structured as
Party A being long five May natural gas futures at USD 3.24 with the exchange’s clearinghouse being the counterparty; and
The exchange’s clearinghouse being long five May natural gas futures at USD 3.24 with Party B being the counterparty.
Party A and B then have no legal obligation to each other. Their respective legal obligations are to the exchange’s clearinghouse. The clearinghouse never takes market risk because it always has offsetting positions with different counterparties.
Before you can trade a futures contract, the broker collects a deposit from you called initial margin. This may be in the form of cash or acceptable securities. The broker holds this deposit for you in a margin account and, in the case of a cash deposit, credits interest on the balance. The amount of initial margin is determined according to a formula set by the exchange. For a single futures contract, it will be a small fraction of the market value of the futures’ underlier. For futures spreads, or if you are using futures to hedge a physical position in the underlier, initial margin may be even lower. Generally, initial margin is intended to represent the maximum one-day net loss you could reasonably be expected to incur on a position.
Every day, the profit or loss is calculated on your futures position. If a loss, your broker transfers that amount from your margin account to the clearinghouse. If a profit, the clearinghouse transfers that amount to your broker who then deposits it into your margin account. This is the daily margining process. The clearinghouse’s margin cash flows net to zero. For every margin payment it receives from one party, it makes an offsetting margin payment to another party.
Through the margining process, futures settle every day. Unlike a forward, where all contract obligations are satisfied at maturity, obligations under the futures contract are satisfied every day on an ongoing basis as mark-to-market profits or losses are realized. This essentially eliminates credit risk for futures.
The calculation of the daily profit or loss for margin purposes is straightforward. On the day a futures position is first entered into, the formula for each contract is
(notional) (today’s settlement price – transaction price)
On all subsequent days, the formula becomes
(notional) (today’s settlement price – yesterday’s settlement price)
Settlement prices are official prices calculated by the exchange at the close of trading for the purpose of making margin calculations. Formulas vary and may depend upon how active trading was at the close. Generally, settlement prices are calculated as some average of transaction prices immediately before the close of trading or as some average of indicative quotes obtained from traders at the close.
Maintenance margin is some fraction—perhaps 75%—of initial margin for a position. Should the balance in your margin account fall below the maintenance margin, your broker will require that you deposit funds or securities sufficient to restore the balance to the initial margin level. Such a demand is called a margin call. The additional deposit is called variation margin. Should you fail to make a variation margin payment, your broker will immediately liquidate some or all of your positions.
Note that the margin payments made in daily settlement of a future are not collateral in a legal sense. When a party posts collateral to, say, secure an OTC derivative obligation, that party legally still owns the collateral. With futures contracts, money transferred from a margin account to an exchange as a margin payment legally changes hands. A deposit in a margin account at a broker is collateral. It legally still belongs to the client, but the broker can take possession of it any time to satisfy obligations arising from the client’s futures positions.
There are four ways to close out a futures contract:
Every futures contract has a last trade date and a delivery period specified by the exchange. In the case of a cash-settled future, the delivery period is the last trade date. On that date, the settlement price is set equal to the cash price of the underlier. There is a final margining based on that settlement price, and then the contract expires.
For physically settled futures, exchange rules depend upon the specific underlier. Usually, there is an entire month—called the delivery month—during which delivery may occur. The last trading day for the future falls towards the end of that month. A party that is short a future may elect to deliver the underlier on any business day in the delivery month. Typically, a notice of delivery must be made to the exchange two business days prior to delivery. The date on which notice is given is called the notice date. The first possible date for notice comes towards the end of the month preceding the delivery month. It is called the first notice date. Upon receiving notice of delivery, the exchange selects a party that is long the future to take the delivery. This may be the party with the largest long position in the future. Alternatively, the party to take delivery may be selected by lot.
The vast majority of futures contracts are traded by hedgers or speculators with no interest in taking or delivering the underlier. Such parties holding long futures will offset them prior to the first notice date. Those with short positions will offset them by the last trade date. Most futures are closed out by offset.
Exchanges specify conditions of delivery. These include acceptable locations for delivery, in the case of commodities or energies. It includes specifics about the quality, grade or nature of the underlier to be delivered. For example, only certain Treasury bonds may be delivered under the Chicago Board of Trade’s Treasury bond future. Only certain growths of coffee may be delivered under the Coffee, Sugar and Cocoa Exchange’s coffee future.
In many commodity or energy markets, parties want to settle futures by delivery, but exchange rules are too restrictive for their needs. For example, the New York Mercantile Exchange requires that natural gas be delivered at the Henry Hub in Louisiana. Suppose two parties need to buy/sell gas at some other hub and have transacted futures to hedge against price movements prior to the transaction. What should they do?
One answer is that they could privately negotiate the trade and then reverse their futures positions by offset. This requires that they take price risk during the period between closing the physical trade and offsetting their respective futures positions. Many exchanges offer an alternative called exchange for physicals (EFP). The mechanics of EFP vary by exchange. Generally, the parties privately negotiate their physical trade. Then, instead of offsetting their futures hedges with trades on the exchange, they inform the exchange that they want to transfer the futures from one party to the other, closing out their respective positions. Essentially, EFP is customizable physical delivery.
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This glossary post was last updated: 6th August, 2021 | 1 Views.