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Future trading

Uncertainly : Need for a future

Futures markets wouldn’t possibly exist, if the markets had no uncertainty. In an ideal market condition, there is no unknown risk, and therefore no hedging is needed. At the same time if risk doesn’t exist, there is no speculation, at least theoretically.

But, the international markets have become more and more uncertain, interrelated and dependent on domestic and international events. This has led to increased volatility and uncertainty. Naturally then, there are parties who want to avoid risk at a later date; and there are parties who would like to speculate and take risk. Both sides – Risk avoiders and Risk takers, have their own arguments in favor of their strategies, as well as they have their own mathematical models to forecast various market scenarios.

Classic Definition

A Futures contract is a standard agreement between a Buyer and a Seller to exchange an amount and an item (or items) for a specific price at a future date. Although the contract is written in present, its settlement will happen in future, hence the name. The contract is legally binding on both the parties to honor the terms & conditions at the settlement time. The item (or items) encapsulated inside the contract is/are referred to as Asset, or Underlying, or Reference Entity. Because the futures derive their value from the underlying, they belong to a family of financial instruments referred to as Derivatives. .

Pupose and Makets

Generally speaking, Futures serve three main purposes:

»	Risk shifting – Parties who wish to hedge (protect against) Price Risk (volatility of the Underlying) can shift such risk to speculators (people with a favorable view of the markets in future) for a Basis risk (§)
»	Raise Operating capital at low-price – Allows corporations to raise Operating capital (short term loans) that help finance a firm’s purchases of short term consumption goods. Lenders would also be more open to finance such transactions backed by inventories
»	Forecast probabilities and expectations of future economic events – If the Future markets are efficient, the forecasts of future economic events can be forecasted using mathematical models

Basis risk

Risk arising due to a possibility of a negative difference between the CASH or current price (SPOT) of the underlying

Futures as in History

Futures in United States date to early 1800’s when Farmers, Grain markets and dealer/brokers used to trade grains for later delivery dates. In May of 1865, Chicago Board of Trade started to transform its homogeneous forward commodity forwards into its first set of Future contracts. In 1936, Commodity Exchange act was passed that regulated the Futures trading markets. Other than physical commodities, Futures extended to Currency (1972); Interest Rate (1975) and Stock indexes (1982).

In 1974, Commodity Futures Trading act was passed which established the Commodity Futures Trading Commission (CFTC) to regulate and standardize the Futures markets. Although, agricultural and commodity futures are still popular, in today’s markets Financial & Energy futures as well as Options are heavily traded. Futures of Metals (Bullion/Non-Bullion); Non-metals as well as Minerals are also traded.

Today's Futures

Futures have shaped and changed quite well in last couple of years. Today almost 85% of the trading is placed on electronic exchanges. Roughly 99% of all future contracts are settled prior to maturity. Also, cash settlement is very popular. Also, the Futures exchanges are also publicly traded, eg. CME (Chicago Mercantile Exchange).

Following table shows some futures that are traded in modern times