A future contract is a legally binding, standardized agreement to buy or sell a specific commodity, financial instrument, or security at a predetermined price on a specified future date. These contracts are traded on futures exchanges and are used for hedging or speculation. The predetermined price is called the “futures price,” and the specified future date is known as the “delivery date” or “settlement date.”
Key Components of Future Contracts
Standardization
Future contracts are standardized in terms of quantity, quality, delivery time, and location. This standardization ensures that the contracts are fungible, meaning that they can be easily traded on an exchange.
Futures Price
The futures price is the agreed-upon price at which the asset will be bought or sold at a future date. This price is determined by the supply and demand dynamics in the market.
Delivery Date
The delivery date, or settlement date, is the specific date in the future when the asset must be delivered or settled.
Margin Requirements
Participants in futures trading are required to deposit a margin, a percentage of the contract’s value, to cover potential losses. This ensures that both parties fulfill their contractual obligations.
Types of Future Contracts
Commodity Futures
These involve physical commodities such as agricultural products (wheat, corn), energy products (crude oil, natural gas), and metals (gold, silver).
Financial Futures
These involve financial instruments such as currencies, interest rates, and stock market indices. Examples include currency futures, Treasury bond futures, and stock index futures.
Single Stock Futures
These are futures contracts with individual stocks as the underlying asset.
Special Considerations
Hedging
Future contracts are extensively used by producers and consumers of commodities, or investors, to hedge or mitigate the risk of price volatility. For example, a wheat farmer might use futures contracts to lock in a price for their crop against potential future price declines.
Speculation
Traders and investors also use futures contracts for speculative purposes. They aim to profit from price movements without intending to actually deliver or receive the underlying commodity.
Arbitrage
Arbitrageurs exploit price differences between the futures market and the spot market. These activities help in bringing efficiency and liquidity to the markets.
Historical Context
Future contracts have a long history, dating back to ancient Mesopotamian civilizations where farmers and merchants would agree on the price of grain for future delivery. The modern futures markets began in the 19th century with the establishment of the Chicago Board of Trade (CBOT) in 1848, which started trading standardized grain futures contracts.
Examples of Future Contracts
Crude Oil Futures
A crude oil futures contract obligates the seller to deliver a specified quantity of crude oil to the buyer at a future date and predetermined price. These contracts are widely traded on exchanges like the New York Mercantile Exchange (NYMEX).
S&P 500 Futures
S&P 500 futures are based on the S&P 500 index, providing traders with a way to speculate on the future direction of the index. These contracts are settled in cash rather than physical delivery.
Related Terms
- Forward Contract: A non-standardized contract between two parties to buy or sell an asset at a predetermined future date and price.
- Options Contract: A contract that gives the holder the right, but not the obligation, to buy or sell an asset at a predetermined price before the contract expires.
- Margin: The amount of money required to open and maintain a futures position.
FAQs
What happens if I cannot fulfill a future contract?
Are future contracts risky?
References
- Hull, John C. Options, Futures, and Other Derivatives. Pearson.
- CFTC. “A Trader’s Guide to Futures”. U.S. Commodity Futures Trading Commission.
Summary
Future contracts serve as essential instruments in financial markets, providing means for hedging, speculation, and arbitrage. By understanding their structure, usage, and risks, traders and investors can effectively navigate the complexities of futures trading. With historical roots stretching back to early civilization and significant modern-day applications, future contracts remain integral to the global economy.
