A futures contract is a standardized legal agreement between two parties to buy or sell a specific quantity of a commodity or a financial instrument at a predetermined price on a future date. This legal arrangement obligates the buyer to purchase, and the seller to sell, the underlying asset unless the contract is offset with another before the settlement date.
Key Components of a Futures Contract
- Underlying Asset: This can include commodities like wheat, oil, or gold, as well as financial instruments such as currencies, interest rates, or stock indices.
- Contract Size: The quantity of the underlying asset to be bought or sold.
- Delivery Date: The specific future date when the transaction must be completed.
- Price: The agreed-upon price at which the transaction will occur.
- Settlement Method: Can be either physical delivery of the commodity or cash settlement.
Types of Futures Contracts
Commodity Futures
These contracts cover tangible products like agricultural goods, metals, and energy resources. Examples include:
- Crude Oil Futures: Contract for buying or selling crude oil.
- Gold Futures: Agreement involving the purchase or sale of gold.
- Soybean Futures: Contracts dealing with buying or selling soybean.
Financial Futures
These include contracts for financial instruments like currencies, interest rates, or financial indices:
- Currency Futures: Contracts involving currency exchange.
- Interest Rate Futures: Agreements on the future value of interest rates.
- Stock Index Futures: Contracts based on financial indices like the S&P 500 or Dow Jones Industrial Average.
Contrast with Options Trading
While futures contracts obligate both the buyer and seller to transact on a set date, options contracts give the buyer the right, but not the obligation, to buy or sell the underlying asset by a certain date.
Comparison Table: Futures vs. Options
| Commodity | Futures Contract | Options Contract |
|---|---|---|
| Obligation | Both parties must transact | Buyer has the right, not obligation |
| Settlement | Specified future date | By exercise date if the option is used |
| Collateral | Margin requirements | Premium paid upfront |
Historical Context
The origins of futures trading can be traced back to the 17th century in Japan with the rice futures market. The modern futures market began with the establishment of the Chicago Board of Trade (CBOT) in 1848, and has since grown to include a wide variety of standardized futures contracts traded on global exchanges.
Evolution of Futures Trading
- 17th Century: Establishment of rice futures in Osaka, Japan.
- 19th Century: Formation of the CBOT, introduction of standardized contracts.
- 20th Century: Expansion to financial instruments, digital trading.
Applicability and Uses
Futures contracts are used for:
- Hedging: Traders and businesses use futures to hedge against price risks in commodities or financial markets.
- Speculation: Investors trade futures to profit from price movements.
- Arbitrage: Exploiting price differences in different markets.
Example Scenario
An airline company might buy crude oil futures to secure future fuel prices, protecting against price volatility.
Related Terms and Definitions
- Forward Contract: A customized contract binding two parties to transact set assets at a predetermined future date. Unlike futures, forward contracts are not traded on exchanges.
- Swap: A derivative contract where parties exchange cash flows or other financial instruments over some period.
- Margin: Collateral required to enter into futures contracts, acting as a performance bond.
FAQs
What happens if a futures contract is not settled?
Are futures contracts risky?
Can individuals participate in futures trading?
References
- “Futures Contract Definition.” Investopedia.
- “Futures Trading: History and Evolution.” Chicago Mercantile Exchange.
- Hull, John C. “Options, Futures, and Other Derivatives.” Pearson Education.
Summary
Futures contracts are crucial financial instruments in markets, enabling hedging, speculation, and arbitrage. They have evolved from traditional commodity trading to include a vast array of financial assets. Understanding the structure, obligations, and applications of futures contracts is essential for market participants seeking to manage risk or capitalize on market opportunities.
