Subject: Derivatives - Futures Primer

Last-Revised: 10 Apr 2009
Contributed-By: Chris Lott (contact me)

A futures contract is an agreement to buy (or sell) some commodity at a fixed price on a fixed date. In other words, it is a contract between two parties; the holder of the future has not only the right but also the obligation to buy (or sell) the specified commodity. This differs sharply from stock options, which carry the right but not the obligation to buy or sell a stock.

These days, all details of a futures contract are standardized, except for the price of course. These details are the commodity, the quantity, the quality, the delivery date, and whether the contract can be settled in goods or in cash. Futures contracts are traded on futures exchanges, of which the U.S. has eight.

Futures are commonly available in the following flavors (defined by the underlying "cash" product):

Agricultural commodity futures
A commodity future, for example an orange-juice future contract, gives you the right to take delivery of some huge amount of orange juice at a fixed price on some date. Alternately, if you wrote (i.e., sold) the
contract, you have the obligation to deliver that OJ to someone.
Foreign currency futures
For example, on the Euro.
Stock index futures
Since you can't really buy an index, these are settled in cash.
Interest rate futures (including deposit futures, bill futures and government bond futures)
Again, since you cannot easily buy an interest rate, these are usually settled in cash as well.

Futures are explicitly designed to allow the transfer of risk from those who want less risk to those who are willing to take on some risk in exchange for compensation. A futures instrument accomplishes the transfer of risk by offering several features:

  • Liquidity
  • Leverage (a small amount of money controls a much larger amount)
  • A high degree of correlation between changes in the futures price and changes in price of the underlying commodity.

In the case of the commodity future, if I sell you a commodity future then I am promising to deliver a fixed amount of the commodity to you at a given price (fixed now) at a given date in the future.

Here are a couple of contrived examples to illustrate how futures might be traded. If the price of the future becomes very high relative to the price of the commodity today, I can borrow money to buy the commodity now and sell a futures contract (on margin). If the difference in price between the two is great enough then I will be able to repay the interest and principal on the loan and still have some riskless profit; i.e., a pure arbitrage (although I might have to pay some storage fees on the commodity).

Conversely, if the price of the future falls too far below that of the commodity, then I can short-sell the commodity and purchase the future. I can (presumably) borrow the commodity until the futures delivery date and then cover my short when I take delivery of some of the commodity at the futures delivery date. I say presumably borrow the commodity since this is the way bond futures are designed to work; I am not certain that comodities can be borrowed.

Note that there are also options on futures! See the article on the basics of stock options for more information on options, as well as the many articles on futures elsewhere in this FAQ.

The following resource may help.

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