Chapter 3: Futures Contracts

Objective

In this chapter we will learn about Futures contracts in detail. We will learn key features of futures contracts, how futures work, types of futures, factors influencing futures pricing, uses of futures and risk involved in futures trading.

Section 3.1

Introduction to Futures Contracts

Definition: A futures contract is a standardized agreement between two parties to buy or sell an underlying asset (like a commodity, stock, or currency) at a predetermined price on a specified future date.
- Futures contracts are traded on exchanges (such as the NSE, CME, or EUREX), and their terms are standardized to ensure consistency in the contract specifications.
- Unlike forward contracts, futures are regulated and marked-to-market daily, minimizing counterparty risk.

Purpose of Futures Contracts:

Hedging: Futures are widely used by companies and investors to hedge against the risk of adverse price movements in the underlying asset.
Speculation: Traders also use futures to speculate on price movements, aiming to profit from future price changes in the asset.
Arbitrage: Futures contracts are used in arbitrage strategies to exploit price differences between markets.

Section 3.2

Key Features of Futures Contracts

Standardization:
- Futures contracts are standardized, meaning that all contracts for a specific asset share the same terms, such as the size of the contract, expiration date, and settlement procedures.
- For example, a crude oil futures contract on the CME typically represents 1,000 barrels of oil.

Settlement:

Physical Settlement: In some futures contracts, the actual underlying asset is delivered at the contract’s expiration. For example, in commodity futures, such as crude oil or gold, the seller delivers the physical commodity to the buyer.
Cash Settlement: In other contracts, the position is closed with a cash payment based on the difference between the contract price and the market price of the underlying asset at expiry. Financial futures (such as index futures) are typically cash-settled.

Speculation: Traders can use derivatives to speculate on the price movement of an underlying asset. Unlike investing in the asset itself, derivatives offer leverage, meaning a small investment can lead to larger returns (or losses).

Example: A trader may speculate that the price of gold will rise, and purchase a gold futures contract.

Expiration Date:

Each futures contract has an expiration date, at which point the contract is settled. The trader can either:
- Hold until expiration (and receive the physical asset or settle in cash), or
- Close the position before expiration to avoid delivery and settle the profit/loss.

Marking to Market:
- Futures contracts are marked-to-market daily, meaning that the gains and losses of the position are calculated and settled on a daily basis.
- Margin Calls: If the market moves against a trader’s position, a margin call may be issued, requiring the trader to add funds to maintain the position.

Section 3.3

How Futures Contracts Work

The Mechanics:

A futures contract is created when two parties agree on the terms (price, quantity, expiry). A buyer agrees to purchase the underlying asset at the agreed price, and the seller agrees to deliver it.
The buyer of the contract is said to be long, and the seller is said to be short the contract.

Example:

Suppose a trader enters into a futures contract to buy 1,000 barrels of crude oil at $60 per barrel, with a contract expiration in 3 months.
If the price of crude oil rises to $65 per barrel by expiration, the buyer profits by $5 per barrel.
If the price falls to $55 per barrel, the buyer incurs a loss of $5 per barrel.

Mark-to-Market Process:

Each day, the exchange calculates the difference between the contract price and the current market price of the underlying asset. This difference is credited or debited to the traders’ margin accounts.
If the position moves in the trader’s favor, the trader’s margin account is credited with profits. If it moves against them, their account is debited.
A margin call occurs when a trader’s margin falls below the required minimum, and additional funds must be deposited to maintain the position.

Section 3.4

Types of Futures Contracts

Futures contracts can be classified based on the underlying asset, which can range from commodities to financial instruments.

Commodity Futures:
- These futures contracts are based on the price of physical goods such as agricultural products, metals, and energy.
  - Examples:
    - Crude oil futures: The price of oil is highly volatile, and oil producers or consumers use futures to lock in prices.
    - Gold futures: Traders use gold futures to speculate on or hedge against the price of gold.
    - Corn futures: Used by farmers to lock in prices for their crops.

