Commercial contracts calling for the purchase or sale of specified quantities of a good at specified future dates. The good in question may be grain, livestock, precious metals, or financial instruments such as treasury bills. Up until the time the contract calls for the delivery of the good, the contract is subject to speculation. Futures contracts originated in the trade in agricultural commodities; for example, American grain farmers were able to sell their harvest in advance on the Chicago Board of Trade, a commodity exchange.
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A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation. In other words, the owner of an options contract may exercise the contract, but both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlyer to the buyer, or, if it is a cash-settled futures, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations
Futures contracts, or simply futures, (but not *future or *future contract) are exchange traded derivatives. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.
Forwards transact only when purchased and on the settlement date. Futures, on the other hand, are margined daily, every day to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market).
The result is that forwards have higher credit risk than futures, and that funding is charged differently.
The fact that forwards are not margined daily means that, due to movements in the price of the underlying asset, a large differential can build up between the forward's delivery price and the settlement price.
This means that one party will incur a big loss at the time of delivery (assuming they must transact at the underlying's spot price to facilitate receipt/delivery).
This in turn creates a credit risk for forwards, but not futures. More generally, the risk of a forward contract is that the supplier will be unable to deliver the required asset, or that the buyer will be unable to pay for it on the delivery day.
The margining of futures eliminates much of this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. This means that there will usually be very little additional money due on the final day to settle the futures contract: only the final day's gain or loss, not the lifetime gain or loss.
In addition, the daily futures-settlement failure risk is borne by an exchange, rather than an individual party, limiting credit risk in futures.
Consider a futures contract with a $100 price: Let's say that on day 50, a forward with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that forward costs $90. This means that the mark-to-market would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of the other side of the future.
A forward-holder, however, would pay nothing until settlement on the final day, potentially building up a large balance; this may be reflected in the mark by an allowance for credit risk. So, except for tiny effects of convexity bias (due to earning or paying interest on margin), futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes, while the forward's spot price converges to the settlement price. Thus, while under mark to market accounting, for both assets the gain or loss accrues over the holding period, for a futures this gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized until expiry.
Note that, due to the path dependence of funding, a futures contract is not, strictly speaking, a European derivative: the total gain or loss of the trade depends not only on the value of the underlying asset at expiry, but also on the path of prices on the way. This difference is generally quite small though.
Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.
Customer margin Within the futures industry, financial guarantees required of both buyers and sellers of futures contracts and sellers of options contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. Also referred to as performance bond margin.
Initial margin is the money required to open a derivatives position (in futures, forex or CFDs) It is a security deposit to ensure that traders have sufficient funds to meet any potential loss from a trade.
If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned.
In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day.
Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the client’s account.
Some US Exchanges also use the term “maintenance margin”, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term “initial margin” and “variation margin”.
The Initial Margin requirement is established by the Futures exchange, in contrast to other securities Initial Margin which is set by the Federal Reserve in the U.S. Markets.
A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.
Maintenance margin A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls.
Performance bond margin The amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.
Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1)(year/trade_duration)-1. For example if a trader earns 10% on margin in two months, that would be about 77% annualized.
Expiry is the time when the final prices of the future is determined. For many equity index and interest rate futures contracts (as well as for most equity options), this happens on the third Friday of certain trading month. On this day the t+1 futures contract becomes the t futures contract. For example, for most CME and CBOT contracts, at the expiry on December, the March futures become the nearest contract. This is an exciting time for arbitrage desks, as they will try to make rapid gains during the short period (normally 30 minutes) where the final prices are averaged from. At this moment the futures and the underlying assets are extremely liquid and any mispricing between an index and an underlying asset is quickly traded by arbitrageurs. At this moment also, the increase in volume is caused by traders rolling over positions to the next contract or, in the case of equity index futures, purchasing underlying components of those indexes to hedge against current index positions. On the expiry date, a European equity arbitrage trading desk in London or Frankfurt will see positions expire in as many as eight major markets almost every half an hour.
The situation where the price of a commodity for future delivery is higher than the spot price, or where a far future delivery price is higher than a nearer future delivery, is known as contango. The reverse, where the price of a commodity for future delivery is lower than the spot price, or where a far future delivery price is lower than a nearer future delivery, is known as backwardation.
When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a future is determined via arbitrage arguments. The forward price represents the expected future value of the underlying discounted at the risk free rate—as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away; see rational pricing of futures.
Thus, for a simple, non-dividend paying asset, the value of the future/forward, F(t), will be found by compounding the present value S(t) at time t to maturity T by the rate of risk-free return r.
or, with continuous compounding
This relationship may be modified for storage costs, dividends, dividend yields, and convenience yields.
In a perfect market the relationship between futures and spot prices depends only on the above variables; in practice there are various market imperfections (transaction costs, differential borrowing and lending rates, restrictions on short selling) that prevent complete arbitrage. Thus, the futures price in fact varies within arbitrage boundaries around the theoretical price.
The above relationship, therefore, is typical for stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. on corn after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist, for example on wheat before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date), the futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the future asset, as expressed by supply and demand for the futures contract.
In a deep and liquid market, this supply and demand would be expected to balance out at a price which represents an unbiased expectation of the future price of the actual asset and so be given by the simple relationship
In fact, this relationship will hold in a no-arbitrage setting when we take expectations with respect to the risk-neutral probability. In other words: a futures price is martingale with respect to the risk-neutral probability.
With this pricing rule, a speculator is expected to break even when the futures market fairly prices the deliverable commodity.
In a shallow and illiquid market, or in a market in which large quantities of the deliverable asset have been deliberately withheld from market participants (an illegal action known as cornering the market), the market clearing price for the future may still represent the balance between supply and demand but the relationship between this price and the expected future price of the asset can break down.
Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid 19th century, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts. Although contract trading began with traditional commodities such grains, meat and livestock, exchange trading has expanded to include metals, energy, currency and currency indexes, equities and equity indexes, government interest rates and private interest rates.
Contracts on financial instruments was introduced in the 1970s by the Chicago Mercantile Exchange(CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbörse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 75 futures and futures options exchanges worldwide trading to include:
Hedgers typically include producers and consumers of a commodity.
For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.
The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator for example.
The CFTC publishes weekly reports containing details of the open interest of market participants for each market-segment that has more than 20 participants. These reports are released every Friday (including data from the previous Tuesday) and contain data on open interest split by reportable and non-reportable open interest as well as commercial and non-commercial open interest. This type of report is referred to as 'Commitments-Of-Traders'-Report, COT-Report or simply COTR.
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