FUTURES

Definition

Futures are standardized financial contracts that obligate the buyer to purchase or the seller to sell a specific quantity of an asset at a predetermined price on a set future date. They are traded on organized futures exchanges and used for hedging or speculation.

A futures contract locks in the price today for a transaction that will occur at a specific date in the future.

Origins

Futures trace back to 17th-century Japan with rice markets and became institutionalized in 19th-century Chicago, where agricultural commodity contracts led to the establishment of the Chicago Board of Trade (CBOT). Today, futures span commodities, financial instruments, and digital assets, managed by entities like CME Group and ICE.

Usage

Industry Applications:

• Commodity Producers – Hedge future production (e.g., wheat, oil, metals).

• Financial Institutions – Hedge interest rate or currency risk.

• Corporates – Manage input cost or foreign exchange exposure.

• Speculators – Profit from price changes in equity indices, bonds, crypto.

• Arbitrageurs – Exploit pricing differences across futures and spot markets.

How Futures works

Basic Structure:

• Parties: Buyer (long) and Seller (short)

• Underlying Asset: Commodity, stock index, interest rate, currency, etc.

• Standardized Terms:

  • Quantity

  • Quality (if applicable)

  • Expiration Date

  • Settlement Type (cash vs. physical)

Lifecycle:

1. Contract is entered via exchange.

2. Initial margin is posted (good faith deposit).

3. Daily mark-to-market gains/losses adjusted via variation margin.

4. At expiration, contract is either settled in cash or physically delivered.

Key Takeaways

• Futures are standardized and exchange-traded, unlike forward contracts.

• Require margin accounts and are subject to daily settlement.

• Used for both hedging real exposure and speculative trading.

• Can be cash-settled (e.g., S&P 500 futures) or physically settled (e.g., oil, gold).

• Highly liquid and leveraged instruments with robust regulatory oversight.

Types of Futures

Futures& Financial Modeling

Futures impact:

• Hedging Models – Lock input costs (e.g., airlines hedge fuel).

• Earnings Forecasts – Use locked-in prices to reduce volatility.

• Risk Management – Calculate Value at Risk (VaR) including derivative exposure.

• Fair Value Pricing – Model expected future spot price and cost of carry.

• Cash Flow Modeling – Reflect margin calls and settlements.

Nuances & Complexities

• Leverage: Small margin deposit controls large notional exposure.

• Liquidity & Slippage: Heavily traded futures (e.g., ES, CL) have tight spreads.

• Contango vs. Backwardation:

  • Contango: Futures price > spot (common in oil, storage-heavy assets).

  • Backwardation: Futures price < spot (often in high-demand periods).

• Rolling Contracts: Traders avoid delivery by rolling positions to next contract.

• Regulations: Governed by CFTC (U.S.), ESMA (EU), with exchange-level risk controls.

Mathematical Formulas

1. Futures Price (Cost of Carry Model):

$$F = S \times e^{(r - q) \times T}$$

Where:

• $F$ = Futures price

• $S$ = Spot price

• $r$ = Risk-free rate

• $q$ = Convenience yield or dividend

• $T$ = Time to maturity

2. Profit/Loss from Futures Trade:

$$\text{P/L} = (\text{Sell Price} - \text{Buy Price}) \times \text{Contract Size}$$

3. Mark-to-Market Margin:

$$\text{Daily P/L} = (\text{Today's Settlement Price} - \text{Yesterday's}) \times \text{Contracts Held}$$

Related Terms

• Forward Contract

• Hedging

• Derivatives

• Options

• Leverage

• Contango

• Margin Call

• Basis Risk

   

  Real-World Applications

  1. Airlines Hedging Fuel

  Southwest Airlines famously used futures to hedge fuel costs, achieving a competitive edge during oil price spikes in the early 2000s.

  2. Commodity Trading

  Glencore uses metal futures to lock prices on inventory, managing global exposure across time zones and currencies.

  3. Stock Index Hedging

  A portfolio manager shorts S&P 500 futures to hedge market beta during economic uncertainty without selling equity holdings.

  4. Crypto Speculation

  Institutional investors use CME Bitcoin futures for regulated exposure to BTC price movements while avoiding physical custody.

References & Sources

• CME Group Education Center – Futures Market Fundamentals

• CFTC.gov – Futures and Options Market Oversight

• John Hull – Options, Futures, and Other Derivatives (Pearson)