Because futures contracts are derived from underlying assets, they belong to a family of financial instruments called derivatives.
Futures contracts all have specifications which outline the following items:
Not all futures contracts are physically deliverable, such as financial futures where the underlying is an instrument. Transfer of the asset still takes place, however.
Some futures, such as those for indices are not deliverable at all. These are referred to as cash settlement contracts. Holders either pay or receive the difference between the value of the contract when initiated and when settled.
Futures markets have three fundamental purposes.
The first purpose is to enable hedgers to shift price risk â€“ asset price volatility â€“ to speculators in return for basis risk â€“ changes in the difference between a futures price and the cash, or current spot price of the underlying asset.
Facilitate the aquisition of operating capital
The second fundamental purpose of a futures market is to facilitate firmsâ€™ acquisitions of operating capital â€“ short term loans that finance firmsâ€™ purchases of intermediate goods such as inventories of grain or petroleum. For example, lenders are relatively more likely to finance, at or near prime lending rates, hedged (versus non-hedged) inventories. The futures contract is an efficient form of collateral because it costs only a fraction of the inventoryâ€™s value, or the margin on a short position in the futures market.
Speculators make the hedge possible because they absorb the inventoryâ€™s price risk; for example, the ultimate counterparty to the inventory dealerâ€™s short position is a speculator. In the absence of futures markets, hedgers could only engage in forward contracts â€“ unique agreements between private parties, who operate independently of an exchange or clearinghouse. Hence, the collateral value of a forward contract is less than that of a futures contract.
Provide market information
The third fundamental purpose of a futures market is to provide information to decision makers regarding the marketâ€™s expectations of future economic events. So long as a futures market is efficient â€“ the market forms expectations by taking into proper consideration all available information â€“ its forecasts of future economic events are relatively more reliable than an individualâ€™s. Forecast errors are expensive, and well informed, highly competitive, profit-seeking traders have a relatively greater incentive to minimize them.
Futures prices are linked with those of their underlying market. They do not, however, trade in lock step with the spot market. Because futures contracts by definition deal with future activities, they include a time related element which varies by market. This creates a spread between the spot price and the futures price.
Carry is the cost (or benefit) which the holder of an asset incurs between the time the futures agreement is made until the time of delivery, as well as the cost for delivery of that asset to the buyer. For example, one holding gold could have a storage cost, plus shipping. Other sources of carry include:
Other factors can come in to play in the spread. They are things which are thought to likely have an impact on the future price of the underlying. An example of this is in eurodollar futures. If the market believes the Federal Reserve will hike interest rates in the future, futures prices for forward months will be affected beyond the point where the interest rate move is likely to occur.
Among the other potential influencers are:
As a futures contract nears its expiration/delivery date, the spread between its price and the spot market price will narrow. This is referred to as convergence. It reflects both a decrease in the carry and a more certain set of expectations in terms of other influences.
Futures Underlying Markets
The use of futures has expanded rapidly to cover virtually every primary type of financial market. The primary ones in current trading are:
Futures contracts are regulated instruments which are transacted on an exchange. The exchange provides buyers and sellers the infrastructure (trading pits or their electronic equivalent), legal framework (trading rules, arbitration mechanisms), contract specifications (grades, standards, time and method of delivery, terms of payment) and clearing mechanisms necessary to facilitate efficient futures trading. Only exchange members are allowed to trade on the exchange. Nonmembers trade through futures commission merchants (FCMs) â€“ exchange members who service nonmember trades and accounts for a fee like stock brokerage firms.
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