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.