General Theory - The Futures Contract
The Futures Contract
Forward contracts can conform to some degree of standardization, although they do not have to. They can be customized in both quantitative and qualitative terms as required by the two parties who enter into the agreement. Forwards are generally clubby "gentlemen's agreements" that are entered into away from the public setting of an exchange; if positions are traded after the deal is made, that is, likewise, a private affair. Forward contracts carry counterparty risk as no intermediary stands between the two parties, either of whom could renege on their obligation.
Futures Compared To Other Securities
Elements of a forward contract:
- Contains non-standardized terms,
- Trades over the counter and is illiquid,
- Has no third party guarantee,
- Is unregulated,
- Is private,
- Margin requirements do not exist,
- Bears counterparty (default) risk, and
- Generally held to expiration - offsetting transactions are less common.
Elements of a futures contract:
- Its terms are standardized in terms of quantity of goods and delivery dates,
- It trades on an exchange that provides pricing transparency (it is an exchange-traded obligation),
- It is guaranteed by a third party, the clearinghouse, there is no counterparty risk.
- Its traders must post a good-faith margin deposit, and
- It trades in a market regulated by a specific government agency.
Because futures trade in undifferentiated commodities and forwards can be tailored to whatever sort of transaction appeals to a buyer and a seller, there have been some truly unique futures contracts. Perhaps the most famous deal occurred in the 1990s, when rock star David Bowie entered into a forward agreement to sell to his record company the rights to songs he hadn't even written yet.
Most futures contracts, it might surprise you to learn, never exist long enough to be delivered against. Far more often, there is an offset, also called a reversing trade. This is a transaction that liquidates a purchase of futures contracts through the sale of an equal number of contracts of the same delivery month, or liquidates a short sale of futures through the purchase of an equal number of contracts of the same delivery month. Both must occur on the same exchange.
For example, let's consider a trader who, on June 1, takes a position to buy 40,000 pounds of live cattle in October for $500 per hundred pounds. Living in a high-rise apartment, this sophisticate has no intention of taking delivery; she bought the contract expecting to sell it before its expiry. Beef prices increase over this time and on June 15 she executes a transaction to sell 40,000 pounds of live cattle for $650 per hundred pounds. By entering into this trade, she closes out her position in terms of the underlying commodity and is not responsible for either buying or delivering a single head of cattle. This netting of positions is what makes it feasible for commodities futures to be traded as financial products, like stocks and bonds.
Of course, not everyone in a public market can be trusted to always live up to her obligations. For this reason, every futures exchange has an associated clearinghouse which, for a reasonable fee, guarantees that all traders will honor its terms. The clearinghouse ensures fulfillment of every contract by acting as the buyer to every seller, then turning around to act as the seller to every buyer. The clearinghouse must, at the risk of losing its reputation in the market and its relationship to the exchange, honor every agreement. It is the middleman. The clearinghouse may be part of the futures exchange or a separate entity; the exchange or a separate group of individuals may own it.
To summarize, a clearinghouse performs the following functions, to wit:
- Clears and settles trades, serving as an intermediary between the two trading parties; this function ensures market integrity;
- In this way, it acts as a guarantor of performance
Exchange members may be clearing or non-clearing. Clearing members are members of both the clearinghouse as well as the exchange; non-clearing members are members of the exchange only. Clearing members tend to be the larger institutions. As part of their clearing responsibilities, these firms must have financial strength as they act as intermediaries between the clearing house and clients with open futures positions. To this end, these firms are required to maintain required margin based upon clients' net positions. The clearinghouse deals with clearing firms, not directly with customers Non-clearing firms trade through clearing firms and may not deal directly with the clearinghouse.
Most trades are transacted directly through clearing members. The bulk of trading through non-clearing members is by speculators trading on their own accounts.
Although offsets are the most frequently preferred means to close a futures contract, there are some who, in the course of their business, need to take delivery of the actual commodity.
Less than 1% of all commodities end in delivery. That holds true even if we expand the definition of "delivery" to include cash settlement, in which traders make payment on the expiration date to settle any gains or losses, rather than making physical delivery. Cash settlement enables trading in interest rates or index futures, because a "Libor" or a "Nasdaq 100" cannot be physically delivered.
Still, delivery provisions will be on the Series 3 exam, so you need to know that a basis grade is the quality of a commodity used as the standard of a futures contract. A premium or a discount would be the amount a price would be increased or decreased to purchase a better-or lower-quality commodity. These are stipulated by the exchange. For example, the CBOT does not just trade corn, it trades No. 2 Yellow corn at prevailing rates. If you want to buy a contract for No. 1 Yellow corn, you would have to pay a premium of 1.5 cents/bushel over the standard contract price for No. 2 Yellow. If you want to buy a contract for No. 3 Yellow, it would be at 1.5 cents/bushel discount below the price for No. 2 Yellow.
Personal FinanceIf you're deciding whether to get a degree abroad, first do your research and talk to alumni who have completed the same program.
Investing BasicsA spot market is a market where a commodity or security is bought or sold and then delivered immediately.
Mutual Funds & ETFsFind out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
Chart AdvisorTraders are turning to these exchange-traded notes and exchange-traded funds to analyze key commodities and determine what could be coming next.
Credit & LoansU.S. students place 27th in math and 20th in science out of 34 countries. The United States must reform its education system or harm future economic productivity and global trade competitiveness.
Investing NewsNot sure where oil and gold are headed? The answer is complex.
Investing BasicsForward rate agreement (FRA) refers to an interest rate or foreign exchange hedging strategy.
InvestingUse Fibonacci studies to analyze gold by picking out hidden harmonic levels that can provide major support or resistance.
Options & FuturesVolatility is not the only way to measure risk. Learn about the "new science of risk management".
Mutual Funds & ETFsFind out more about the United States Natural Gas exchange-traded fund, the characteristics of the ETF and the suitability and recommendations of it.
A security with a price that is dependent upon or derived from ...
A securities license entitling the holder to register as a limited ...
A transaction that can cancel out a forward contract that has ...
The security that is delivered by the short position holder in ...
A financial instrument whose value is based on the value of another ...
A qualification earned by insurance professionals and conferred ...
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 >>
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 >>
Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>
The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>