The Futures Market
I. Introduction
The futures market is a worldwide collection of exchanges which trade standardized contracts in products for future delivery at a fixed price. The largest futures exchanges can be found in New York, Chicago, and London, but futures are also traded in many of the largest Asian cities. Another name typically used for futures markets is commodity markets. A wide variety of products are traded on the futures market, and include such categories of products as grains and meat, fibers, food, lumber and rubber, fuels, metals, financial instruments and money, stock indexes, and foreign currencies. Starting in the 1970's, financial futures began to grow in popularity, and now constitute the majority of futures contracts traded. Because futures have value depending on some underlying product, we often call them a derivative financial instrument. Their value is derived from the value of another product. Any financial instrument whose value depends on the value of an underlying product is called a derivative. An option is another example of a financial derivative.
The central element of futures markets is the futures contract. To understand it clearly, consider the case of corn futures traded on the Chicago Board of Trade (CBOT). Each contract is for 500 bushels of corn and will have an expiration date, say March 2001. This contract will have a price for the corn to be delivered after expiration of the agreement. For example, the price per bushel might be $2.85 1/2. If one is selling futures (called the short), then one is agreeing to sell 5000 bushels in March of 2001 at $2.85 1/2 per bushel. The price of the contract would be $14,275 = ($2.85 1/2 per bushel)(5000 bushels). If one is buying corn futures (called the long), then one is agreeing to buy 5000 bushels of March corn at $2.85 and a half. However, many people buy and sell these contracts without worrying about delivery of the corn. They can offset their position by simply entering on the other side of the market. A long could offset his position by selling, while a short could offset his position by buying futures.
The futures price on the contract will change from day to day. For example, if corn futures are priced at $2.85 and a half per bushel today, they may be higher or lower tomorrow. If today the price (per bushel) is $2.85 1/2, and tomorrow the price is $2.87, then whoever is long futures tomorrow is agreeing to buy 5000 bushels at $2.87 per bushel at expiration of the contract. One can experience profits or losses when one buys or sells futures. If today I am long (buy) corn futures, and the futures price rises, then I make a profit. If I am short (sell) corn futures, and the futures price rises, then I will have a loss.
When one buys or sells futures, one must make a deposit with the broker. This money is called the initial margin (say 5% of the value of the contract being bought or sold). As the futures price changes, one may be asked to add to this to keep a minimum amount called the maintenance margin. For example, suppose that you go short (sell) March 2001 corn futures at $2.85 1/2. The price of the contract is $14,275. Assume that you are required to deposit $714 as an initial 5% margin. Furthermore, suppose that the maintenance margin is $500. Whatever happens to the futures price, you must have at least $500 on deposit with your broker. Now suppose that the next day, the corn futures price rises to $2.90 which means that the contract price rises to $14,500 = ($2.90)(5000). Note that you are selling 5000 bushels at $14,275, while the current contract price allows a seller to get $14,500. You have a LOSS of $225. This $225 will be deducted from your margin account which means that you now have $489 ($714 - $225). Now you have fallen below your maintenance margin of $500, and your broker will demand that you deposit additional funds. Your contract is now priced at $14,500, which means that you are now agreeing to sell 5000 bushels of corn in March of 2001 at $14,500. Any subsequent changes in price will be credited or charged to your margin account. This process is called daily settlement and is an important difference between futures and forward markets. You can offset your position at any time by simply going long (buying) an identical corn futures contract.
II. Futures Quotations
Basic quotations on futures prices are published in each issue of the Wall Street Journal. The quotations will give the product being traded; the exchange on which it is traded; the quantity of product for each contract; the unit of denomination of the price for the future; the expiration date for the future; the opening, high, low, and settlement price during the day; the change in settlement price from the previous trading day; the high and low price over the lifetime of the future; and the open interest (i.e. the number of outstanding contracts for the future).
III. Futures, the Spot Market, and the Value of News
Perhaps the most obvious variable influencing the futures price of a product is its spot or cash price. The spot price of a product is the price which must be paid for immediate ownership of that product. Cash or spot price quotations are usually published on the same page of the Wall Street Journal as the futures prices. Typically, as spot prices on products rise, the futures prices on such products will also rise.
Another important relation between spot and futures markets is that the futures price will always converge to the spot price as the futures contract nears expiration. Any difference between these two prices will always be arbitraged away as the contract expires. Therefore, the effect of changes in spot prices on futures prices will be greater for contracts which are due to expire soon.
To effectively trade in futures markets, one must be extremely knowledgeable about the supply and demand conditions for the product in which one is trading. Economic and political news will affect the futures markets. This is perhaps easiest to see by considering the 1990 Persian Gulf War and the dramatic effect it had on petroleum futures. However, smaller news stories such as labor strikes in South Africa or political upheavals in Russia can have substantial effects on some commodities such as gold. Poor weather in Colombia or Brazil can affect coffee futures. Since this news is global in nature, and since the markets react so quickly to such reports, futures traders must have quick access to such information to trade effectively.
IV. Types of Futures
Besides the more mundane types of futures such as wheat, copper, and natural gas, a wide variety of financial futures are being traded each day all over the world. These include futures on stock indexes such as the S&P 500; futures on T-Notes and T-Bonds; and futures on T-Bills and Eurodollars. Foreign currency futures were introduced in 1972 and have grown in volume every year. Most trading is concentrated in British pounds, Japanese yen, Swiss and French francs, as well as German marks.
For stock index futures there is no physical delivery of the index when the contract expires. Instead, a cash equivalent settlement is made when the contract expires. Stock index futures are especially useful for fund managers who are seeking to hedge the systematic risk of their portfolios. Systematic risk refers to risk in a portfolio which cannot be eliminated by diversifying the portfolio. It is the risk created by general movements in the market.
It is important to realize that the price quotations of futures in bonds, bills, and Eurodollars are not the actual prices at which one buys and sells. They are subject to conversion factors. These conversion factors are somewhat complicated, so they will not be discussed here. In addition, such things as the delivery date, maturity of the bond, and the accrued interest will affect the actual price of the futures. Naturally, one must make a careful study of each of these factors in order to trade effectively.
Discussion Questions:
#1. What is the meaning of going long and going short in the futures market?
#2. Suppose that you are long corn futures and the futures price rises. Do you make
money or lose money? Why?
#3. What is meant by offsetting one's futures position?
#4. Explain the concepts of initial and maintenance margins?
#5. What information is given in the Wall Street Journal on futures quotations?
#6. What categories of futures products are commonly traded?
#7. Why does news affect the futures markets? Give some examples.
#8. Suppose you must pay 1 million British pounds 3 months later. You believe that the
pound will appreciate. How could you use currency futures to hedge yourself?
#9. What kind of risk can be hedged using stock index futures?
#10. What kind of futures does Taiwan have? Who would use these futures?