What Is a Futures Contract?

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What Is a Futures Contract?

A futures contract is an agreement to either buy or sell an asset on a publicly-traded exchange. The contract specifies when the seller will deliver the asset. The asset is a commodity, stock, bond, or currency. The contract also sets the price. Most contracts allow a cash settlement instead of the physical delivery of the asset. 

How Does a Futures Contract Work?

Future contracts are traded on a public exchange. These include the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange. These are all now owned by the CME Group.

The Commodities Futures Trading Commission (CFTC) regulates all these futures exchanges. Buyers and sellers must register with the CFTC.

The role of the exchange is important in providing a safer trade. The contracts go through the exchange's clearinghouse. Technically, the clearinghouse buys and sells all contracts. 

Futures exchanges make contracts easier to buy and sell by making them fungible. That means they are interchangeable.

Contracts must be for the same asset, quantity, and quality. They must also be for the same delivery month and location.

Fungibility allows the buyers to "offset" contracts. That's when they buy and then subsequently sell the contracts. It allows them to pay off or extinguish the contract before the agreed-upon date. For that reason, futures contracts are derivatives.

Key Takeaways

  • A futures contract is an agreement to trade an asset at a certain price on a specified date
  • Futures contracts allow companies to offset the risk of a future price change
  • They are used in commodities and financials

Types of Futures Contracts

Futures contracts are written for commoditiesstocksbonds, or currencies.

Commodities 

Commodities are hard assets ranging from wheat to gold to oil. The U.S. government defines commodities in the 1936 Commodity Exchange Act.

Investing in commodities futures is risky because prices are very volatile. Investors must know the market very well to avoid large losses.

The most important is the oil futures contract because they determine oil prices. Those are the basis for all gasoline prices. Oil prices determine at least half of the price of each gallon of gas. A rise in oil prices will raise the pump price as well. Other energy-related futures contracts are written on natural gas, heating oil, and RBOB gasoline.

Commodities contracts are also written on metals. These include precious metals, such as gold, silver, copper, and platinum. They also include aluminum, steel, iron, and even scrap metal.

Commodities contracts are also used on agricultural products and livestock. These include corn, soybeans, wheat as well as cattle, hogs, and milk. These futures allow farmers and others in food production to guarantee the price they will receive for their product. This protects them from the impact of weather, disease, and changing consumer diets.

Financials

Treasury futures trade U.S. government notes and bonds. Most U.S. Treasury futures contracts have a face value at maturity of $100,000. The 2-year and 3-year U.S. Treasury futures contracts have a face value at maturity of $200,000. 

Traders invest in futures when they sense a shift in the economic trend. If they think rates will drop, then buy a futures contract. They would sell the contract at tomorrow's higher price, pocketing the profit.

When interest rates fall, the value of Treasurys rise.

Futures contracts are also written on eurodollars. Traders are protecting themselves from future changes in U.S. interest rates. Eurodollars are U.S. dollars deposited in commercial banks in foreign countries. They follow the Libor rate. The trader is hoping to take advantage of profitable differences between Libor and U.S. interest rates.

Futures Contract Versus Other Similar Agreements

Forward Contract

The forward contract is a more personalized form of a futures contract. The delivery time and amount are customized to address the particular needs of the buyer and seller. since they are customized, they are traded over-the-counter (OTC) or off-exchange. Since they aren't traded on an exchange, they carry a higher rate of default risk.

Forward Rate Agreement

A forward rate agreement is an over-the-counter forward contract. It is written on a short-term interest rate. The buyer of an FRA is a "notional borrower." That means the buyer commits to pay a fixed rate of interest on some amount that is never actually exchanged. The seller of an FRA agrees notionally to lend a sum of money to a borrower. Investors use FRAs to hedge interest rate risk or to speculate on future changes in interest rates. 

Futures Option

A futures option gives the purchaser the right, or option, to buy or sell a futures contract. It specifies both the date and the price. Contracts on options are commonly set for a month or more. Weekly contracts are becoming popular for those who like to wager on short-term events.

Futures options cost less than purchasing an actual futures contract. This can reduce risk if used wisely. Options also allow for more diversification by participating in different asset classes.

How Futures Contracts Affect the Economy

Companies use futures contracts to lock in a guaranteed price for raw materials such as oil. Farmers use them to lock in a sales price for their livestock or grain. Futures contracts guarantee they can buy or sell the goods at a fixed price. They plan to transfer possession of the goods under the contract. The agreement also allows them to know the revenue or costs involved. For them, the contracts reduce a significant amount of risk.

Hedge funds use futures contracts to gain more leverage in the commodities market. They have no intention of transferring any commodity. Instead, they plan to buy an offsetting contract at a price that will make them money. In a way, they are betting on the future price of that commodity. Price assessment and price forecasts for raw materials are how commodities futures affect the economy. Traders and analysts determine these values.

Article Sources

  1. CME Group. "Definition of a Futures Contract." Accessed June 4, 2020.

  2. United States Commodity Futures Trading Commission. "History of the CFTC." Accessed June. 4, 2020.

  3. United States Commodity Futures Trading Commission. "Commodity Exchange Act & Regulations." Accessed June 4, 2020.

  4. U.S. Energy Information Administration. "Gasoline Explained." Accessed June 4, 2020.

  5. CME Group. "Metals Products Home." Accessed June 4, 2020.

  6. CME Group. "Agricultural Products Home." Accessed June 4, 2020.

  7. CME Group. "The Livestock Overview." Accessed June 4, 2020.

  8. CME Group. "The Basics of U.S. Treasury Futures." Accessed June 4, 2020.

  9. CME Group. "Introduction to Eurodollar Futures and Options." Accessed June 4, 2020.

  10. CME Group. "Futures Contracts Compared to Forwards." Accessed June 4, 2020.

  11. FinCAD. "Forward Rate Agreements." Accessed June 4, 2020.

  12. CME Group. "Why Options on Futures Gives Added Benefit of Diversifying Risk." Accessed June 4, 2020.