Dakota State University
Madison, SD, USA

Futures Primer

Definitions: Derivatives, Futures, and Options

Derivatives are financial securities whose values depend on (are derived from) the value of some underlying asset. The underlying asset might be just an index. And the value of the derivative actually reflects the change in the value of the underlying asset.

A futures contract is an agreement to buy or sell a specific quantity of some asset at some time in the future at a price agreed upon at the time the agreement is made.

An option gives the buyer the right, but not the obligation, to buy (a call) or sell (a put) a specific quantity of some asset at some time in the future at a price agreed upon at the time the agreement is made.

Purpose of Derivatives

Derivatives exist to redistribute risk. The risk involved is the uncertainty in future prices. Derivatives markets are considered very risky, but they are different from, say, casinos. The risk in derivative markets already exists in the cash/asset markets, and people facing that risk are trying to reduce it or eliminate it. In casinos the risk is an artificial risk created to allow a game to be played.

Eligible Assets

Any asset whose future price is uncertain could be a candidate for a futures contract. There must be enough consumers and producers who want to diminish the price uncertainty (hedgers) and enough other traders willing to take on that risk (speculators) in order for the contract to be successful, i.e., worthwhile for the contract to be listed on a futures exchange.

Examples of Assets covered by Futures Contracts

Corn, wheat, cotton, coffee, cocoa, pork bellies, gasoline, heating oil, lumber, live cattle, gold, silver, yen, pounds, pesos, marks, T-bills, T-bonds, Eurodollar CDs, S&P 500 Index, single stocks, weather, ...

A Specific Example: Corn Prices

Assume a farmer knows in May he will have 5,000 bushels of corn to sell in early September. The price of corn at the moment is $2.50, but he can't sell his corn now. The agricultural community and the financial markets estimate that corn will be selling for $3.00 a bushel in September. If the farmer would like to make sure he gets $3.00 a bushel for his corn in September (5,000 x $3 = $15,000), he could sell a standard futures contract on corn (5,000 bushels) now, in May. That contract will be priced at $3.00.

Assume that when September comes corn is actually selling for $2.70. He sells his 5,000 bushels of corn at $2.70 ($13,500), which is a price less than the $3.00 per bushel he wanted. However, the futures contract on corn will have dropped in price from $3.00 to $2.70, a decrease of $.30. Since the farmer sold the contract a decrease in price represents a profit of $.30 per bushel ($1,500). So the farmer gets his $3.00 per bushel target price even though the price of corn is not at $3.00 when he sells his corn. (Total revenue = $13,500 + 1,500 = $15,000)

However, assume that when September arrives corn is actually selling for $3.50. He sells his corn for $3.50 (5,000 x $3.50 = $17,500), which is a price higher than he was hoping for. However, the futures contract will have risen in price by $.50. Since the farmer sold the contract the increase in price represents a loss of $.50 per bushel (5,000 x $.50 = $2,500). So the farmer still nets his target price of $3.00 ($17,500 - 2,500 = $15,000), even though the market price is higher than that.

By using the futures contract the farmer has eliminated uncertainty in the future price of corn.

A Zero-Sum Game

Now, where did the profit or loss come from on the futures contract? From speculators (or another hedger facing the opposite risk exposure). In the first scenario a speculator will have lost the $.30 per bushel that the farmer made. In the second a speculator will have earned the $.50 per bushel that the farmer lost. The farmer was hedging, redistributing the price risk to the speculator, who was willing to take on the risk for the chance to earn a substantial profit. What the farmer makes or loses a speculator must lose or make. Futures trading is a zero-sum game. (Unlike the stock market, which in theory could simply keep rising all the time.)

Daily Marking to Market

A gain or loss on a stock purchase is not realized until the stock is sold. However, futures contracts are marked to market daily. A futures contract has no value when purchased or sold initially. During the day as the price fluctuates the contract will take on value depending on whether the price rises or falls and whether the trader was long (bought the contract) or short (sold the contract). Whatever gain or loss was achieved during the day is added or subtracted to the trader's account at the end of each trading day. A stock market investor could buy a stock and forget about it, but a futures trader cannot do that. Even if a futures trader is right about the long-term trend in the price, the trader's account could be wiped out by a sharp intraday change in price.

(Contracts are not really bought or sold. Traders enter contracts to buy or sell the underlying asset. But it is easier to talk about buying or selling the contract itself.)

Leverage and Margins

Futures trading is highly leveraged. The price change on a $1,000,000 Eurodollar CD can be controlled with a margin of about only $700. (Margins fluctuate.) These margins are not a down payment on the contract. (Margin on stock is a down payment on the stock.) The margins are good faith deposits against an adverse change in price. The loss on a futures contract can be much greater than the margin. If the loss is greater than the funds in the trader's account, the trader must put in more money.

