A futures contract is a standardised agreement (a forward contract) between a buyer and a seller to exchange an amount and grade of an item at a specific price and future date. The item or underlying asset may be an agricultural commodity, a metal, mineral or energy commodity, a financial instrument or a foreign currency. Because futures contracts are derived from these underlying assets, they belong to a family of financial instruments called derivatives.
Traders buy and sell futures contracts on an exchange Ã¢â¬â a marketplace that is operated by a voluntary association of members. 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 futures trading. Only exchange members are allowed to trade on the exchange. Nonmembers trade through commission merchants Ã¢â¬â exchange members who service nonmember trades and accounts for a fee.
The September 2004 light sweet crude oil contract is an example of a petroleum (mineral) future. It trades on the New York Mercantile exchange (NYM). The contract is standardized Ã¢â¬â every one is an agreement to trade 1,000 barrels of grade light sweet crude in September, on a day of the sellerÃ¢â¬â¢s choosing.
Futures markets have three fundamental purposes. The first is to enable hedgers to shift price risk Ã¢â¬â asset price volatility Ã¢â¬â to speculators in return for basis risk Ã¢â¬â changes in the difference between a futures price and the cash, or current spot price of the underlying asset. Because basis risk is typically less than asset price risk, the financial community views hedging as a form of risk management and speculating as a form of risk taking.
Generally speaking, to hedge is to take opposing positions in the futures and cash markets. Hedgers include (but are not restricted to) farmers, feedlot operators, grain elevator operators, merchants, millers, utilities, export and import firms, refiners, lenders, and hedge fund managers. Meanwhile, to speculate is to take a position in the futures market with no counter-position in the cash market. Speculators may not be affiliated with the underlying cash markets.
To demonstrate how a hedge works, assume Hedger A buys, or longs, 5,000 bushels of corn, which is currently worth $2.40 per bushel, or $12,000=$2.40x5000; the date is May 1st and Hedger A wishes to preserve the value of his corn inventory until he sells it on June 1st. To do so, he takes a position in the futures market that is exactly opposite his position in the spot Ã¢â¬â current cash Ã¢â¬â market. For example, Hedger A sells, or shorts, a July futures contract for 5,000 bushels of corn at a price of $2.50 per bushel; put differently, Hedger A commits to sell in July 5,000 bushels of corn for $12,500=$2.50x5000. Recall that to sell (buy) a futures contract means to commit to sell (buy) an amount and grade of an item at a specific price and future date.
Absent basis risk, Hedger AÃ¢â¬â¢s spot and futures markets positions will preserve the value of the 5,000 bushels of corn that he owns, because a fall in the spot price of corn will be matched penny for penny by a fall in the futures price of corn. For example, suppose that by June 1st the spot price of corn has fallen five cents to $2.35 per bushel. Absent basis risk, the July futures price of corn has also fallen five cents to $2.45 per bushel.
So, on June 1st, Hedger A sells his 5,000 bushels of corn and loses $250=($2.35-$2.40)x5000 in the spot market. At the same time, he buys a July futures contract for 5,000 bushels of corn and gains $250=($2.50-$2.45)x5000 in the futures market. Notice, because Hedger A has both sold and bought a July futures contract for 5,000 bushels of corn, he has offset his commitment in the futures market.
This example of a textbook hedge Ã¢â¬â one that eliminates price risk entirely Ã¢â¬â is instructive but it is also a bit misleading because: basis risk exists; hedgers may choose to hedge more or less than 100% of their cash positions; and hedgers may cross hedge Ã¢â¬â trade futures contracts whose underlying assets are not the same as the assets that the hedger owns. So, in reality hedgers cannot immunise entirely their cash positions from market fluctuations and in some cases they may not wish to do so. Again, the purpose of a hedge is not to avoid risk, but rather to manage or even profit from it.
The second fundamental purpose of a futures market is to facilitate firmsÃ¢â¬â¢ acquisitions of operating capital Ã¢â¬â short term loans that finance firmsÃ¢â¬â¢ 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 contact is an efficient form of collateral because it costs only a fraction of the inventoryÃ¢â¬â¢s value, or the margin on a short position in the futures market.
Speculators make the hedge possible because they absorb the inventoryÃ¢â¬â¢s price risk; for example, the ultimate counterparty to the inventory dealerÃ¢â¬â¢s short position is a speculator. In the absence of futures markets, hedgers could only engage in forward contracts Ã¢â¬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.3
The third fundamental purpose of a futures market is to provide information to decision makers regarding the marketÃ¢â¬â¢s expectations of future economic events. So long as a futures market is efficient Ã¢â¬â the market forms expectations by taking into proper consideration all available information Ã¢â¬â its forecasts of future economic events are relatively more reliable than an individualÃ¢â¬â¢s. Forecast errors are expensive, and well informed, highly competitive, profit-seeking traders have a relatively greater incentive to minimize them.