5.2 Futures contracts

Definition of futures contracts

A futures contract is a standardized agreement to buy or sell a specific asset at a predetermined price on a set future date. Unlike options, both parties are obligated to follow through on the transaction. These contracts are central to derivatives pricing and portfolio management because they enable risk transfer and transparent price discovery.

Key characteristics

• Both parties must complete the transaction at the specified date (no choice to walk away)
• Traded on organized exchanges, which ensures liquidity and price transparency
• Require margin deposits to reduce counterparty risk
• Let investors gain exposure to asset price movements without owning the underlying asset
• Widely used for hedging against adverse price movements

Standardization aspects

Futures contracts aren't negotiated between buyer and seller. The exchange sets every detail:

• Contract quantity, quality, and delivery location are all predetermined
• Expiration dates are typically quarterly (March, June, September, December)
• Tick sizes define the minimum price movement and vary by contract
• Settlement procedures are overseen by clearing houses, not left to the counterparties

This standardization is what makes futures fungible, meaning any contract of the same type is interchangeable with another, which is critical for liquidity.

Types of futures contracts

Futures span a wide range of underlying assets. The pricing models and hedging techniques you'll use differ depending on the type, so it's worth knowing the major categories.

Financial futures

• Stock index futures track indices like the S&P 500 or NASDAQ-100
• Interest rate futures derive value from rate changes (e.g., Treasury bond futures, Eurodollar futures)
• Currency futures hedge against foreign exchange rate fluctuations
• Volatility futures are based on implied volatility indices like the VIX
• Credit futures are linked to credit default swap indices or bond indices

Commodity futures

• Energy: crude oil, natural gas, electricity
• Agricultural: grains, livestock, and soft commodities (coffee, cocoa, sugar)
• Metals: precious metals (gold, silver) and industrial metals (copper, aluminum)
• Environmental: emissions credits and weather derivatives
• Lumber: used for construction and housing market hedging

Futures pricing models

Pricing models sit at the core of futures valuation. They tell you what a futures contract should cost based on current market conditions, and they're how you spot arbitrage opportunities.

Cost of carry model

This model calculates the theoretical futures price from the current spot price plus the costs of "carrying" the asset until delivery. The formula is:

$F_t = S_t \cdot e^{(r + s - y)(T - t)}$

Where:

• $F_t$ = futures price
• $S_t$ = current spot price
• $r$ = risk-free interest rate
• $s$ = storage costs (as a continuous rate)
• $y$ = convenience yield (the benefit of physically holding the asset)
• $T - t$ = time to maturity

The logic: you're paying the spot price now, financing that purchase at rate $r$, paying to store it at rate $s$, but subtracting the convenience yield $y$ if holding the physical asset has value (e.g., a refinery holding crude oil can keep production running). This model applies mainly to storable commodities and financial instruments.

Arbitrage-free pricing

The no-arbitrage principle says that futures prices should not allow risk-free profit. If the futures price drifts away from its theoretical value, arbitrageurs will trade the spot and futures markets simultaneously until the gap closes.

For specific asset types, the no-arbitrage condition adjusts:

• Stock index futures account for dividends paid by the index components
• Currency futures incorporate interest rate differentials between the two currencies (covered interest rate parity)
• Put-call parity links futures prices to options prices, providing another consistency check

These relationships form the foundation for more complex derivatives pricing.

Futures vs forward contracts

Futures and forwards both lock in a future price, but they differ in important structural ways. Choosing between them depends on your need for standardization, credit protection, and flexibility.

Standardization differences

• Futures trade on organized exchanges with fixed contract sizes, delivery dates, and publicly visible prices
• Forwards are customized OTC agreements where the two parties negotiate size, delivery date, and asset specifications
• Forward prices may be less transparent since they don't trade on a public exchange

Settlement differences

This is the biggest practical distinction:

• Futures are marked to market daily. Gains and losses flow through your margin account every day
• Forwards typically settle only at maturity, meaning no cash changes hands until the end
• Futures require margin accounts and can trigger daily margin calls; forwards often don't require margin, which increases counterparty risk
• Futures use a clearing house as the central counterparty, virtually eliminating default risk; forwards rely on the creditworthiness of whoever is on the other side

Because of daily settlement, futures and forward prices on the same underlying can differ slightly when interest rates are stochastic (correlated with the underlying asset price). For most practical purposes in an intro course, though, they're treated as approximately equal.