Delivery

Actual delivery of the underlying asset of a futures contract is not usually expected. Only about 1% of futures contract result in actual delivery of the asset. The other contracts are "offset" by simply doing the opposite of the original order. The farmer in the above example would have bought a corn contract to cancel the one he had sold earlier. Horror stories of having 40,000 pounds of pork bellies dumped in your garage unexpectedly don't really happen. However, if you are holding a contract at expiration and don't really want to take or make delivery as called for in the contract, it can be very expensive to unravel the deal. The contracts are legally enforceable.

Consequently many traders offset any contracts at the end of the month before the month of delivery, just so there is no chance of getting caught holding a contract at expiration. This is especially true because some contracts give the seller a wide range of days during the expiration month in which to make delivery. Other contracts, like Eurodollars, specify cash settlement of the contracts; delivery never takes place.

Financial Futures

Listed futures contracts have existed in the United States since the Civil War days. Futures on commodities started trading in Chicago, the heart of the grainbelt. However, financial futures started in the very early 1970's when currency exchange rates were allowed to float free for the first time. This injected a large dose of price (exchange rate) uncertainty into any international transaction. Futures contracts on currencies were created to allow parties to international transactions to hedge the price uncertainty they faced.

Other financial futures were added to allow hedging (and therefore speculating) of interest rate risk, gold and silver prices, and eventually stock market indexes and now even some individual stocks. Financial futures now account for a far greater volume and amount of money than physical commodities.

An Example of A Hedge using a Financial Futures Contract

Suppose a bank is going to buy a Eurodollar CD in three months. The bank is concerned that interest rates may fall during the three months and that the CD will not carry as high an interest rate as the bank would like. The bank could buy a futures contract on a Eurodollar to hedge against a drop in interest rates.

Suppose Eurodollars currently carry a 5.50% add-on interest rate. The financial community and the market think Eurodollars will be yielding 5.75% in three months. The bank could buy a futures contract on a Eurodollar CD. That contract would carry an index price of 94.25 (100-5.75).

If in three months new Eurodollar CDs are actually yielding 5.25%, then the Eurodollar futures contract will have risen to 94.75 (100-5.25). That would represent an increase in the index of .50 and represents a profit to the bank of $1,250 (50 ticks x $25/tick). That profit would offset the lower interest rate then available on the new Eurodollar CDs.

If in three months new Eurodollar CDs are actually yielding 6.00%, then the Eurodollar contract will have fallen to 94.00 (100-6.00). That would represent a loss of $625 (25 ticks) to the bank. However, the bank will be buying a CD that will return a higher interest rate than anticipated.

In both cases the bank will achieve near its target rate of 5.75%. Note that the bank cannot lock in the current rate of 5.50% unless it actually buys a Eurodollar CD. It can only lock in (approximately) the 5.75% that the market thinks now will be available in three months.

Contract Specifications

Each contract has different specifications because the underlying assets are different. The contract specifies the asset, the amount of the asset, and the date of expiration. The advantage to having exchanges is that the contracts are standardized and therefore much more attractive to both hedgers and speculators. In futures trading the two parties doing the trading are actually making the contract with the exchange's clearinghouse, which guarantees performance of both sides of the transaction. So a trader wishing to offset a contract does not have to find the other party to the original transaction; the clearinghouse will substitute any other party.

Mechanics of Futures Trading

Futures trading was done in pits on the floor of the exchanges. In pits trading is done by "open outcry," giving anyone within earshot a chance at the transaction. Since it is very noisy in the pits hand signals are used extensively.

To see an example of the pit trading of futures in action see Eddie Murphy's movie "Trading Places," which includes trading of futures contracts on orange juice as an important element in the story.

Nowadays most of the trading is done electronically. The floor of the Chicago Board of Trade, for example, has become relatively quiet. Although a few pits are still active, most of the action is now going on silently on computers.

Risk in Futures Trading

Hedgers are trying to reduce the risk they face in the asset side of their position. Therefore, losses hedgers incur in the futures trading is offset by profits in the asset market (though there may be a considerable time mismatch in the losses and profits and margin calls could cause uncomfortable interim negative cash flows).

Speculators, on the other hand, are assuming risk that is not hedged in the asset market. Trading futures for speculators is very risky. A recent statement by a futures brokerage firm estimates that about 80% of futures traders lose. Prices can move very fast in futures trading, and the exceedingly high leverage inherent in futures contracts makes the profits and losses mount very rapidly. The expressions "wiped out" and "probability of ruin" are both commonly used in futures trading.

Of those who do win many win only a very little. But- ah, ha!- some win spectacularly well, turning a few thousand dollars into many millions of dollars in just a few years. Hence the strong attraction to investors willing to take on the large risks of futures trading.

College of Business & Information Systems
Dakota State University
Madison, SD 57042
Page Manager: Jim Janke
Contact at: jim.janke@dsu.edu
URL: http://courses.dsu.edu/finance/fmc/primer.htm
Last update: March 19, 2007