Futures Contract

Definition

Wine bottle and glass
What will be the future price
of a Bordeaux primeur?

A futures contract is a standardized contract traded on an organized market to secure or commit to a price for a specified quantity of a given product (the underlying) at a future date. There is a wide range of contracts whose characteristics are predetermined according to the needs expressed by economic agents:

  • The underlying may be a commodity: wheat, oil, metals, etc. or a financial instrument: rate, price, stock market index, etc.
  • The quantity (in the case of commodities) or the nominal (financial products)
  • The method of quotation: in percentage or value
  • The minimum variation in price (the "tick")
  • The maturities
  • The method of liquidation: by delivery of the underlying (the least frequent case) or in cash

Example: Winefex® was a future contract on Bordeaux wine launched by Euronext.

  • The underlying is a primeur Bordeaux wine chosen from well-known or even prestigious appellations (Saint-Estèphe, Margaux,...)
  • The quantity of a contract is fixed at 5 cases of 12 bottles of 75 centilitres each.
  • The price is expressed in Euro per bottle.
  • The minimum price variation is €0.1 per bottle or €6 per contract
  • Deadlines are set in November, March, May, July and September
  • The contract may be settled by actual delivery of the wine by the seller or in cash at the closing price of the maturity date.

An organised market

Futures contracts are traded exclusively on official and regulated markets (Matif, Liffe, CBOT, Eurex...). Only market members have access to trading. Open outcry trading, once practiced on the CBOT (Chicago Board Of Trade), is virtually abandoned for electronic trading.

Buyers and sellers may possibly know each other during the negotiation, or it may be completely anonymous. In any case, when trades are executed, it is the clearing house that comes in and becomes the buyer for all the sellers and the seller for all the buyers.

The clearing house therefore assumes the counterparty risk for the participants. To do so, each participant must pay the clearing house a security deposit at the execution of each negotiation. These security deposits are revalued daily on the basis of the market value of the positions held by the participant (they are said to be "marked to market").

The difference (daily clearing rate - previous day's clearing rate) > 0 is paid by the sellers to the clearing house, which then passes it back to the buyers. These are the margin calls. Futures markets thus have the particularity that the result of each trade is calculated and collected or paid daily.

At maturity, the contracts are liquidated as provided for in the specifications, either by actual delivery of the underlying by the seller, or in cash at market price, with sellers then paying buyers the value achieved by contracts on the day of liquidation. But above all, participants have the possibility at any time to "unwind" their position by buying (or selling) the same quantity of contracts originally sold (or bought), which makes their position disappear.

It is important to note that the price of futures closely follows the prices of the underlying asset. The closer you get to maturity, the more the two markets (the spot market and the futures market) tend to converge.

Use of futures

For an economic agent seeking protection against the risk of fluctuations in commodity prices or financial indicators, futures allow the price of the underlying asset to be fixed in advance. In the example of the "Winefex" mentioned above, wine producers who want to hedge against a fall in wine prices when they put their production of the year up for sale can therefore forward sell contracts. On the other hand, wine merchants will eventually buy contracts.

Example: A Bordeaux wine producer plans to put his production up for sale in November of the current year. He therefore sells an appropriate quantity of contracts for this deadline. Whatever the price of Bordeaux wine in November, he is assured that he can sell his production at the price negotiated when the contracts are sold. In return, he loses the opportunity to benefit from a possible increase in the price of Bordeaux wine.

Not all participants in the futures market are looking for protection against price fluctuations. Speculators come to try to make profits by betting on price movements. If they anticipate a fall in prices, they sell contracts, thus realizing a capital gain by buying them back at a lower price when the maturity date approaches. Conversely, if they anticipate an increase in prices, they buy contracts, which allows them to resell them more expensive later.

If there were only "hedgers" (those who use futures as a hedging instrument) on the market, sellers would always offer the highest possible price, and buyers the lowest possible. The difference between the average price offered and the average price charged (the spread) would be very large at all times, and very few transactions could take place. Speculators interpose intermediate offers and thus provide liquidity to the market. To sum up, for a hedger to be able to hedge against the rise in prices, there must be a speculator in front of him who bets on the fall in prices!