Futures: The Standardized Exchange Contract

A futures contractIn finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.Read on Wikipedia → creates an obligation to buy or sell an asset on agreed terms for a future date. It normally trades on an exchange, which defines the contract’s size, dates, and settlement rules.

Like a forwardIn finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.Read on Wikipedia →, it can protect a business from a price change or let a trader take a position on that change. The important differences concern how the contract is traded and how its obligations are handled.

Trading a standard contract

The two parties to a forward can agree on terms that fit a specific need. With futures, they choose from contracts already defined by the exchange. This makes it easier to find another participant trading the same contract, but the available size or date may not exactly match a business payment.

A clearing houseA clearing house, often written as clearinghouse, is a financial institution formed to facilitate the exchange of payments, securities, or derivatives transactions. The clearing house stands between two clearing firms.Read on Wikipedia → acts between buyers and sellers. Its role as a central counterparty, or CCPA central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk. An extensive overview of the academic literature can be found in Berndsen (2021).Read on Wikipedia →, means each side has obligations to it rather than directly to the original trading partner.

The underlying assetIn finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements:an item that can or must be bought or sold, a future act which must occur, a price at which the future transaction must take place, and a future date by which the act must take place.Read on Wikipedia → can be a commodity, such as gold, or a financial asset, such as a currency. Futures also trade on stock indexes, which measure the performance of groups of shares.

A price quote is usually for a unit of the underlying asset. The size of the contract tells us how that quote translates into a total amount. In the chapter’s gold example, the price is $1,750 per ounce and the contract covers 100 ounces:

100 ounces × $1,750 per ounce = $175,000

The trader does not pay $175,000 simply to open the futures position. That number is the agreed value of the gold covered by the contract.

How a price change becomes a gain or loss

The chapter’s currency example shows the effect of a futures position. A trader buys four contracts covering £62,500 each, for a total of £250,000. The starting futures price is $1.2223 per pound.

The buyer has a long positionIn finance, a long position in a financial instrument means the holder of the position owns a positive amount of the instrument. The holder of the position has the expectation that the financial instrument will increase in value. This is known as a bullish position. The term "long position" is often used in context of buying options contracts.Read on Wikipedia →, which benefits if the price rises. In the example’s final scenario, the rate reaches $1.3000 per pound:

£250,000 × ($1.3000 − $1.2223) per pound = $19,425

If the final rate is $1.2000 instead, the buyer loses $5,575. The short side, which agreed to sell, has the opposite result before costs.

These are the total results of the chapter’s example, excluding interest and fees. If a position is closed earlier, its result depends on the futures price at closing, rather than a later currency rate.

Why the trader needs cash before the end

Futures gains and losses are settled regularly, usually each trading day. The trader also provides marginIn finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty to cover some or all of the credit risk the holder poses for the counterparty. This risk can arise if the holder has done any of the following:Borrowed cash from the counterparty to buy financial instruments, Borrowed financial instruments to sell them short, Entered into a derivative contract.Read on Wikipedia →, which is security for the position’s obligations. A loss may therefore require cash well before the contract’s final date.

In the currency example, the initial margin is $5,000 per contract, or $20,000 for all four. That amount supports a position covering £250,000. The gain or loss is calculated on the whole currency position, not just the money first provided as margin.

A common misunderstanding is to treat that $20,000 as the maximum possible loss. It is not. Losses can exceed the initial margin, and the trader may have to provide more funds to keep the position open.

The amounts here are historical teaching examples, not current exchange requirements. Hull develops the detailed margin, delivery, and settlement procedures in chapter 2.

Two contracts can have similar total results while creating different cash needs along the way. That timing is an important part of choosing between a forward and a futures contract.

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