Futures are Standardized forward contract agreements between buyers and a sellers to exchange an amount and grade of an item at a specific price and future date.

Because futures contracts are derived from underlying assets, they belong to a family of financial instruments called derivatives.

 

Purpose of Trading Futures

Futures markets have three fundamental purposes:

1_Hedging

The first purpose is to enable hedgers to shift price risk asset price volatility to speculators in return for basis risk changes in the difference between a futures price and the cash, or current spot price of the underlying asset.

2_Facilitate the acquisition of operating capital

The second fundamental purpose of a futures market is to facilitate firms acquisitions of operating capital short term loans that finance firms 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 inventorys value, or the margin on a short position in the futures market.

Speculators make the hedge possible because they absorb the inventorys price risk; for example, the ultimate counterparty to the inventory dealers short position is a speculator. In the absence of futures markets, hedgers could only engage in forward contracts 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_Provide market information

The third fundamental purpose of a futures market is to provide information to decision makers regarding the markets expectations of future economic events. So long as a futures market is efficient the market forms expectations by taking into proper consideration all available information. Its forecasts of future economic events are relatively more reliable than an individuals. Forecast errors are expensive, and well informed, highly competitive, profit-seeking traders have a relatively greater incentive to minimize them.

 

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:

• Commodities - agriculturals, livestock, metal, energy products, etc.
• Financial instruments - fixed income and similar types of markets
• Foreign exchange rates - currencies
• Equities - single stock futures
• Index - stock market, commodity, currency, and others

Futures Trading

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) – exchange members who service nonmember trades and accounts for a fee like stock brokerage firms.

Futures Exchanges

• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)
• Eurex
• CBOE Futures Exchange (CFE)
• New York Board of Trade (NYBOT)
• New York Mercantile Exchange (NYMEX)
• London International Financial Futures and Options Exchange (LIFFE)
• Commodities Exchange (COMEX)