Futures Contract

A futures contract is a standardized agreement, traded on an organized exchange, to buy or sell a specified quantity of an asset at a price agreed today, for delivery or cash settlement on a set date in the future. The asset may be a commodity such as wheat or crude oil, a currency, a government bond, an interest rate, a stock index or a cryptocurrency. A clearing house stands between buyer and seller, becoming the counterparty to each, and collects margin from both sides so that losses are covered as prices move. These features distinguish futures from a forward contract, which is a private, customized agreement between two parties.

Futures are used both to hedge price risk and to speculate, and futures markets are an important source of publicly observed prices for many commodities and financial assets.

Forward trading in commodities has ancient roots, and the Dojima rice market in Osaka, Japan, operated an organized futures-like market in the eighteenth century. The modern futures market grew from the Chicago Board of Trade, founded in 1848, which introduced standardized contracts for grain in the 1860s. Financial futures arrived in the 1970s: currency futures began trading on the International Monetary Market of the Chicago Mercantile Exchange in 1972, shortly after the breakdown of the Bretton Woods system, followed by interest rate and stock index futures. In the United States futures markets are regulated by the Commodity Futures Trading Commission, established in 1974.

Each exchange defines the contract specification: the underlying asset, the contract size, the price increment, the delivery months and the settlement method. Traders only negotiate price and quantity. Once a trade is executed, the clearing house, a type of central counterparty, replaces the original counterparties through novation.

Both sides post initial margin, a deposit sized to cover likely one-day losses. Positions are marked to market at least daily, and gains and losses are paid in cash as variation margin. If a trader's account falls below the maintenance level, the broker issues a margin call, and positions that are not funded can be closed. Collateral other than cash may be accepted at a haircut. Most futures are closed out before expiry by an offsetting trade; only a small fraction result in physical delivery.

Example

A US importer expecting to pay euros in three months buys one euro FX futures contract on CME, which covers EUR 125,000, at 1.1000 US dollars per euro, giving a notional amount of USD 137,500. If the futures price rises to 1.1200 by expiry, the importer gains 0.0200 × 125,000, or USD 2,500, through daily variation margin, offsetting the higher cost of buying euros in the spot market. If the price falls, the importer pays variation margin but buys euros more cheaply. The hedge is imperfect if the payment date or amount does not match the contract, a mismatch known as basis risk.

• Futures are standardized and exchange-traded; forwards are bilateral and customized.
• Futures carry clearing house credit risk and daily cash settlement; forwards carry bilateral counterparty risk and typically settle at maturity.
• An options contract gives a right but not an obligation, for which the buyer pays a premium; a futures contract obliges both sides.

Futures prices are linked to spot prices through arbitrage, based on the cost of carrying the asset until delivery. In currency markets this means futures prices reflect interest rate differentials, much as forward rates do.

Cryptocurrency exchanges popularized perpetual futures, which have no expiry date and are kept close to the spot price by periodic funding payments between long and short holders. Many crypto derivatives venues operate outside traditional futures regulation, and high leverage combined with automated liquidation has produced large losses during volatile periods.

Leverage magnifies gains and losses: a small margin deposit controls a large position. Margin calls can force traders to find cash quickly in stressed markets, contributing to liquidity spirals, and the concentration of risk in clearing houses means their resilience is a matter of systemic importance. Regulators also watch futures markets for manipulation, such as cornering a deliverable supply. Defenders note that futures improve price discovery and give producers and consumers an efficient way to transfer price risk to those willing to bear it.