Futures contract

A futures contract is a standardised, exchange-traded agreement obligating the buyer to purchase, and the seller to deliver, a specified quantity of an underlying asset at a predetermined price on a future date. Futures are widely used in commodity, financial and energy markets to hedge price risks, facilitate price discovery and support speculative trading strategies. Their standardisation, central clearing and regulatory oversight distinguish them from over-the-counter forward contracts, making them highly liquid instruments integral to global financial markets.

Background and Conceptual Foundations

Futures contracts originated in agricultural markets during the nineteenth century as a means for farmers and merchants to manage uncertainty arising from seasonal production cycles and volatile prices. Exchanges formalised contract terms, establishing standardised quantities, delivery grades and settlement procedures. This allowed traders to buy and sell contracts without negotiating bilateral terms, enhancing liquidity and reducing counterparty risk.
Modern futures markets now encompass a wide array of underlying assets, including commodities (such as oil, gold and wheat), financial instruments (equity indices, government bonds and interest rates), and currencies. The pricing of futures reflects expectations of future market conditions, storage costs, interest rates and other economic variables.
Central to the functioning of futures markets is the role of clearing houses, which guarantee contract performance and ensure the integrity of the trading system.

Structure and Key Features

Futures contracts exhibit several defining characteristics:

• Standardisation: Exchanges specify contract size, expiry months, quality or grade of deliverable assets, and delivery locations.
• Margin requirements: Traders must deposit an initial margin and maintain a minimum maintenance margin to cover potential losses.
• Daily settlement (marking to market): Gains and losses are credited or debited to trading accounts at the end of each trading day based on price movements.
• Central clearing: Clearing houses become the counterparty to every trade, effectively eliminating bilateral default risk.
• Exchange trading: Futures are traded on organised exchanges, ensuring transparency, liquidity and regulatory oversight.

These features support efficient trading and risk management across diverse market participants.

Types of Futures Contracts

Futures markets provide a broad range of contracts, classified by underlying asset:

• Commodity futures: Include crude oil, natural gas, gold, silver, grains, livestock and soft commodities such as coffee and sugar.
• Financial futures: Cover government bonds, short-term interest rates, equity indices (e.g., FTSE 100 futures) and volatility indices.
• Currency futures: Used to hedge or speculate on exchange rate movements between major currencies.
• Energy futures: Encompass electricity, oil products and emissions allowances.
• Environmental and weather futures: Emerging areas designed to manage climate-related risks.

The diversity of products enables market participants to hedge exposures or exploit market opportunities across multiple sectors.

Pricing of Futures Contracts

Futures pricing typically follows the cost-of-carry model, which incorporates:

• Spot price of the underlying asset
• Storage and insurance costs (for physical commodities)
• Interest rates, representing the opportunity cost of capital
• Convenience yield, reflecting the benefits of holding the physical asset

The theoretical relationship between spot and futures prices is central to arbitrage strategies. Deviations may occur during periods of supply disruption, high demand or market stress.
Futures markets operate under conditions known as:

• Contango: Futures prices exceed spot prices, often when storage costs or interest rates are high.
• Backwardation: Futures prices fall below spot prices, commonly seen in markets with supply shortages or strong current demand.

These conditions influence hedging decisions and trading strategies.

Uses and Applications

Futures contracts serve several important economic and financial functions:

• Hedging:
  • Producers may sell futures to lock in prices for future output.
  • Manufacturers or consumers of commodities hedge input costs.
  • Investors hedge portfolio risks using equity index futures.
  • Importers and exporters hedge currency exposures.
• Speculation:Traders anticipate price movements to profit from futures price changes, using leverage to amplify returns.
• Arbitrage:Arbitrageurs exploit price discrepancies between futures, spot markets and related instruments to earn risk-managed returns.
• Price discovery:Futures markets aggregate information on supply, demand and macroeconomic expectations, forming forward-looking price indicators.

These functions make futures indispensable tools in modern risk management and trading.

Margining and Risk Management

The margining system is central to maintaining market integrity:

• Initial margin ensures traders have sufficient capital at stake.
• Maintenance margin must be upheld; falling below it triggers a margin call.
• Mark-to-market adjusts account balances daily, limiting the accumulation of large losses.

This process protects clearing houses and reduces counterparty risk, enabling high participation levels even in volatile conditions.

Settlement and Delivery

Futures contracts may be settled through:

• Physical delivery: The underlying asset is exchanged at expiry according to contract specifications. This is common in some commodities.
• Cash settlement: No physical exchange occurs; traders settle differences between contract and settlement prices. Equity index futures typically follow this method.

Most futures positions are closed out before expiry through an offsetting trade rather than held to settlement.

Advantages of Futures Contracts

Futures offer numerous benefits:

• High liquidity in major contracts enables efficient entry and exit.
• Leverage allows significant exposure with relatively small capital outlay.
• Low counterparty risk due to central clearing.
• Cost-effectiveness compared to alternative hedging instruments.
• Transparency through exchange-traded pricing and reporting.

These characteristics attract both institutional and retail participants.

Risks and Limitations

Despite their benefits, futures contracts entail several risks:

• Leverage risk: Gains and losses are magnified, potentially leading to rapid capital erosion.
• Market volatility: Futures prices can fluctuate significantly, affecting both hedgers and speculators.
• Basis risk: The futures price may not move perfectly in line with the underlying asset, affecting hedge effectiveness.
• Liquidity risk: Certain contracts or delivery months may have limited trading activity.
• Margin calls: Adverse movements may require additional capital to maintain positions.