Futures contracts are standardized legal agreements for buying or selling a specified quantity of a commodity or financial instrument at a predetermined price on a specific future date. They are traded on futures exchanges and are widely used for speculation, hedging, and managing price risk.
Definition and Structure of Futures Contracts
Futures contracts specify:
- Underlying Asset: The commodity, financial instrument, or economic measure to be traded.
- Contract Size: The standardized amount of the asset to be delivered.
- Delivery Date: The specific date on which the transaction will occur.
- Settlement Type: Physical delivery or cash settlement.
Written in precise terms, a futures contract may have the following format:
Types of Futures Contracts
Commodity Futures
Commodity futures involve physical goods such as:
- Agricultural Products: Wheat, corn, soybeans.
- Energy Products: Crude oil, natural gas.
- Metals: Gold, silver, copper.
Financial Futures
Financial futures include contracts based on:
- Currencies: EUR/USD, GBP/USD.
- Interest Rates: U.S. Treasury bonds, Eurodollar deposits.
- Stock Indices: S&P 500, NASDAQ-100.
Index Futures
These are used to trade financial indices and allow for speculation or hedging on the overall movement of an index.
Special Considerations
Margin Requirements
Both initial and maintenance margins are required:
- Initial Margin: The upfront deposit required to open a futures contract position.
- Maintenance Margin: The minimum equity level that must be maintained in the investor’s margin account.
Mark-to-Market
Accounts are typically updated daily to reflect gains and losses as prices fluctuate, known as mark-to-market.
Examples of Futures Contracts
- S&P 500 Futures: Allowing traders to speculate on the future value of the S&P 500 Index.
- Crude Oil Futures: Used by energy companies to hedge against price volatility in oil markets.
- Gold Futures: Enabling investors to bet on the future price movement of gold.
Historical Context
Futures trading dates back to ancient times, with some of the earliest known contracts recorded in Mesopotamia around 1750 BC. Modern futures trading began with the establishment of the Chicago Board of Trade (CBOT) in the mid-19th century.
Applicability
Futures contracts are extensively used by:
- Speculators: To profit from price movements.
- Hedgers: To protect against adverse price fluctuations.
- Arbitrageurs: To take advantage of price discrepancies.
Comparisons to Other Instruments
Futures vs. Forwards
- Futures: Traded on exchanges, standardized, marked-to-market.
- Forwards: Over-the-counter, customizable, settled at contract end.
Futures vs. Options
Related Terms
- Derivative: Financial contract deriving its value from an underlying asset.
- Spot Market: Market for immediate delivery of the underlying asset.
- Hedging: Strategies to mitigate risk using futures.
FAQs
Q1: What are the main uses of futures contracts?
Q2: What is the role of futures exchanges?
Q3: Can individuals participate in futures trading?
Q4: What is a 'margin call'?
Q5: How are futures settled?
References
- Hull, J. (2021). Options, Futures, and Other Derivatives. Pearson.
- Chicago Mercantile Exchange. (n.d.). Futures and Options Handbook.
- Bodie, Z., Kane, A., & Marcus, A. J. (2018). Investments. McGraw-Hill Education.
Summary
Futures contracts are critical tools in modern financial markets, providing mechanisms for price discovery, risk management, and speculative opportunities. Their standardized nature, coupled with the efficiency of futures exchanges, makes them accessible and practical for a broad range of market participants.