Futures exchanges and clearing houses

Role of exchanges

Exchanges provide the infrastructure that makes futures trading possible:

• Centralized marketplace where buyers and sellers meet
• Set and enforce standardized contract specifications
• Disseminate real-time price data
• Implement trading rules to maintain fair and orderly markets
• Monitor for potential market manipulation or abuse

Major examples include the CME Group (Chicago Mercantile Exchange), ICE (Intercontinental Exchange), and Eurex.

Clearing house functions

The clearing house is arguably the most important institution in futures markets. It steps between every trade, becoming the buyer to every seller and the seller to every buyer. This is called novation.

Its responsibilities include:

• Managing the daily mark-to-market process
• Calculating and collecting margin requirements
• Facilitating delivery or cash settlement at expiration
• Implementing risk management procedures to protect against member defaults
• Providing a trade guarantee that effectively eliminates counterparty risk

Margin requirements

The margin system is what keeps futures markets financially sound. It ensures that both sides of a trade have enough capital to cover potential losses.

Initial margin

The initial margin is the upfront deposit required to open a futures position. Think of it as a performance bond, not a down payment.

• Typically ranges from 3-12% of the total contract value, depending on the asset's volatility
• Calculated based on historical price movements and potential risk (exchanges often use models like SPAN)
• Can be posted in cash or acceptable securities such as Treasury bills

Maintenance margin

The maintenance margin is the minimum balance you must keep in your account while holding an open position.

• Usually set at about 75-80% of the initial margin
• Monitored daily by the clearing house and your broker
• If your account drops below this level, you'll receive a margin call

Margin calls

When your account balance falls below the maintenance margin:

1. Your broker issues a margin call
2. You must deposit enough funds to bring the account back up to the initial margin level (not just the maintenance level)
3. This must typically be done within 24 hours
4. If you fail to meet the call, the broker will liquidate your position

This mechanism prevents losses from accumulating unchecked and protects the overall market.

Mark-to-market process

Mark-to-market is the daily procedure that distinguishes futures from most other financial contracts. It converts paper gains and losses into real cash flows every single day.

Daily settlement

Here's how it works:

1. At the end of each trading day, the exchange determines a settlement price (based on closing prices or a calculated benchmark)
2. Each open position is revalued at this new settlement price
3. The change from the previous day's settlement price determines the day's profit or loss
4. Gains are credited to the winning side's margin account; losses are debited from the losing side's account

This daily true-up means you never build up a large unrealized loss (or gain) over the life of the contract.

Variation margin

Variation margin is the daily cash flow resulting from mark-to-market:

• Calculated as: (today's settlement price - yesterday's settlement price) × contract size × number of contracts
• Positive variation margin = profit for that day; negative = loss
• Transferred between accounts through the clearing house
• Reinforces the zero-sum nature of futures: one party's gain is exactly the other's loss

Futures trading strategies

Hedging with futures

Hedging uses futures to reduce or eliminate price risk in a position you already hold (or plan to take).

• Short hedge: You own the asset and sell futures to protect against a price decline. Example: a farmer sells wheat futures to lock in a price before harvest.
• Long hedge: You plan to buy the asset and buy futures to protect against a price increase. Example: an airline buys jet fuel futures to stabilize input costs.
• Cross-hedge: When no futures contract exists for your exact asset, you use a correlated contract instead. This introduces basis risk, the risk that the futures price and your asset's price don't move in perfect lockstep.

Determining the right hedge ratio (how many contracts to use) requires careful analysis, often using regression of spot price changes on futures price changes.

Speculation using futures

Speculators aim to profit from price movements without any underlying exposure to hedge.

• Futures offer high leverage because margin requirements are a small fraction of contract value. A 5% margin means a 1% price move creates a 20% return (or loss) on your margin.
• Strategies include directional bets (long or short), spread trading (buying one contract month and selling another), and momentum or contrarian approaches
• The leverage cuts both ways, so risk management is critical
• Common users include hedge funds, proprietary trading firms, and commodity trading advisors (CTAs)

Futures contract specifications

Contract size

Contract size defines how much of the underlying asset one contract represents. Some examples:

• Corn futures: 5,000 bushels per contract
• Treasury bond futures: $\$100{,}000$ face value per contract
• E-mini S&P 500 futures: $\$50$ × the index level

E-mini and micro contracts offer smaller sizes for retail traders or more precise hedging. Larger contracts generally have lower transaction costs per unit of the underlying.

Delivery terms

For physically delivered contracts, the exchange specifies:

• Quality standards (e.g., grade of crude oil, purity of gold)
• Acceptable delivery locations and any price adjustments for location differences
• The delivery process, including notice dates and delivery windows

These details matter most if you hold a position into the delivery period.

