Futures and Futures Markets

When an airline locks in next year’s jet fuel price, a chocolate maker secures its cocoa or a pension fund halves its stock exposure overnight, a futures contract is usually involved. Futures markets are older than most stock exchanges – rice futures traded in Osaka in the 18th century – and today they’re among the largest markets in the world.

What a futures contract is#

A futures contract is a binding agreement between two parties:

• The buyer commits to buying an asset at a price set today on a specific future date.
• The seller commits to delivering it.

Unlike an option, there’s no choice – both sides are bound. And no purchase price changes hands at the start, only a margin deposit.

Futures are standardised: quantity, quality, delivery date and place are fixed. That makes them liquid and tradable on exchanges such as CME Group in Chicago or Eurex in Frankfurt.

Margin and daily settlement#

When a futures position is opened, both sides post initial margin with the clearing house, often just a few percent of the contract value. After that, every position is marked to market daily:

• If the price rose, the buyer is credited and the seller debited.
• If it fell, the reverse.
• If an account falls below the maintenance margin, a margin call follows.

This system makes futures markets very safe, because large unpaid losses can’t build up. For the individual trader, though, it means small price moves produce big gains or losses relative to the margin. Futures are therefore highly leveraged.

Hedging: the original purpose#

Futures were invented to transfer price risk – that’s hedging.

• A farmer sells futures on the coming harvest in spring and locks in the sale price. If wheat falls, the gain on the futures offsets the lower proceeds.
• An airline buys jet fuel or crude oil futures to protect against rising fuel costs.
• A pension fund sells index futures to reduce stock exposure quickly without selling hundreds of individual stocks.

Hedgers give up potential gains from favourable price moves – they trade uncertainty for predictability. On the other side are often speculators who deliberately take on price risk because they expect a particular move. Without them, hedgers would struggle to find counterparties.

Delivery or cash settlement#

Commodity futures provide for physical delivery – but the vast majority of contracts are closed or rolled to a later month beforehand. How costly rolling is depends on the shape of the futures curve, as explained in Commodities and Gold (contango and backwardation). Index futures are cash-settled, since you can’t deliver an index.

Index futures: the market before the market#

Futures on the S&P 500, Nasdaq-100 and Dow trade nearly 24 hours a day on weekdays. That’s why they show, long before the opening bell, how the cash market is likely to start. When TV says “futures point to a higher open”, that’s what they mean.

An index future’s price doesn’t exactly match the index. The difference, the basis, mainly reflects interest rates and expected dividends until expiration. If it strays from fair value, arbitrageurs step in.

Summary#

Futures are standardised, binding forward contracts on commodities, indices, rates and currencies. Margin and daily settlement make the market robust but positions highly leveraged. Invented for hedging, they also serve speculation and act as an early indicator of the market open. That completes Module 6 – you now know the most powerful tools in financial markets, and their risks.