Futures Contract
A futures contract is a standardised legal agreement to buy or sell a specific quantity of a commodity, financial instrument, or index at a predetermined price on a specified future date. Futures are traded on organised exchanges, cleared through a central counterparty, and marked to market daily. They are used by producers and consumers to hedge price risk and by traders to speculate on price movements. Futures differ from forward contracts in their standardisation and exchange trading.
Structure
A futures contract specifies the underlying asset, its quantity and quality, the delivery month and location, the minimum price increment, and the daily price limits. Contracts are standardised so that they are fungible and can be traded easily. Each exchange designates a contract size, such as a fixed number of bushels of grain or barrels of oil, and a delivery procedure, though most contracts are closed out before delivery.
Trading occurs in a centralised market with transparent prices. The clearing house interposes itself between buyers and sellers, becoming the counterparty to every trade, which greatly reduces counterparty risk. To manage this risk, the clearing house requires initial margin, collects variation margin through daily settlement, and maintains a guarantee fund.
Margins and settlement
Margins in futures markets are performance bonds, not down payments. The initial margin is posted when a position is opened, and the maintenance margin is the minimum balance that must be kept. If the balance falls below the maintenance level, the trader receives a margin call and must deposit additional funds. Daily marking to market means that gains and losses are settled in cash each day, preventing the accumulation of large uncollateralised exposures.
This system, combined with central clearing, has proved robust, though it can transmit stress when price moves are extreme and margin calls force liquidations. The role of margin in amplifying selling during market stress has been a subject of regulatory scrutiny.
Uses
Futures serve hedging and speculative purposes. A farmer can sell futures to lock in a price for a future harvest, protecting against a fall in prices. An airline can buy futures on jet fuel to stabilise costs. A portfolio manager can use index futures to adjust equity exposure quickly and cheaply. Speculators provide liquidity and contribute to price discovery, taking the other side of hedgers' positions in exchange for the prospect of profit.
Futures also allow leverage, since only a fraction of the contract value is posted as margin. Leverage magnifies both gains and losses and requires disciplined risk management.
Types
Financial futures include contracts on interest rates, currencies, and equity indices. Commodity futures include agricultural products, energy, and metals. Some contracts settle in cash rather than by physical delivery, particularly for indices and financial instruments. Newer contracts include futures on volatility, weather, and emissions allowances.
The commodity futures market has attracted debate about the role of financial investors in price formation, particularly following the food and energy price spikes of the 2000s. Whether index investment destabilises prices or merely reflects expectations remains contested.
Regulation
Futures markets are regulated to protect market integrity, ensure transparency, and limit systemic risk. Regulators set position limits to prevent excessive concentration, monitor large trader positions, and oversee the clearing system. After the global financial crisis, reforms extended central clearing and reporting requirements to more of the derivatives market, including standardised over-the-counter contracts.
Basis, contango and backwardation
The difference between the futures price and the spot price is called the basis. The basis changes as the contract approaches maturity, converging to zero at delivery. The pattern of futures prices across maturities, called the term structure, reveals market expectations and the cost of carry. When futures prices exceed the spot price, the market is in contango, reflecting storage costs, financing costs, and convenience yield. When futures prices are below the spot price, the market is in backwardation, often indicating current scarcity or a strong convenience yield for immediate delivery.
These patterns matter for hedgers and investors. In contango, a long futures position loses value as the contract rolls toward the higher spot price, a cost known as negative roll yield. In backwardation, the roll yield is positive. Commodity index investors are sensitive to these effects, and their returns depend not only on spot price changes but also on the shape of the futures curve.
Delivery and cash settlement
Most futures contracts are closed out before delivery, but the delivery mechanism anchors futures prices to the physical market. Delivery specifications, including grade, location, and timing, affect the value of the contract and can create basis risk between the futures price and the price of the specific grade a hedger uses. Cash-settled contracts, common for indices and financial futures, avoid the need for physical delivery by settling against a reference price.
The credibility of the delivery mechanism is important for market functioning. If delivery is difficult or costly, futures prices can deviate from the underlying asset price, reducing hedging effectiveness. Exchanges therefore design contracts carefully, specifying deliverable grades and locations to ensure that the contract reflects the relevant market.