Derivatives - Future Contracts

Future contracts are also agreements between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase.

  • Terms and conditions are standardized.
  • Trading takes place on a formal exchange wherein the exchange provides a place to engage in these transactions and sets a mechanism for the parties to trade these contracts.
  • There is no default risk because the exchange acts as a counterparty, guaranteeing delivery and payment by use of a clearing house.
  • The clearing house protects itself from default by requiring its counterparties to settle gains and losses or mark to market their positions on a daily basis.
  • Futures are highly standardized, have deep liquidity in their markets and trade on an exchange.
  • An investor can offset his or her future position by engaging in an opposite transaction before the stated maturity of the contract.

Example: Future Contracts
Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25 per bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for his next crop, while McDonald's is trying to secure a buying price in order to determine how much to charge for a Big Mac next year. The farmer and the corporation can enter into a futures contract requiring the delivery of 5 million bushels of tomatoes to McDonald's in December at a price of $3.50 per bushel. The contract locks in a price for both parties. It is this contract - and not the grain per se - that can then be bought and sold in the futures market.

In this scenario, the farmer is the holder of the short position (he has agreed to sell the underlying asset - tomatoes) and McDonald's is the holder of the long position (it has agreed to buy the asset). The price of the contract is 5 million bushels at $3.50 per bushel.

The profits and losses of a futures contract are calculated on a daily basis. In our example, suppose the price on futures contracts for tomatoes increases to $4 per bushel the day after the farmer and McDonald's enter into their futures contract of $3.50 per bushel. The farmer, as the holder of the short position, has lost $0.50 per bushel because the selling price just increased from the future price at which he is obliged to sell his tomatoes. McDonald's has profited by $0.50 per bushel.

On the day the price change occurs, the farmer's account is debited $2.5 million ($0.50 per bushel x 5 million bushels) and McDonald's is credited the same amount. Because the market moves daily, futures positions are settled daily as well. Gains and losses from each day's trading are deducted or credited to each party's account. At the expiration of a futures contract, the spot and futures prices normally converge.

Most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. For example, let's suppose that at the expiration date in December there is a blight that decimates the tomato crop and the spot price rises to $5.50 a bushel. McDonald's has a gain of $2 per bushel on its futures contract but it still has to buy tomatoes. The company's $10 million gain ($2 per bushel x 5 million bushels) will be offset against the higher cost of tomatoes on the spot market. Likewise, the farmer's loss of $10 million is offset against the higher price for which he can now sell his tomatoes.

Options: Calls and Puts
Related Articles
  1. Financial Advisors

    Tips on Passing the CFA Level I on Your First Attempt

    Obtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
  2. Financial Advisors

    Putting Your CFA Level I on Your Resume

    Learn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
  3. Professionals

    Investment Analyst: Career Path and Qualifications

    Learn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
  4. Professionals

    CAIA Vs. CFA: How Are They Different?

    Find out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
  5. Professionals

    Equity Investments: CFA Level II Tutorial

    Chapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
  6. Professionals

    What To Expect On The CFA Level III Exam

    The Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
  7. Professionals

    What To Expect On The CFA Level I Exam

    Becoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
  8. Options & Futures

    The Alphabet Soup of Financial Certifications

    We decode the meaning of the many letters that can follow the names of financial professionals.
  9. Professionals

    How to Ace the CFA Level I Exam

    Prepare to ace the CFA Level 1 exam by studying systematically.
  10. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  1. Do financial advisors work only in banks?

    While the majority of financial advisors work for financial institutions such as banks, a large proportion of them are self-employed ... Read Full Answer >>
  2. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  3. Can I use my 401(k) to pay for my college loans?

    If you are over 59.5, or separate from your plan-sponsoring employer after age 55, you are free to use your 401(k) to pay ... Read Full Answer >>
  4. What are the benefits of financial sampling?

    Financial sampling allows auditors to approximate the rate of error within financial statements. For accounting purposes, ... Read Full Answer >>
  5. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  6. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
Hot Definitions
  1. Take A Flier

    The slang term for a decision to invest in highly speculative investments.
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center