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The Economic Purpose of the Futures Market
Many people think that futures markets are just about speculating or
“gambling.” While it is true that futures markets can be used for
speculating, that is not the primary reason for their existence.
Futures markets are actually designed as vehicles for hedging and
risk management, that is, to help people avoid “gambling” when they
don’t want to. For example, a wheat farmer who plants a crop is, in
effect, betting that the price of wheat won’t drop so low that the
farmer would have been better off not planting at all. This bet is
inherent to the farming business, but the farmer may prefer not to
make it. The farmer can hedge this bet by selling a wheat futures
contract. This document discusses how futures markets work and how
they are used for both hedging and speculating.(CFTC)
What is a Futures Commodity Contract?
In finance, a futures contract is a standardized contract, traded on
a futures exchange, to buy or sell a certain underlying instrument
at a certain date in the future, at a pre-set price. The future date
is called the delivery date or final settlement date. The pre-set
price is called the futures price. The price of the underlying asset
on the delivery date is called the settlement price. The futures
price, naturally, converges towards the settlement price on the
delivery date.
A futures contract gives the holder the right and the obligation to
buy or sell, which differs from an options contract, which gives the
buyer the right, but not the obligation, and the option writer
(seller) the obligation, but not the right. In other words, the
owner of an options contract can exercise (to buy or sell) on or
prior to the pre-determined settlement/expiration date. Both parties
of a "futures contract" must exercise the contract (buy or sell) on
the settlement date. To exit the commitment, the holder of a futures
position has to sell his long position or buy back his short
position, effectively closing out the futures position and its
contract obligations.
Futures contracts, or simply futures, are exchange traded
derivatives. The exchange acts as counterparty on all contracts,
sets margin requirements, etc.
Futures vs. Forwards
While futures and forward contracts are both a contract to trade on
a future date, key differences include: |
- Futures
are always traded on an exchange, whereas forwards always trade
over-the-counter
- Futures
are highly standardized, whereas each forward is unique
- The price
at which the contract is finally settled is different:
- Futures
are settled at the settlement price fixed on the last trading
date of the contract (i.e. at the end)
- Forwards
are settled at the forward price agreed on the trade date (i.e.
at the start)
- The credit
risk of futures is much lower than that of forwards:
- The profit
or loss on a futures position is exchanged in cash every day.
After this the credit exposure is again zero.
- The profit
or loss on a forward contract is only realised at the time of
settlement, so the credit exposure can keep increasing
- In case of
physical delivery, the forward contract specifies to whom to
make the delivery. The counterparty on a futures contract is
chosen randomly by the exchange.
- In a
forward there are no cash flows until delivery, whereas in
futures there are margin requirements and periodic margin calls.
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Standardization
Futures contracts ensure their liquidity by being highly
standardized, usually by specifying:
- The
underlying. This can be anything from a barrel of sweet 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.
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Margin
Main article: Margin (finance)
Although the value of a contract at time of trading should be zero,
its price constantly fluctuates. This renders the owner liable to
adverse changes in value, and creates a credit risk to the exchange,
who always acts as counterparty. To minimise this risk, the exchange
demands that contract owners post a form of collateral, in the US
formally called performance bond, but commonly known as margin.
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.
Because a series of adverse price changes may exhaust the initial
margin, a further margin, usually called variation or maintenance
margin, is required by the exchange. This is calculated by the
futures contract, i.e. agreeing a price at the end of each day,
called the "settlement" or mark-to-market price of the contract.
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.
Traders would rarely (and unadvisedly) hold 100% of their capital as
margin. The probability of losing their entire capital at some point
would be high. By contrast, if the margin-equity ratio is so low as
to make the trader's capital equal to the value of the futures
contract itself, then they would not profit from the inherent
leverage implicit in futures trading. A conservative trader might
hold a margin-equity ratio of 15%, while a more aggressive trader
might hold 40%.
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).
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.
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 forward 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 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 discounting the present value
S(t) at time t to maturity T by the rate of risk-free return r.
F(t)
= S(t) x (1+r)(T-t)
or, with
continuous compounding
F(t) = S(t)er(T-t)
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.
Futures contracts and exchanges
There are many different kinds of futures contract, reflecting the
many different kinds of tradable assets of which they are
derivatives. For information on futures markets in specific
underlying commodity markets, Google these topics.
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- Foreign
exchange market
- Money
market
- Bond
market
- Equity
index market
- Soft
Commodities market
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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 Terminbörse (now
Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are
more than 75 futures and futures options exchanges worldwide trading
to include:
Chicago Board of Trade (CBOT) -- financials (bonds) and traditional
commodities: maize, oats, rough rice, soybeans, soybean meal,
soybean oil, wheat,
Chicago Mercantile Exchange -- financial futures and traditional
commodities: lumber, live cattle, feeder cattle, boneless beef,
boneless beef trimmings, lean hogs, frozen pork bellies, fresh pork
bellies, Basic Formula Price milk, butter,
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
London Commodity Exchange - softs: grains and meats. Inactive market
in Baltic Exchange shipping.
Tokyo Commodity Exchange TOCOM
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
Futures exchange
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 their 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. (From Wikipedia, the free encyclopedia)
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