Futures
contracts, or simply futures, are exchange traded
derivatives. The exchange's clearinghouse acts as counterparty
on all contracts, sets margin requirements, etc.
Futures
vs. Forwards
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:
- Forwards
transact only when purchased and on the settlement date. Futures,
on the other hand, are rebalanced, or "marked to market,"
every day to the daily spot price of a forward with the same
agreed-upon delivery price and underlying asset.
- The
fact that forwards are not rebalanced daily means that,
due to movements in the price of the underlying asset,
a large differential can build up between the forward's
delivery price and the settlement price.
- This
means that one party will incur a big loss at the
time of delivery (assuming they must transact at the
underlying's spot price to facilitate receipt/delivery).
- This
in turn creates a credit risk. More generally, the
risk of a forward contract is that the supplier will
be unable to deliver the required commodity, or that
the buyer will be unable to pay for it on the delivery
day.
- The
rebalancing of futures eliminates much of this credit
risk by forcing the holders to update daily to the price
of an equivalent forward purchased that day. This means
that there will usually be very little additional money
due on the final day to settle the futures contract.
- In
addition, the daily futures-settlement failure risk is
borne by an exchange, rather than an individual party,
limiting credit risk in futures.
- Example
for a futures contract with a $100 price: Let's say that
on day 50, a forward with a $100 delivery price (on the
same underlying asset as the future) costs $88. On day
51, that forward costs $90. This means that the mark-to-market
would require the holder of one side of the future to
pay $2 on day 51 to track the changes of the forward price.
This money goes, via margin accounts, to the holder of
the other side of the future. (A forward-holder, however,
would pay nothing until settlement on the final day, potentially
building up a large balance. So, except for tiny effects
of convexity bias or possible allowance for credit risk,
futures and forwards with equal delivery prices result
in the same total loss or gain, but holders of futures
experience that loss/gain in daily increments which track
the forward's daily price changes, while the forward's
spot price converges to the settlement price.)
- Futures
are always traded on an exchange, whereas forwards always
trade over-the-counter, or can simply be a signed contract
between two parties.
- Futures
are highly standardised, whereas some forwards are unique.
- 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.
Some exchanges
tolerate 'nonconvergence', the failure of futures contracts
and the value of the physical commodities they represent to
reach 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 participants
holding CBOT SRW futures contracts are qualified by the CBOT
to make or receive delivery of commodities to settle futures
contracts. Therefore, it's impossible for almost any individual
producer to 'hedge' efficiently when relying 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
selected 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.
Standardization
Futures
contracts ensure their liquidity by being highly
standardized, usually by specifying:
- The underlying
asset or instrument. This could be anything from a barrel
of crude oil to a short term interest rate.
- The type
of settlement, either cash settlement or physical settlement.
- 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.
- The currency
in which the futures contract is quoted.
- 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.
- The delivery
month.
- The last
trading date.
- Other
details such as the commodity tick, the minimum permissible
price fluctuation.
Margin
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 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
Settlement
is the act of consummating the contract, and can be done in
one of two ways, as specified per type of futures contract:
- Physical
delivery - the amount specified of the underlying asset
of the contract is delivered by the seller of the contract
to the exchange, and by the exchange to the buyers of the
contract. Physical delivery is common with commodities and
bonds. In practice, it occurs only on a minority of contracts.
Most 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 liquidate an earlier purchase
(covering a long). The Nymex crude futures contract uses this
method of settlement upon expiration.
- Cash
settlement - a cash payment is made based on the underlying
reference rate, such as a short term interest rate index such
as Euribor, or the closing value of a stock market index.
A futures contract might also opt to settle against an index
based on trade in a related spot market. Ice Brent futures
use this method.
- Expiry
is the time when the final prices of the future is determined.
For many equity index and interest rate futures contracts
(as well as for most equity options), this happens on the
third Friday of certain trading month. On this day the t+1
futures contract becomes the t futures contract. For
example, for most CME and CBOT contracts, at the expiry on
December, the March futures become the nearest contract. This
is an exciting time for arbitrage desks, as they will try
to make rapid gains during the short period (normally 30 minutes)
where the final prices are averaged from. At this moment the
futures and the underlying assets are extremely liquid and
any mispricing 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 almost every half an hour.
Pricing
The situation
where the price of a commodity for future delivery is higher
than the spot price, or where a far future delivery price is
higher than a nearer future delivery, is known as contango.
