Introduction to Futures

Kerry Back

A forward contract is a contract to deliver something and to be paid at a later date.
A futures contract is functionally like a forward contract, but it is traded on an exchange with anonymous counterparties and special provisions to deal with default risk.
Primary exchanges are the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).
The futures clearinghouse provides guarantees to both sides in case of a failure to deliver.

Standardization

Futures contracts are standardized regarding quantity, quality, and delivery. Standardization improves liquidity.
Hedgers are left with ``basis risk,’’ meaning the difference between the standardized contract and what, where, and when they really want.
Example: CME/NYMEX WTI (West Texas Intermediate) crude oil contract is for 1,000 barrels to be delivered to Cushing, Oklahoma with restrictions on sulfur, gravity, and other qualities: CME WTI contract specifications.

CME corn: 5,000 bushels of No. 2 yellow corn at par, No. 1 yellow corn at 1.5 cents per bushel over contract price, or No. 3 yellow corn at between 2 and 4 cents per bushel under contract price depending on broken corn and foreign material and damage grade factors.
CME Mexican peso: 500,000 pesos
CME E-mini S&P 500: $50 multiplier (cash settled)

There are some futures contracts with no delivery procedures. They are cash settled.
Instead of delivery, cash changes hands based on the price at maturity of the underlying asset.
Example: E-mini S&P 500 futures. The futures price is an index level (e.g., 4600). It is determined by supply and demand in the futures market, usually $\neq$ actual S&P 500 index.

If you buy the E-mini S&P 500 futures contract and S&P index at maturity > futures price at which you bought, you make money.
You make $50 times the difference between the index at maturity and the futures price.
$50 is the “contract size.”

Contracts are traded for delivery at monthly intervals.
When you hear that ``oil is up 2%,’’ this almost certainly refers to the futures contract that is nearest to maturity (the shortest contract), called the front month contract.
Contracts at different maturities are highly correlated, so other contracts are probably also up, but near-maturity contracts tend to be more volatile, so other contracts are probably up by less than 2%.

The buyer does not pay the seller when a futures contract is traded.
Both have to post collateral (margin) to ensure they can uphold their future obligations. Generally less than 10% of the contract value.

Positions are usually cancelled by making offsetting trades.
Example: buy a contract at $70. Later sell when price is at $80. Made $10 per unit. Would need margin around $7 for this trade.