Financial Futures:

These futures contracts are based on financial instruments like stock indices, interest rates, and foreign currencies.
- Examples:
  - Stock index futures (e.g., S&P 500 futures, Nifty futures): These track the performance of an index and are popular for hedging equity portfolios.
  - Currency futures: Contracts that involve the future exchange of currencies, such as EUR/USD futures.
  - Treasury futures: Futures contracts that are based on U.S. government bonds or Treasury notes.

Interest Rate Futures:

These are used to hedge against or speculate on changes in interest rates. For example, traders might use futures based on U.S. Treasury bills or LIBOR rates.
Example: A trader who expects interest rates to rise may sell Treasury futures to lock in a higher yield.

Section 3.5

Uses of Futures Contracts

Futures contracts serve multiple purposes for various market participants:

Hedging:
- Definition: Hedging involves using futures to offset potential losses in another asset or investment.
- Example:
  - A wheat farmer: A farmer may sell wheat futures to lock in a price for their crop before harvest. If the price of wheat falls by harvest time, the loss in the value of their crop will be offset by the gain in the futures contract.
  - A multinational corporation: A company that imports raw materials in foreign currency may use currency futures to hedge against the risk of adverse exchange rate movements.

Speculation:

Traders and investors use futures to speculate on the direction of an asset’s price.
Example:
- A trader may buy crude oil futures if they believe oil prices will rise due to geopolitical instability or supply disruptions.
- A financial institution may speculate on interest rates using Treasury futures, buying when they believe rates will fall and selling when they believe rates will rise.

Arbitrage:

Futures contracts are often used by arbitrageurs to exploit price discrepancies between markets or contracts.
Example: If a commodity futures contract is trading at a different price on two different exchanges, an arbitrageur may buy the asset at a lower price on one exchange and sell it at a higher price on the other exchange to lock in a risk-free profit.

Section 3.6

Futures Contract Pricing

The price of a futures contract is influenced by several factors, including the price of the underlying asset, time to maturity, and the cost of carry.

Spot Price:
- The spot price is the current market price of the underlying asset.
- Futures prices often closely track the spot price, adjusted for factors like storage costs, interest rates, and dividends.

Cost of Carry:
- The cost of carry refers to the expenses associated with holding the underlying asset, such as storage costs, insurance, and financing costs.
- For example, if a trader wants to hold a futures contract on crude oil, they may need to account for storage costs and interest rates for financing the position.

Futures Pricing Formula:
- The price of a futures contract is typically derived from the spot price, adjusted for the cost of carry. The formula is: $Yield\text{Futures Price} = \text{Spot Price} + \text{Cost of Carry} – \text{Income Yield}$
Futures Spread:
- A futures spread refers to the difference between the prices of two futures contracts, which can be based on different expiration dates or different contract types.
- Traders use spread strategies (e.g., bull spreads, bear spreads) to profit from changes in the spread rather than outright price changes.

Section 3.7

Risks in Futures Trading

Leverage Risk:
- Futures contracts use leverage, meaning a small movement in the price of the underlying asset can result in significant profits or losses.
- Example: A 1% price change in the underlying asset can lead to a 10% or more change in the trader’s margin.
Market Risk:
- Futures traders are exposed to market risk, as prices can move in unexpected directions due to factors like economic events, geopolitical developments, or weather patterns (in the case of agricultural commodities).

Liquidity Risk:
- Although futures markets are generally liquid, some contracts (especially on niche or illiquid assets) may lack sufficient trading volume, making it difficult to enter or exit positions without affecting prices.
Margin Risk:
- Since futures contracts are margined, traders need to maintain a margin balance in their accounts. If the margin falls below the required level due to adverse price movements, a margin call is issued, requiring the trader to deposit additional funds.

Final Takes

Conclusion

Futures contracts are essential tools in financial markets, providing traders, investors, and businesses with the ability to hedge risks, speculate on price movements, and take advantage of arbitrage opportunities. They are standardized contracts traded on exchanges, with built-in mechanisms to ensure transparency, liquidity, and regulation.

Understanding how futures contracts work, their pricing, and the risks involved is crucial for anyone looking to participate in futures trading, especially in F&O markets. In the next chapters, we will explore how options contracts work and how they differ from futures, providing a more complete picture of F&O trading strategies.