The reverse, where the price of a commodity for future delivery
is lower than the spot price, or where a far future delivery
price is lower than a nearer future delivery, is known as backwardation.
When the
deliverable asset exists in plentiful supply, or may be freely
created, then 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 compounding the present value
S(t) at time t to maturity T by the rate
of risk-free return r.
or, with
continuous compounding
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.
The above
relationship, therefore, is typical for stock index futures,
treasury bond futures, and futures on physical commodities when
they are in supply (e.g. on corn after the harvest). However,
when the deliverable commodity is not in plentiful supply or
when it does not yet exist, for example on wheat before the
harvest or on Eurodollar Futures or Federal funds rate futures
(in which the supposed underlying instrument is to be created
upon the delivery date), the futures price cannot be fixed by
arbitrage. In this scenario there is only one force setting
the price, which is simple supply and demand for the future
asset, as expressed by supply and demand for the futures contract.
In a deep
and liquid market, this supply and demand would be expected
to balance out at a price which represents an unbiased expectation
of the future price of the actual asset and so be given by the
simple relationship
.
In fact,
this relationship will hold in a no-arbitrage setting when we
take expectations with respect to the risk-neutral probability.
In other words: a futures price is martingale with respect to
the risk-neutral probability.
With this
pricing rule, a speculator is expected to break even when the
futures market fairly prices the deliverable commodity.
In a shallow
and illiquid market, or in a market in which large quantities
of the deliverable asset have been deliberately withheld from
market participants (an illegal action known as cornering the
market), the market clearing price for the future may still
represent the balance between supply and demand but the relationship
between this price and the expected future price of the asset
can break down.
Futures
contracts and exchanges
There are
many different kinds of futures contracts, reflecting the many
different kinds of tradable assets of which they are derivatives.
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
Terminbase (now Eurex) and the Tokyo Commodity Exchange (TOCOM).
Today, there are more than 75 futures and futures options exchanges
worldwide trading to include:
- CME Group
(formerly CBOT and CME) -- Currencies, Various Interest Rate
derivatives (including US Bonds); Agricultural (Corn, Soybeans,
Soy Products, Wheat, Pork, Cattle, Butter, Milk); Index (Dow
Jones Industrial Average); Metals (Gold, Silver), Index (NASDAQ,
S&P, etc)
- ICE Futures
- the International Petroleum Exchange trades energy including
crude oil, heating oil, natural gas and unleaded gas and merged
with IntercontinentalExchange(ICE)to form ICE Futures.
- Euronext.liffe
- South
African Futures Exchange - SAFEX
- Sydney
Futures Exchange
- London
Commodity Exchange - softs: grains and meats. Inactive market
in Baltic Exchange shipping.
- Tokyo
Stock Exchange TSE (JGB Futures, TOPIX Futures)
- Tokyo
Commodity Exchange TOCOM
- Tokyo
Financial Exchange TFX (Euroyen Futures, OverNight CallRate
Futures, SpotNext RepoRate Futures)
- Osaka
Securities Exchange OSE (Nikkei Futures, RNP Futures)
- London
Metal Exchange - metals: copper, aluminium, lead, zinc, nickel
and tin.
- New York
Board of Trade - softs: cocoa, coffee, cotton, orange juice,
sugar
- New York
Mercantile Exchange - energy and metals: crude oil, gasoline,
heating oil, natural gas, coal, propane, gold, silver, platinum,
copper, aluminum and palladium
- Dubai
Mercantile Exchange
- Futures
exchange
- Singapore
International Monetary Exchange (SIMEX)
- Futures
on many Single-stock futures
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.
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..
Futures
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 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.
References
- John
C. Hull, Options, Futures, and Other Derivatives, 6th
edition 2006, Prentice-Hall
- Keith
Redhead, (31 Oct 1996), Financial Derivatives: An Introduction
to Futures, Forwards, Options and Swaps, Prentice-Hall
- Abraham
Lioui & Patrice Poncet, (March 30, 2005), Dynamic Asset
Allocation with Forwards and Futures, Springer
- Valdez,
Steven, . An Introduction To Global Financial Markets.
Macmillan Press Ltd. (ISBN 0-333-76447-1)
- Arditti,
Fred D., 19nn. Derivatives: A Comprehensive Resource for
Options, Futures, Interest Rate Swaps, and Mortgage Securities.
Harvard Business School Press. ISBN 0-87584-560-6.
Futures
Exchanges & Regulators
