A future contract is a legally binding agreement between two parties to buy or sell a specific quantity of a specific underlying instrument on a certain date in the future (expiry date) at a price agreed upon when concluding the contract. A person who buys a futures contract enters into a contract to purchase an underlying instrument and is said to be “long” the contract. A person who sells a futures contract enters into a contract to sell the underlying instrument and is said to be “short” the contract. The price at which the contract trades (the “contract price”) is determined by relative buying and selling interest on a regulated exchange. Buyers have a profit if the price increases and sellers have profit if the price decreases.
The following may serve as underlying instruments:
- physical assets (equities, warrants, options, commodities, precious metals)
- benchmarks (currencies, interest rates, indices).
Unlike forward contracts, futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. As the two parties to the contract do not necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored.
Large exchanges on which future contracts are traded are the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange (NYMEX) and the Eurex Exchange. On these and other exchanges, a very wide range of commodities and financial assets form the underlying assets in the various contracts. The commodities include pork bellies, live cattle, sugar, wool, lumber, copper, aluminum, gold and tin. The financial assets include stock indices, currencies, and Treasury bonds.
One way in which a future contract is different from a forward contract is that an exact delivery date is usually not specified. The contract is referred to by its delivery month, and the exchange specifies the period during the month when delivery must be made. For commodities, the delivery period is often the entire month. The holder of the short position has the right to choose the time during the delivery period when it will make delivery. Usually, contracts with several different delivery months are traded at any one time. The exchange specifies the amount of the asset to be delivered for one contract and how the futures price is to be quoted. In the case of a commodity, the exchange also specifies the product quality and the delivery location. Consider, for example, the wheat future contract currently traded on the Chicago Board of Trade. The size of the contract is 5,000 bushels. Contracts for five delivery months (March, May, July, September and December) are available for up to 18 months into the future. The exchange specifies the grades of wheat that can be delivered and the places where delivery can be made.
Future prices are regularly reported in the financial press. Suppose that on March 1, the June future price of gold is quoted as $600. This is the price, exclusive of commissions, at which traders can agree to buy or sell gold for June delivery. It is determined on the floor of the exchange in the same way as other prices (i.e. by the laws of supply and demand). If more traders want to go long than to go short, the price goes up. If the reverse is true, the price goes down.
Can a future contract eliminate all the currency risks?
A future contract can eliminate all exchange rate risk by locking in the rate that is paid for foreign currency, but some risk still remains. This is due to unpredictable movements in interest rates, which lead to uncertainty about interim gains and losses and margin payments. This risk due to the variability in interest rates is called marking-to-market risk because it results from the practice of daily settlement a process known as marking-to-market. The marking-to-market risk makes futures contracts riskier than forward contracts, which do not have interim payments, and also in comparison to forward contracts currency futures do not eliminate all risk associated with the particular transaction.
The major advantages and disadvantages of using futures contracts to hedge risk
| Advantages | Disdvantages |
|---|---|
| Standardized contracts sizes and delivery dates | Margin required |
| Market transparency | Exchange trading hours may be limited |
| Highly liquid market which generates small bid-offer spreads | If maximum price movement limits operate, future contracts may become totally illiquid at short notice |
| Market regulated by rules laid down by the exchange | Basis difference between spot (cash) market and future market instruments |
| Ease of buying and selling contracts | Contracts may be withdrawn from the market |
| Dealing restricted to members of the exchange |
