A futures contract or simply futures 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. The fundamental difference between futures and forwards is the fact that futures are traded on exchanges. Forwards trade over the counter.
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 set price specified on the last trading date. The future date is called the delivery date or final settlement date. The set price is called the delivery price or settlement price.
A futures contract gives the right and the obligation to buy or sell. Contrast this with an options contract, which gives the buyer the right, but not the obligation, and the writer (seller) the obligation, but not the right. In other words, an option buyer can choose not to exercise when it would be uneconomical for him. The holder of a futures contract and the writer of an option, do not have a choice. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing the position. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.
A futures contract is very similar to a forward contract, which is also a contract to trade on a future date. The main differences are, that:
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futures are always traded on an exchange, whereas forwards always trade over-the-counter.
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| futures are highly standardized, whereas each forward is unique. |
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| the price at which the contract is finally settled is different: |
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futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end)
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forwards are settled at the forward price agreed on the trade date (i.e. at the start)
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| the credit risk of futures is much lower than that of forwards: |
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the profit or loss on a futures position is exchanged in cash every day. After this the credit exposure is again zero.
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the profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing.
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| in case of physical delivery, the forward contract specifies whom to make the delivery to. The counterparty on a futures contract is chosen randomly by the exchange. |
Futures contracts are highly standardized, to ensure that they are liquid. The standardization usually involves specifying:
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The underlying. This can be anything from a barrel of Sweet Crude Oil to a short term interest rate.
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| The type of settlement, either cash settlement of physical settlement. |
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The amount and units of the underlying asset per contract. This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.
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| The currency in which the futures contract is quoted. |
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The grade of the deliverable. In the case of bonds, this specifies which bonds can be delivered. 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.
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| The delivery month. |
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| The last trading date. |
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| Other details such as tick size, the minimum permissible price fluctuation. |
FUTURES CONTRACT AND EXCHANGE
There are many different kinds of futures contract, 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.
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| Foreign exchange market |
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| Money market |
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| Bond market |
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| Equity index market |
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| Soft Commodities market |
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 the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo International Financial Futures Exchange (now Tokyo Finance Exchange).
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Chicago Board of Trade (CBOT) -- financials (bonds), traditional commodities: maize, oats, rough rice, soybeans, soybean meal, soybean oil, wheat,
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Chicago 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, butter,
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International Petroleum Exchange - energy including crude oil, heating oil, natural gas and unleaded gas.
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| Euronext.liffe |
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London Commodity Exchange - 'soft', grains and meats. Inactive market in Baltic Exchange shipping.
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London Metal Exchange - metals, mainly copper, aluminum, lead, zinc, nickel and tin.
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| New York Board of Trade - soft,: cocoa, coffee, cotton, orange juice, sugar |
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New York Mercantile Exchange - Energy and metals: crude oil, gasoline, heating oil, natural gas, coal, propane, gold, silver, platinum, copper, aluminum and palladium
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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 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.
