Chapter 14 - Futures Contracts

Learning Objectives

• Understanding the basics of futures markets and how to obtain quotes for futures contracts.

• Identifying risks involved in futures market speculation.

• Understanding the link between cash prices and futures prices.

• Learning how futures contracts can be used to transfer price risk.

Futures Contracts Overview

• A futures contract is an agreement between a buyer and seller to complete a transaction at a set date in the future.

• Futures contracts are standardized while forward contracts are customized.

• Futures exchanges act as intermediaries, eliminating default risk and ensuring liquidity.

Forward Contracts

Basics

• Definition: Agreement made today to trade an asset at a future date; terms are negotiated and customized.

• Key Components:

  • What to trade

  • Where to trade

  • When to trade

  • How much to trade

  • Quality of the good

• Forward Price: Price set at the agreement date; payment occurs at transaction date.

• Default Risk: Risk faced if one party defaults; both parties must agree to cancel.

Futures Contracts

Basics

• More similar to a forward contract but include standardized terms.

• Price is determined in the trading pit or electronic market (known as the futures price).

• No default risk due to the guarantees by the Futures Exchange.

• Canceling a contract requires offsetting trades rather than mutual agreement.

Major Futures Exchanges

• Historical Events:

  • Chicago Board of Trade (CBOT)—established in 1848, first U.S. futures exchange.

  • New York Mercantile Exchange (NYMEX) and others are notable contributors to futures trading today.

• Exchange Mergers: CME Group formed from multiple mergers, enhancing liquidity and market reach.

Financial Futures

• Important milestones in financial futures:

  • Currency futures (1972)

  • Gold futures (1974)

  • U.S. Treasury futures (1976-1981)

  • Stock Index futures (1982)

• Financial futures constitute most trading volume in modern markets.

Key Aspects of Futures Contracts

1. Underlying Commodity or Financial Instrument

2. Contract Size

3. Maturity Date (Expiration Date)

4. Settlement Procedure

5. Futures Price

Cash and Futures Prices

• Cash Price: The price for immediate delivery of commodities.

• Futures markets often exhibit arbitrage opportunities as prices diverge.

• Basis: Difference between cash price and futures price (Basis = Cash price - Futures price).

  • Carrying charge market: when cash price < futures price

  • Inverted market: when cash price > futures price

Speculation and Hedging with Futures

Speculating with Futures

Long Position

• Going long means buying a futures contract. Futures price increases yield profits.

Short Position

• Going short means selling a futures contract. If futures prices decrease, profits are made.

Hedging Strategies

1. Short Hedge: Protects against falling prices—sells futures contracts offsetting existing inventory value risks.

2. Long Hedge: Protects against rising prices—buys futures contracts to fix acquisition costs.

Trading Accounts and Margins

• Initial Margin: Required deposit when establishing a futures position.

• Maintenance Margin: Minimum amount to maintain a futures position without triggering a margin call.

• Positions are marked-to-market daily; losses or gains affect the account balance.

Conclusion

• Futures contracts are critical tools for both speculation and hedging in commodity and financial markets.

• Understanding the relationships between cash prices, futures prices, and market structures is essential for effective trading and risk management strategies.