The futures rate is the agreed-upon price specified in a futures contract for the purchase or sale of an underlying asset at a future date. Futures contracts are standardized agreements traded on exchanges and involve assets such as commodities, currencies, or financial instruments.
Basic Definition
In its simplest form, the futures rate represents the forecasted valuation of the underlying asset at the contract’s expiration date. It includes considerations for factors such as interest rates, storage costs, and expectations of future price movements.
Types of Futures Contracts
- Commodity Futures: Pertains to physical commodities like oil, gold, and agricultural products.
- Financial Futures: Involves financial instruments like currencies, interest rates, and stock indices.
Special Considerations
- Margins: Traders are required to deposit an initial margin and maintain a maintenance margin to manage risk.
- Leverage: Futures contracts allow high leverage, meaning that small price changes can result in significant profits or losses.
- Settlement: Can be either physical (actual delivery of the asset) or cash-settled (difference in prices).
Pricing Formula
The futures price \( F \) can be generally represented as:
Where:
- \( S \) is the spot price of the underlying asset.
- \( r \) is the risk-free interest rate.
- \( c \) represents the storage cost.
- \( y \) is the income from holding the asset (like dividends).
- \( T \) is the time remaining until contract expiration.
Examples
Commodities Futures
A futures contract for crude oil may be set at $70 per barrel, promising delivery in three months. If the market price rises to $75 per barrel, the contract holder gains the difference, assuming the contract was bought rather than sold.
Financial Futures
For a S&P 500 index futures contract set at 4,000 points, if the actual index value at the contract expiration is 4,100 points, the contract holder gains 100 points.
Historical Context
Futures trading dates back to ancient times with sophisticated forms of these contracts evolving in Japan during the 17th century in rice markets. The modern form took shape in the 19th century with the establishment of commodity exchanges, notably the Chicago Board of Trade.
Applicability
Traders use futures for:
- Hedging, to protect against price volatility.
- Speculation, to profit from anticipated market movements.
Comparisons
- Spot Rate vs. Futures Rate: The spot rate is the current price of an asset for immediate delivery, whereas the futures rate is for delivery at a future date.
- Futures vs. Forwards: Unlike futures, forward contracts are not standardized and are traded over-the-counter.
Related Terms
- Margin Call: A demand for additional funds when the market moves against a position.
- Contango: A situation where the futures price is higher than the expected spot price.
- Backwardation: A situation where the futures price is lower than the expected spot price.
FAQs
Q: What is the margin requirement?
A: The initial and maintenance margins are set by exchanges to ensure traders have sufficient collateral.
Q: Can futures contracts be liquidated before expiry?
A: Yes, positions can be closed anytime before the contract expires, avoiding the need for delivery.
Q: Are there risks in trading futures?
A: Yes, futures trading carries significant risk due to leverage and market volatility.
References
- Hull, John C. “Options, Futures, and Other Derivatives.” Prentice Hall.
- CME Group. “Futures Fundamentals.” CME Group.
Summary
The futures rate is pivotal in financial and commodity markets, providing a mechanism for price discovery, risk management, and speculation. Understanding its intricacies helps traders and investors navigate complex financial landscapes effectively.