Expiration dates

• Mark the final trading day and settlement date
• Most follow a quarterly cycle (March, June, September, December), though some have monthly expirations for near-term months
• As expiration approaches, the futures price converges toward the spot price
• Traders who want to maintain exposure must roll their position by closing the expiring contract and opening the next one

Futures market participants

Hedgers

Hedgers use futures to offset risk in their core business or portfolio. They take positions opposite to their real-world exposure. A wheat farmer (who is naturally long wheat) sells wheat futures. A cereal manufacturer (who needs to buy wheat) buys wheat futures. Portfolio managers use index futures to quickly adjust market exposure.

Speculators

Speculators take on the risk that hedgers want to shed, and they do so hoping to profit. They provide liquidity and play a major role in price discovery. Their strategies range from fundamental analysis to quantitative models to high-frequency trading.

Arbitrageurs

Arbitrageurs exploit price discrepancies between related markets. For example, if the futures price deviates from the cost-of-carry model's fair value, an arbitrageur can simultaneously trade the spot and futures markets to lock in a risk-free profit. This activity pushes prices back into alignment and keeps markets efficient. Modern arbitrage often relies on sophisticated algorithms and high-speed execution.

Futures contract termination

There are three ways a futures position can end.

Offsetting positions

This is by far the most common method. You close your position by entering an equal and opposite trade in the same contract. If you're long 10 December corn futures, you sell 10 December corn futures. Your net position goes to zero, and you realize your cumulative profit or loss. No delivery takes place.

Physical delivery

A small percentage of contracts (mainly in commodity markets) result in actual delivery of the underlying asset. The seller delivers the commodity; the buyer takes ownership. This process involves delivery notices, inspections, and documentation. Physical delivery is what forces futures prices to converge with spot prices at expiration.

Cash settlement

For contracts where physical delivery is impractical (stock index futures, interest rate futures), the contract settles with a final cash payment. The payment equals the difference between the contract price and a defined settlement price (often based on a specific index value). This simplifies expiration and avoids delivery logistics.

Futures pricing and spot prices

The relationship between futures prices and expected future spot prices reveals market expectations about supply, demand, and carrying costs.

Contango

Contango occurs when the futures price exceeds the current spot price (or more precisely, the expected future spot price). This is the "normal" situation for many commodities because it reflects the cost of carry: storage, insurance, and financing.

• The futures curve slopes upward (longer-dated contracts cost more)
• As a contract approaches expiration, its price tends to decline toward the spot price
• Investors who hold long futures positions and repeatedly roll them forward face negative roll yield in contango, since they're selling cheaper expiring contracts and buying more expensive ones

Backwardation

Backwardation occurs when the futures price is below the current spot price (or expected future spot price). This can happen when:

• There's a current supply shortage driving spot prices up
• The convenience yield of holding the physical commodity is high
• The market expects future prices to fall
• The futures curve slopes downward
• Long futures positions benefit from positive roll yield in backwardation, since you roll from a higher-priced expiring contract into a cheaper one

Futures and risk management

Portfolio risk reduction

Futures are one of the fastest and cheapest ways to adjust portfolio risk:

• Hedge systematic risk by selling index futures to reduce market beta
• Adjust interest rate sensitivity using Treasury futures
• Implement tactical asset allocation shifts without buying or selling the underlying securities
• Separate alpha (skill-based returns) from beta (market exposure) in investment strategies

The key advantage: you can manage risk without disturbing your underlying holdings.

Corporate risk management

Companies use futures to stabilize cash flows and reduce earnings volatility:

• Commodity risk: A manufacturer locks in raw material costs; a producer locks in selling prices
• Currency risk: An exporter hedges foreign currency receivables
• Interest rate risk: A company with floating-rate debt uses interest rate futures to effectively fix its borrowing cost
• Equity risk: Firms hedge stock-based compensation exposure with index futures

Regulatory framework

CFTC oversight

The Commodity Futures Trading Commission (CFTC) is the primary regulator of U.S. futures markets. Its responsibilities include:

• Setting rules for exchanges, clearing houses, and market participants
• Monitoring for market manipulation and abusive trading practices
• Enforcing position limits to prevent cornering and excessive speculation
• Requiring registration and compliance from futures commission merchants (FCMs) and other intermediaries

Position limits

Position limits cap the number of contracts any single entity can hold in a particular market. They exist to prevent manipulation and keep markets orderly.

• Set by exchanges and/or the CFTC, depending on the contract
• Vary based on the underlying commodity and current market conditions
• Hedge exemptions allow commercial entities engaged in bona fide hedging to exceed speculative limits
• Large traders must report their positions, and brokers are responsible for monitoring compliance